So, who is this Mr. Flash guy anyway? Does he realize that name is ridiculous? (Yes). And most importantly, does he even follow his own advice? Well, let’s find out…
If you’ve read Finance in a Flash — 2020 Edition, you know that I’m a big proponent of low-cost index fund investing. Specifically, I believe that the majority of people saving for retirement would be best served with a straightforward “three fund portfolio.”
The Three Fund Portfolio
So, what is the three fund portfolio? The three fund portfolio consists of a U.S. stock index fund, an international stock index fund, and a U.S. bond index fund. It’s that simple! In terms of how much is invested in each fund, that piece is much more flexible. A conventional three fund portfolio suggests a high stock vs. bond ratio when you're young, and anywhere from zero to one third of that allocation in international stocks.
Of course, everyone is different. The generic investment advice prescribed by the three fund portfolio is just that—a starting point. More aggressive investors may forgo bonds altogether and invest a full third of their retirement savings in international stocks. Other, more conservative investors, may choose to weigh more heavily towards bonds and instead forgo international stocks.
These variations are due to personal preference, risk tolerance, and retirement goals. One-size-fits-all investing guidelines do not exist. However! For the vast majority of people out there, low-cost index funds are definitely the way to go.
What to Avoid
The answer: high expense ratio funds and individual stock selections. Let’s dig into what this means.
At its core, an index or mutual fund is a collection of assets that are meant to represent a specific asset class, industry, or the stock/bond market as a whole. Index funds in particular get there name from mimicking various market indices, such as the S&P 500 and Nasdaq 3000.
Every index and mutual fund comes paired with an “expense ratio.” Expense ratios represent the percentage of your investments that will be paid to the fund operator on an annual basis to manage the fund.
A 1.00% or 0.50% expense ratio may not seem like much, but it can add up to tens or hundreds of thousands of dollars over the course of your career. Beware the expense ratio!
What does a good expense ratio look like? Vanguard’s Total Stock Market index fund (acronym: VTSAX), for instance, offers an outstanding 0.04% expense ratio. This is the cream of the crop and what everyone should strive for in their investment portfolio.
Individual stock selections are also not typically advised, but for different reasons. Placing too much of your portfolio in any one company (even if it’s your employer!) comes at substantial risk; what if the company devalues, or worse, declares bankruptcy? You could lose everything!
Investing in broad-based index funds (e.g., VTSAX) reduces the risk of individual companies going under by investing in the stock market as a whole.
So, how do I stack up? Do I follow the three fund portfolio and only invest in low-cost index funds? Let’s find out!
Alright, according to the three fund portfolio, I should be heavily invested in U.S. stocks and minimally invested in U.S. bonds, with the choice of a small-to-zero percentage in international stocks.
First, the good news: I am 100% invested in stocks! Given that I have many working years ahead of me, I believe I can be given a pass for not having a bond allocation. All of my investments are in domestic stocks, which again is not a dramatic deviation from the general guidelines set forth by the three fund portfolio.
The vast majority of my stocks (80%) are invested through VFIAX (the Vanguard S&P 500 index fund). This fund also has a 0.04% expense ratio. Fantastic—off to a good start!
This is when things take a turn for the worse. I have… Wait for it… 20% of my total portfolio invested in individual stocks… Uh oh! This goes against most conventional wisdom, and is certainly not recommended by the experts.
How could this possibly have happened, you ask? Well, Coronavirus. I simply could not pass up the opportunity to invest in airlines, cruise ships, and retailers that were all selling for a fraction of their historical prices. In decrying conventional wisdom, I have invested this money with the complete understanding that I might lose everything.
When gambling on individual stocks, sectors, or industries, the key is to acknowledge the risk. You must be okay if things don’t go according to plan, even if it results in losing your entire investment.
Perfect. Now that I’ve lost 90% of my credibility, what about the next 10%?
With limited 401(k) fund options, at least I am safeguarded from gambling on individual stocks with my retirement account. Be warned, however, I set this account up nearly five years ago. And to be honest, I haven’t really checked in on it since.
As expected, here goes the remainder of my credibility. I have 30% of my 401(k) invested in the Dryden S&P 500 index with a 0.04% expense ratio. Perfect! But wait, why only 30%?
Here’s the tough part. I have the remaining 70% divided among three separate mutual funds: a large cap blend, a mid cap blend, and a small cap blend. Sounds diversified, doesn’t it? Well, not really. The S&P 500 index offers a higher overall level of diversification (as there is no total stock market index to choose from), and a much lower expense ratio.
That’s right, I am paying between 0.50% and 0.65% a year on each of these funds! What have I done?! Just looking at this now is giving me heartburn.
Phew, that was a wild ride. What lessons can we learn from this? First, never listen to a stranger on the internet (just kidding! You can listen to me). The next lesson is that the first thing I plan on doing tomorrow morning is signing into my Prudential 401(k) and transferring every penny to the 0.04% expense ratio funds.
In all honesty, the real lesson is that investment guidelines are just that—guidelines. There is no one approach that applies to everyone. But by centering yourself on the fundamentals (low-cost index fund investing), you can make massive strides towards financial success. And as long as you know the risks, taking measured deviations from the fundamentals is entirely acceptable as well.
I hope you enjoyed this journey with me! Keep an eye out for the next iteration of: does Mr. Flash follow his own advice!
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Want to learn about all of the essentials of personal finance in one place? Check out Finance in a Flash - 2020 Edition for everything you need to know!