This is a guest post from Gabe Lumby, CPA. He runs Cash Cow Couple & Tightwad Travelers with his brother Jacob. When he isn’t busy running his online businesses, he enjoys spending time with his family and fishing for crappie on the local lakes in Southwest Missouri.
When putting together an investment portfolio, the options are endless. This is especially true when dealing with stocks.
There are a million different possible combinations and categorizations including active vs passive, value vs growth, small-cap vs large-cap, domestic U.S. vs international, and sector specific vs market wide. There are also a number of different options that attempt to blend these various categories.
Then there is the issue of (index) mutual funds and exchange-traded funds (ETFs). Both of these vehicles are used to accomplish the same investing objective of diversification. They are just different means to an end. Whether you own an S&P 500 index fund or an S&P 500 index ETF, you still essentially own the S&P 500. It just so happens that ETFs are usually slightly more tax efficient and sometimes have lower expense ratios, which give them a slight advantage.
Let’s jump into the various categories that are available when choosing stock allocation in a diversified mutual fund or ETF.
Actively Managed vs Passive
An actively managed mutual fund attempts to beat the market through buying under priced securities and selling overpriced securities. Most actively managed funds have a fund manager and a squad of analysts attempting to find the next hot deal. Some will try to find market trends, others will try to use valuations like the P/E ratio, but the goal is always to outperform the broad market index.
Most actively managed funds have much higher expense ratios than passively managed alternatives. Herein lays the problem. Because it’s so difficult to properly forecast short term movements in the stock market, managers have a tough time outperforming an index after accounting for fees. Most research shows that actively managed funds tend to underperform their passive alternatives over a long period of time.
A passive fund tracks a market index such as the S&P 500. The fund manager, which is usually a computer, only makes trades to keep the fund in balance with the associated market index. Because of the efficiency of this process, passive index funds (and ETFs) tend to have very low fees and their only goal is to replicate the gain of their respective index – such as the S&P 500 or Russell 2000.
In light of the evidence available that compares each, I choose to invest entirely in passive ETFs.
Value vs Growth
Value stocks are those that have a low price to earnings or price to book ratio. There are multiple hypotheses on why some companies have lower valuations at any given time, but let’s not get too concerned with that.
The thing to remember is that value stocks have historically outperformed growth stocks over a long period of time. They tend to slightly underperform during bull (upward) markets (like the 2000 tech boom) but significantly outperform during bears (when the tech bubble popped).
A growth fund contains stocks that are expected to grow more rapidly compared to the rest of the market. Growth stocks typically have some recent history of above-average growth in earnings. Investors like to see this growth and that makes these stocks appear sexy and attractive. This pushes prices higher during good markets, but often results in crashes that tend to destroy growth stocks later on.
Overall, I like a value tilt with my portfolio. It has outperformed in the past and I’m hoping it will continue to do so in the future. I have no idea if that will be the case.
Small-Cap vs Mid-Cap vs Large-Cap
A small-cap fund holds stocks that generally have market capitalization of between $250 million and $2 billion. A large-cap fund holds stocks that have a market capitalization of more than $10 billion. There are also mid-cap funds that hold between $2 billion and $10 billion.
Small cap companies have historically done very well when compared to larger, more established firms. This might be because investors tend to favor the more established firms which usually pay dividends, which lowers both the risk premium and expected return, or possibly because the smaller companies have much more room for growth and expansion.
On the other hand, small cap stocks usually involve more risk and volatility and there is debate on whether or not they outperform larger companies on a risk adjusted basis.
I still choose to hold some small cap ETFs in hopes that they will continue to outperform in the future. I’m not too concerned with volatility because I won’t touch the funds for many years.
U.S. Domestic vs International
A U.S. domestic fund consists entirely of U.S. stocks while an international fund consists of stocks outside the U.S. (at least from a U.S. perspective). You may be surprised to learn that the U.S. stock market capitalization makes up only around 1/3 of the total world stock market capitalization. Therefore, it’s wise to diversify and hold stocks from many different countries.
Foreign stocks are often broken down into EAFE and emerging markets on the broadest scale. EAFE stands for Europe, Australia, and the Asia Far East, all of which are supposed to be indicative of developed first world foreign nations. In recent years, these countries have been highly correlated with U.S stocks.
Emerging markets are slightly less developed countries which tend to be more risky and less correlated to the returns of U.S equities.
There is a diversification benefit provided from adding as much diversification as possible in a portfolio.
Sector vs General Funds
A sector fund consists of stocks that are part of a particular industry or sector. For example, there are energy, health, precious metal, and telecommunication sectors. REITs, or real estate investment trusts, are another sector that investors can appreciate.
Holding a sector like energy involves more risk than just choosing to hold the entire stock market. This is easily understood because the entire market would include energy stocks. Choosing to hold a specific sector involves idiosyncratic risk, which means it doesn’t reward the investor for taking the risk.
REITs can be a nice addition to a portfolio because they represent an asset class (real estate) that isn’t as available inside the broader market. Holding and REIT index like the one provided by Vanguard should provide additional diversification benefits over time. I own both domestic and international REIT funds.
If you are just getting started, I know this can all be a bit overwhelming. Don’t worry, it gets easier. More importantly, you don’t have to be an expert to get started investing.
If you can’t tell, I like Vanguard a lot. If you want to choose your own investments, Vanguard ETFs are robust and entirely free to trade. Consider what I wrote above and find an allocation that works for you.
If you are brand new to investing and don’t want to mess with implementing the above advice yourself, we would recommend Betterment as the best robo advisor option in 2017. Betterment does have a few competitors for you to compare and the robo advisor space is constantly evolving. Robo advisors offer a low cost investment option that is ideal for those not wanting to DIY and for those who don’t want to be sold some product by a financial salesman.
How do you choose your stock investments? Let me know your thoughts with a comment below!