Minimal Investor 2 – Understanding Diversification

Adam

Written by Adam on October 5, 2018. Updated April 29, 2019.
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Hey hey, and welcome back to lesson 2 of Minafi’s Minimal Investor course.

Lesson 1 Review – Accounts in Order

Before jumping into lesson 2, let’s review lesson 1. In lesson 1 you did 4 key things:

  1. Madke a list of all accounts you have.
  2. Made sure you can log in to each of them.
  3. Figured out which investment account type(s) to use for this course (401k, Roth IRA, IRA, Brokerage).
  4. Opened a company 401k and/or Vanguard Account.

We won’t be making any purchases in your investments accounts this lesson, but we will be looking at some of the funds they offer to start understanding where we should invest.

If you haven’t completed all the steps from lesson 1, you’ll have a few lessons before you absolutely need those accounts open. We won’t be making a purchase until lesson 4, so you still have some time to open one up (and please, open a Vanguard account).

In that time, we’ll be looking at what investments are offered and making an informed decision on what to invest in. That said, let’s jump into lesson 2!

Lesson 2 Overview

The next goal is getting to an understanding how to evaluate funds. If I just gave you recommendations, then you could use them and invest now – however, I want to teach you enough so that you know exactly what you’re invested in and why you’re invested in it. Because of that, the next 3 lessons will be spent learning the what and why. It’s also important to know that there is no “right” way to invest. The strategy used in this course will focus on a few things:

  1. Reducing taxes by buying for the long term in the right accounts (lesson 1)
  2. Reducing market swings so that your funds aren’t fluctuating wildly (this lesson)
  3. Reducing risk by diversifying your funds (this lesson)
  4. Reducing fees by picking low expense ratio funds and not using a financial advisor (lesson 3)

We already accomplished (1) in lesson 1. The goal of lesson 2 is to understand the power of diversification in an investment strategy and what that means for you specifically given the fund choices in your investment account. By the end of lesson 2, you should know the differences between a few different types of investments and why one is far superior to the others for long-term investing. This should help points (2) and (3) on the above list. Here’s the rundown of how you’ll get there:

  1. Understand what market sectors are
  2. Take a look at market categories
  3. Look at how diversification helps in a downturn
  4. Learn the difference between investment types

I’m burying the lead here but…

Before we get into any of that – by the end of this article, you’re going to understand why you only need 3 funds to invest in the entire market. This approach is called a 3-fund portfolio, and it is the most basic diversified portfolio you can invest in. When I say “3 fund portfolio” you’ll know what that means, and why it invests in the entire market.

1) Understand what market sectors are

Do you remember the “dot com boom” in 2000? Technology is the market sector that collapsed the most during that time period. In 2008 during the great recession/housing crisis, it was a combination of the housing market sector and the financial sector. Sectors are groupings of companies in the same industry. Depending on how granular you want to get there could be a lot of sectors. Luckily, in the investing world we tend to group these sectors into a select few:

  • Financial – Bank of America, Wells Fargo, etc
  • Technology – Apple, Google, Facebook
  • Consumer Discretionary – Retail, consumer services
  • Consumer Staples – Food, beverages, Essentials
  • Energy – Oil, gas, power
  • Health Care – Hospitals, insurance
  • Industrials – Aerospace, defense
  • Telecom – Phones, Internet, Cable

At different times, different sectors will be booming or busting. While I firmly believe that technology helps improve the human condition, that doesn’t mean every company in that sector is a sound business. In this course I won’t be going into how to evaluate individual companies and stocks to pick them — it’s not something I do.

What are you drawn to on this list?

Imagine you have $100 and you want to invest it in these sectors. How would you allocate your funds? You would likely use all the information available to you in order to select an allocation that optimizes results. Here’s the kicker though: there’s always going to be people who know more information than you. You may have decided to put a large amount in the Finance section, but are unaware that the current student loan crisis is about to bring all banks to their knees.

My strategy is to not worry about learning these facts – and you shouldn’t either. You could spend every hour of every day reading up on news of companies and still not making the right decision at the right time.

