This morning, I happily talked about how Vanguard had changed their fee structure, which basically eliminated fees for me. Prior to this fee change, I was using a slightly unorthodox balancing strategy to avoid fees - although I love Vanguard funds and their investment philosophy, I didn’t like their fees. Now that the fees are eliminated for many investors like myself, my only constraint is the minimum required to invest in various Vanguard funds, which is $3,000. So I thought I’d outline my revised portfolio plans based on this change.

Why am I investing? This is the first question that any investor should ask when deciding on a portfolio. My reason for investing is so that sometime between the ages of 40 and 50, my wife and I can build our dream home. We want a place in the country with some woods and lots of room for children and (especially) grandchildren to visit and relax. If there is still money left over, it will last until our mid fifties and aid in retirement.

How do I achieve that? Since that goal is 15 years off and also that it’s not something that will damage my life if I incur losses, I’m quite open to a healthy batch of risk. I want a strong portion in growth stocks, a smaller portion in a broad market fund, and a tiny sliver in bonds. Thus, here’s my desired portfolio:

30% Vanguard 500 (VFINX)
30% Vanguard Total International Stock Index Fund (VGTSX)
30% Vanguard Small Cap Growth Index Fund (VISGX)
10% Vanguard Long Term Bond Index Fund (VBLTX)

Right now, my balances are roughly as follows:

$5,500 Vanguard 500
$0 everything else

My goal, based on the previous fee structure with Vanguard, was to reach $10,000 in the Vanguard 500 and then move on to the other funds, but instead I’m changing that policy. I’m now saving, in an online savings account, the minimum needed to buy into the other funds one at a time, starting with the Vanguard Total International Stock Fund, and I’m leaving the Vanguard 500 alone and not buying any more for the time being.

So, here’s my fund-buying strategy for the next few years in order to build my portfolio:

First, save $3,000 in a high interest savings account and buy in on the Vanguard Total International Stock Index Fund. Once I’m in, I’ll make no additional investments until my initial buying is complete.

Next, save $3,000 in that same high interest savings account and buy in on the Vanguard Small Cap Growth Index Fund. Once I’m in, I’ll again make no additional investments until my initial buying is complete.

Then, to complete my initial buying, I’ll buy in on the Vanguard Long Term Bond Index Fund with again the minimal $3,000.

What then? Each month, I allot myself a certain amount to invest for our home, say, $500. I then look at the balances of all of the funds. Here’s an example of what it might look like when I’m all done in a few years:

$8,000 Vanguard 500 (VFINX)
$7,000 Vanguard Total International Stock Index Fund (VGTSX)
$5,000 Vanguard Small Cap Growth Index Fund (VISGX)
$3,000 Vanguard Long Term Bond Index Fund (VBLTX)

I then convert these to percentages of my overall portfolio:

34.8% Vanguard 500
30.4% Vanguard Total International Stock Index Fund
21.7% Vanguard Small Cap Growth Index Fund
13.0% Vanguard Long Term Bond Index Fund

… and I spend the month’s allotment on whichever fund’s percentage is the most below the desired percentage. In this case, that would be the Vanguard Small Cap Growth Index Fund, so I would invest the $500 in that. This changes the percentages to

34.0% Vanguard 500
29.7% Vanguard Total International Stock Index Fund
23.4% Vanguard Small Cap Growth Index Fund
12.8% Vanguard Long Term Bond Index Fund

Not perfectly balanced, but it’s closer. As time wears on, the percentages will gradually move closer and closer to my ideal portfolio.

Then, when the time comes, I cash them all out and my wife and I visit an architect. That’s the dream, anyway.

A little over a month ago, in late February and early March, the stock market in the United States took an 8% hit in a little over a week, a very painful drop for anyone with a stock investment. For me, this was a rather nerve-wracking time, as it was the first time I had significant stock investments during a market hiccup.

