The Three Fund Portfolios.

Less control, but more simplicity.

This will be the first of three postings on the use of mutual funds.  The next posting will address a core portfolio of mutual funds.  It will be followed by a posting on how to use mutual funds to supplement domestic (US in this case) stocks.  However, this posting has to first address the decision whether to buy stocks and bonds directly or use mutual funds.

So far this year, previous postings addressed managing a portfolio that holds actual stocks.  Many people believe it is easier to pick a mutual fund than a few stocks.  It is hard to understand why people think it is easier to pick a manager for a mutual fund than to recognize a few good businesses.  Nevertheless, that is the case for many people.

When one first starts, the total amount of the portfolio may not seem large enough to justify the purchase of a number of stocks.  A mutual fund may provide diversification that would not otherwise be available. In some cases, mutual funds are the only accessible option for the individual.  For example, many people have 401(k)s that restrict them to mutual funds.  Perhaps they are forced to become comfortable with mutual funds. 

Regardless of why people prefer to build portfolios of mutual funds, they do. Consequently, a portfolio of mutual funds is worth discussing .  An April 20, 2011 posting entitled “Investing PART 13: Mutual funds” discussed issues related to mutual funds, as well as some legitimate uses of mutual funds, but it never addressed constructing a portfolio of mutual funds. 

Nothing that follows should be taken as an endorsement of mutual funds.  As stated in the posting cited above, “They are an extremely inefficient, hard to analyze, and risky way to invest in certain asset classes that should be the major focus of individual investors.”  Despite their limitations, if used carefully and used with an understanding of their limitations, mutual funds can play an important role in an investor's portfolio. 

They can be used to achieve diversification with less capital.  They also can be used to achieve diversification into areas where the investor does not feel comfortable making individual investment decisions.  Further, they can be used to acquire assets that would otherwise be unappealing (e.g., due to their tax treatment) or difficult for the investor to acquire.

Finally, as discussed in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?” managing a portfolio like the widows’ and orphans’ portfolio can involve anywhere from 2 to 6 trades in a year as decisions have to be made about what to do with dividends.  Obviously, it also requires selecting the stocks to put in the portfolio in the first place.  That can involve selecting 10 to 15 stocks.  That may be more than many people want to do.  A mutual fund portfolio can involve fewer decisions about where to invest and fewer decisions about when to trade.  For many people, that alone would justify the mutual fund portfolio.  The ability to achieve diversification with only one decision has tremendous appeal to many people.

 

The mutual funds available to each investor depend upon whether the investments are in or outside of a 401(k).  If it is within a 401(k), offerings will be restricted to only selected funds offered within that 401(k).  If they are outside the 401(k), technically, the investor could pick any mutual fund but often feels constrained to those offered by a particular broker or mutual fund company.  So, in the next two postings references to individual mutual funds should be taken as illustrative examples of the appropriate type of mutual fund.  (In order to facilitate the use of the named funds as an illustration, the posting includes descriptions of the funds).

Important consideration in any mutual fund is the expenses that the mutual fund charges the investor.  The examples referenced in the next posting are all Vanguard funds.  Vanguard places a lot of emphasis on low management costs.  Consequently, Vanguard was a convenient source for examples of how to construct a simple mutual fund portfolio.  That should not be taken to imply that the same could not be done with bonds from other fund management companies.  Therefore, funds offered by Fidelity will be used in the third posting in this series.