Instead, imagine an allocation of that $100 that puts some money into each and every group. This means you’ll never hit the lottery investing in the top winner, but you’ll also never be the biggest loser either.

This strategy is called market sector diversification. It means that if any specific market sector takes a plunge you won’t lose your shirt.Takeaways

  • Market sectors are groups of companies like Technology, Financials, and Telcom.
  • Investing in specific stocks or sectors implies you know more than everyone else about that, and is usually wrong.

2) Take a look at market categories

While market sectors are made of companies within a specific industry, market categories are a much more broad term that cuts in a different way. Here are the base market categories.

  • US Stock Market
    • Large-cap – Very large companies
    • Mid-cap – Medium companies
    • Small-cap – Smaller companies
  • International Stock Market
    • Emerging Markets – Countries with growing, more volatile markets
    • Europe Market
    • Pacific Market
  • Bond Market

For all US Stock Market and International funds there are typically sub-divided into 3 other groups:

  • Growth Stocks – Companies where growth is expected in the future, and that price is already reflected in the value of the stock (ex: Apple, Amazon, Facebook, Disney)
  • Value Stocks – Stocks that are priced well for the earnings the company is making (Microsoft, Johnson & Johnson, GE)
  • Mix – If the fund doesn’t say growth or value, it’s likely a mix of both

Most investors will tell you value stocks are the best. They’re the kind of companies Warren Buffet and others invest in. However, they also require tremendous research in order to understand if a company is indeed a value. Like with market sectors, it’s better to just invest a little bit in each of these market categories. 

Types of stocks

The Easy Way

That’s a lot of groupings of funds! The easiest way to invest in this entire group of funds is a single “target retirement date” fund. These funds typically invest funds between US Stock Market, International Market and Bond markets in a single fund.

Technically, you could invest in this one fund, say Vanguard Target Retirement 2060 Fund, and be set from a diversification standpoint. This fund invests in:

  • 55% US Stock Market
  • 35% International
  • 10% Bonds

This fund targets people who hope to retire in the year 2060, and each year will adjust these percentages. Compare that to the Vanguard Target Retirement 2015 Fund allocation:

  • 26% US Stock Market
  • 17% International
  • 57% Bonds

 In both examples, the US Market to International ratio is about 66/33%, but the Bonds number grew a ton! 

I don’t recommend these funds for four reasons:

  • You can’t control what percent of your funds is in which market class
  • The fees associated with target retirement funds are slightly higher than doing it yourself. (we’ll look at fees in lesson 3 – fees)
  • This doesn’t allow you place your funds in the most tax advantaged account (we’ll talk about this in lesson 4 tax-efficient investing).
  • If you want to change that, you’ll need to sell the entire fund and pay taxes (we’ll get into taxes in lesson 8 taxes).

“So then how do I invest in these?”

The easiest way I’ve found is through a Simple Three Fund Portfolio at Vanguard. We’ll be going over some of the content in this article in future lessons, but the tl;dr:

You can invest in 3 Vanguard funds and effectively be invested a little bit in everything going on in the world.

That’s a bit extreme, but between 3 funds (which are in that article) you’ll be invested in 18,126 different things!

Takeaways

  • The 3 main market categories are US Stock Market, International Market, and Bonds
  • If you invest in 1 fund in each group you can have a diversified portfolio.

3) Look at how diversification helps in a downturn

We’ve looked at what diversification is, but not why it’s awesome. Take a look at the following chart from The Novel Investor. Each box represents a Market Category or Market Sector.

novel investor diversification

You’ll notice that no market category or sector is consistently at the top. Emerging Markets have a good run in the mid-2000s, then fall off fast. Real Estate has a good rebound from the recession but then falls off fast.

Trying to pick a winner in a market is a waste of time.

I prefer to invest a little in every class then end up somewhere in the middle. You notice the “AA” box that’s consistently in the middle of the pack? That’s a portfolio made up of 40% bonds and the rest stocks. I think this is too much in bonds (I prefer [Age/2]%), but the idea is the same — by diversifying between all of the assets you’ll always be somewhere in the middle.

Takeaways

  • By diversifying your investments you’re guaranteed to be in the middle of the pack.
  • Diversifying investments means fewer fluctuations over time.