Right around that time (March 2, to be exact), Ben Stein posted a column at Yahoo! Finance entitled Keeping Your Cool In A Shaky Market. In short, the article basically encouraged readers to not sell like madmen because of the market hiccup, and actually offered some encouragement to buy.

On March 5, I took Stein’s advice and bought into the Vanguard 500, an index fund that matches the S&P 500 tightly. I bought shares in the fund at $128.89 a pop on March 5.

Yesterday, the Dow closed at a new all-time high, which reminded me that I had in fact bought heavily into a broad index fund just a little over a month before, so I went and checked the current value of a Vanguard 500 share. $135.67. In other words, my investment based solely on the principle of “buying low” saw a gain of 5.3% in a little over a month.

This doesn’t mean that I would buy immediately in every downturn, but that I saw no real reason for the previous downturn. There really is no sector that is truly overvalued right now (except possibly housing), so why would the market take a burp like that? As Stein points out, the market isn’t always rational. I saw it as a 5% off sale in the stock market, and a month later, it’s back to where it was.

So what did I learn from this?

My general investment principle is “buy low, sell when I need to.” I see no reason to really deviate from that general plan, and it seems to be working well. I generally buy a small amount each month (dollar cost averaging), but when there are opportunities like the one early last month, I’ll buy more. I also have no intention of selling anything until there’s a reason to sell it.

Watch what you invest. I keep my eye on what I’m invested in; I even have a spreadsheet that contains a bunch of data on the S&P 500 that I look at on occasion to see if there’s anything odd going on (like one sector bubbling up). For the most part, the numbers on this sheet have been roughly the same over the last year or two, and there’s no sign of a big bubble anywhere like there obviously was in stocks circa late 1999 and early 2000. I basically keep this as a “check” so that when there are little hiccups (or even big ones), I can feel fine buying in in the wake of the downturn, like I just did.

Don’t sweat it if you make a mistake. In other words, if you need the money to survive, don’t dabble in the stock market. I love seeing gains, but I also know that even if the market utterly collapsed, I wouldn’t be deeply worried because of that loss.

Here are three interesting questions sent in by readers of the series of mutual fund posts this week.

I don’t understand how the companies that run these funds make enough money to make it worthwhile after ads, expenses, and so on.

When you look at a mutual fund on Morningstar, you’ll see two key numbers: the expense ratio and the total assets. Multiply them together and you’ll get a pretty good sized number. Take the Vanguard 500, for example. It has an expense ratio of 0.18%, but it has $118,883,000,000 in assets. Multiply them together and Vanguard is netting $214 million a year out of the fund. Even with a small expense ratio, a fund can bring in a lot of money. An investment house does have a lot of expenses, but with that kind of money coming in, they can easily afford what they need to do and bring in some serious cash.

How do I balance a mutual fund portfolio if it’s invested in several different places?

The easiest way is to focus each account on a specific piece or two of your portfolio. This is especially easy if these investments are in 401(k) or Roth IRA accounts where you can move around the balance without incurring tax penalties. Sometimes an account won’t have enough in it to cover a single piece of your desired portfolio; in that case, you should finish out that piece in another account.

You keep mentioning capital gains tax. How do they work?

A capital gains tax is a tax that the government charges you when you sell an asset and make a profit on it. If you buy a stock at $10 and then sell it at $15, you have to pay capital gains tax on that $5 difference. Typically, capital gains tax are filed as part of your income tax return and are typically subject to a lower tax rate than normal income. More importantly, if you have a capital loss in a given year, you can subtract that loss from the gain and only pay taxes on the overall gain.

Sometimes you are subject to capital gains tax even if you don’t sell anything from a mutual fund. This is called turnover and occurs when a fund does a lot of selling of assets during a year without replacing these sales - they instead distribute the fund’s gains to the holders, putting them on the hook for capital gains. This distribution usually reduces the value of the fund, so it basically means that part of your investment can be handed right back to you and you have to pay capital gains tax on it.