4) Learn the difference between investment types

“How do you invest in a market category?” is a likely next question. That’s where ETFs come into play. ETF stands for “Exchange Traded Fund”. These are funds that invest in a bunch of stocks (and other things).

Imagine a fund (in this case Vanguard Total Stock Market Index) that invests in over 3,000 different stocks in small portions. The most this fund invests in a single stock is 1.25%. ETFs are an amazing way to invest in a diverse amount of market sectors because they can invest small portions into each. Vanguard Total Stock Market Index (VTSMX) consists of these market sectors:

The amount invested in each market sector isn’t even, but that actually makes sense. These proportions are meant to mirror companies in the United States. By investing in this fund you don’t need to worry about how much is invested in any given stock, or even in any given market sector.

What Next?

So we’ve talked about stocks and ETFs, but what about mutual funds? Well, mutual funds are actually the same at ETFs for the most part. Mutual funds also consist of multiple stocks (and ETFs or other mutual funds).

Honestly, I haven’t needed to draw a big distinction between mutual funds and ETFs. Vanguard has a good article on the differences between them if you’re curious. One notable difference is that stocks and ETFs trade on the stock market, so when you make a purchase the exact value might fluctuate depending on when your trade goes through.

Mutual funds, however, are only exchanged every night after the market closes. Because of that, you don’t need to worry about the specifics to execute a trade in real time.

I prefer mutual funds myself. There’s less chance for something to go completely wrong with a trade since the prices are locked in at the close of business. The downside to this is that you can’t instantly sell at any time. With mutual funds, when you sell the trade won’t go through for another 24-36 hours. I sell funds so rarely that mutual funds end up being the best way to not worry about the specifics and invest for the longer term.

Bonds

The last major investment type is bonds. Bonds are effectively financing someone else’s investment. Take a mortgage for example – you borrow $250,000 at 4% interest. You are paying someone 4% for the privilege of borrowing money. Bonds work in this same way, except the borrowers range from governments to stable businesses to less reliable players. Unlike stocks which are an investment in a company, bonds are an investment that someone will pay back that debt.

Bonds tend to be much safer than stocks, and are an important part of a portfolio.

“How do you buy bonds?”

Bonds aren’t something you just go to the bank and pickup. Instead, the best way is to buy an ETF or a Mutual Fund that invests in thousands of bonds. This means that if any one government or company that’s paying towards that bond doesn’t pay it back the bond itself won’t see a noticeable negative change. I wouldn’t dare invest in bonds directly.

Takeaways

  • Stocks are the most volatile investment
  • Mutual funds and ETFs both invest in a bunch of funds
  • Bond funds invest in a bunch of bonds.

Lesson 2 Recap

That was a lot, but you made it through! This is a DENSE lesson, but diversification is the base that forms the foundation for much of what we’ll be investing in. It’s why you’re able to invest in a few things and not worry, comfortable in the knowledge that your investments are spread across multiple markets.

You learned market sectors are groups of stocks like technology or financials. You learned market categories include stocks in a specific market. You learned the difference between stocks, ETFs, Mutual Funds, and Bonds.

One recommendation before next lesson is to read about The Simple Three-Fund Portfolio at Vanguard. If you just want advice on what to do, you could use this right now and go with it. If you want to know why these are the funds, minimize your fees, minimize your taxes and learn how to rebalance your accounts each year we’ll be figuring that out in the coming lessons.

Next Lesson

With our understanding of the markets down, in the next lesson we’ll look into some specific funds, and teach you how to look at funds available in your brokerage (401k, or other location). We’ll be looking at this with an eye for market sectors, market classes and fees (NEW). The goal next lesson will be to understand how to look at a fund on a list of funds and know if it’s a good one or a bad one.

Do you have any questions on topics from this lesson? Feel free to reply to this lesson, or jump on Slack to chat (this is a new Slack group, so don’t be scared off if it’s just a few other Minimal Investor readers!).

Adam

About Adam

Hi, I'm Adam! I help millennials invest to reach financial independence sooner than they ever thought possible. Want to see what you could do to reach FI sooner? You're in the right place!

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