Here’s an example of why turnover can be bad. Let’s say you bought $70,000 worth of a fund. It goes to $100,000. Two days later, the annual distribution occurs. You get a check for $30,000 and your fund’s value drops back to $70,000. You’re then on the hook for the capital gains tax on that $30,000 whether you like it or not.

One way to avoid this is to look for funds with low turnover, because those are much less likely to do a distribution (and thus cost you money).

As a finale to mutual fund week, I wanted to share my thoughts on the continual debate between mutual funds (especially index funds) and individual stock picking. There are both positives and negatives to each and I hope not to sway you too strongly in one direction or another, because each have their proponents (for instance, just read . So let’s look at some of the major benefits and drawbacks of each strategy side by side.

Individual stock picking allows for massive and quick returns. If you invest in individual stocks, you give yourself the opportunity to pick the next Starbucks and ride all the way to the top, doubling or tripling your investment annually. This is simply not going to happen in a mutual fund.

Mutual funds hedge you against massive and quick failures. On the other hand, your individual pick might be the next Enron, which would mean bankruptcy. Investment in a mutual fund leverages this risk because you’re invested in a lot of companies.

Individual stock picking requires a lot of homework for success. Jim Cramer recommends one hour of research per week per individual stock holding, and I think that’s a pretty sound prescription if you want to see big successes.

Mutual funds require little research, but detach you from the day to day mechanics. With a mutual fund, it’s easy to get in, but it’s hard to really have a pulse on what’s going on with your investment. With an individual stock, you can just obsessively follow a certain company; with a mutual fund, it’s too broad to follow, so you just have to trust the fund manager.

Individual stock picking costs you on the buy-in and the sell with brokerage fees, but leave you alone once you’re invested. Thus, many small trades can eat you alive just with the fees, let alone the capital gains taxes. However, if you plan your moves carefully and have some strong money to invest, the fees become quite tiny in comparison.

Mutual funds generally cost nothing extra to get in, but slowly sip away expenses over time. Again, some careful planning can minimize this drain - get into an index fund that has a very low expense ratio.

So, which is better? Individual stocks are generally high-risk and high-reward but they require some serious footwork. Mutual funds generally have lower risk and don’t require as much homework, but they won’t get you rich in a few years. As for me? Mutual funds are the foundation; individual stocks are things to play with.

After writing all week about how great mutual funds are, it’s important to note that they’re not the be-all end-all of investments. Here are four good arguments for why you should not invest your money in mutual funds.

You can’t get exceptional growth from a mutual fund because the skyrocketing investments are held back by ones that aren’t skyrocketing. This is the big argument against mutual funds from the perspective of the individual stock investor, and it’s true: a single well-picked growth stock can utterly annihilate the gains from any fund.

They take a percentage of your money every year just for the “benefit” of holding it. Every year, a mutual fund takes a piece of your investment for their own - the expense ratio, to be exact. Other investments hold their original value without being slowly leeched.

The “success” of mutual funds is skewed by survivorship bias. In essence, survivorship bias means that the returns, on average, of an investment group’s mutual funds are higher than reality because investment houses kill poor funds quickly. They kill off all the bad ones and then average the ones that remain. Of course you can beat the market if you “cheat” like that.

Funds are marketed like anything else - and you pay for that marketing. You know the ads you see in magazines touting how great a fund is? You directly pay for them through special fees called 12b-1 fees. Not only that, the ads are designed to make the fund appear better than it actually is.

So why should you invest in mutual funds at all? They take your cash, stunt your returns, and lie to you about how great they are… why even invest in them? Well, each of these arguments has either a fatal flaw or a strong counterargument. Let’s walk through these one by one.

First, you can’t get exceptional growth from a mutual fund because the skyrocketing investments are held back by ones that aren’t skyrocketing. This is true, but you also can’t get exceptional loss from a mutual fund, either. Owning Enron individually would have bankrupted you, but owning a fund with Enron in it would have just been a little bump in the road.

Second, they take a percentage of your money every year just for the “benefit” of holding it. Obviously, someone has to put in the time to actually manage the fund and actively managed ones can be expensive, but you can really reduce this expense ratio by focusing on index funds. Many of them have expense ratios that are less than 0.2%, which in a fund like the Vanguard 500 that has returned over 12% over its history is really a tiny amount.

Third, the “success” of mutual funds is skewed by survivorship bias. Well, you aren’t investing in the entire offering of an investment house, so anyone that mentions survivorship bias is repeating talking points. It’s trivial to avoid survivorship bias by doing a bit of research; just find out what the numbers are on the fund you’re interested in and ignore such wide statistics.

Lastly, funds are marketed like anything else - and you pay for that marketing. Again, just do a bit of research and avoid funds that charge 12b-1 fees. Look at discount brokers and investment houses who don’t dump cash into advertising, like Vanguard, for instance.

In short, most of the big arguments against funds either have a good counterargument or can be avoided with some simple research.

You’ve read up on mutual funds and you’ve picked a small handful out that you want to invest in. Now what? How can you buy in incrementally and then keep them balanced over time? Here’s a great strategy for building up the portfolio the way you want it, getting it balanced right, and then keeping it balanced.

Your first step is to figure out the percentages you want in each fund. This is a personal decision, but I would recommend for most people that they have at least 30% in fairly aggressive funds (I have 60% in my target portfolio) and at least 10% in something pretty conservative that will weather a bumpy ride.

For an example, I’m going to use the portfolio that I am shooting to achieve in the next three years for my home investments (which have a fifteen to twenty year timetable before I completely cash out):

30% Vanguard 500 (VFINX)
30% Vanguard Total International Stock Index Fund (VGTSX)
30% Vanguard Small Cap Growth Index Fund (VISGX)
10% Vanguard Long Term Bond Index Fund (VBLTX)

Next, figure out how much you need to actually build the portfolio. In other words, find out the minimum investment needed for each of the funds you’re going to invest in, then use that to determine how big your “starting” portfolio has to be. For me, all of the funds cost $3,000 to buy in, so that means I need a total investment of $30,000 to build that portfolio. In terms of starting dollar amounts, I need to look something like this:

$9,000 Vanguard 500 (VFINX)
$9,000 Vanguard Total International Stock Index Fund (VGTSX)
$9,000 Vanguard Small Cap Growth Index Fund (VISGX)
$3,000 Vanguard Long Term Bond Index Fund (VBLTX)

There’s another factor, though; Vanguard charges $2.50 a quarter for each fund you hold that’s under $10,000, and so I should start these $9,000 funds at $10,000. So here’s my actual position that I plan to start with:

$10,000 Vanguard 500 (VFINX)
$10,000 Vanguard Total International Stock Index Fund (VGTSX)
$10,000 Vanguard Small Cap Growth Index Fund (VISGX)
$3,500 Vanguard Long Term Bond Index Fund (VBLTX)

Once you’ve got the dollar amounts figured out, start investing in the funds. You’ll hear a lot of opinions on the order you should invest in. My feeling is that there should be one in your portfolio that you consider to be your “anchor” - not too risky, but not too conservative - and that’s the one you should start out in. For me, it’s pretty obvious - it’s the Vanguard 500.

I don’t have enough money to buy into the fund I want! Open up a high yield savings account, like one at ING Direct (the one I use) or HSBC Direct (another good one), and start putting money incrementally into that account until you can cover the minimum, then start buying the fund directly with those same increments until you reach your target. Then repeat the process with the other pieces.

Should I literally build a piece until I reach my target dollar amount? Some people might want to build a portfolio piece to near their target value and then move on to another. To tell the truth, either approach is fine. My plan is to build each piece up to their “starting” amount and then just let it ride while I build up other pieces. Once I have all of the funds with at least their starting amount, then I’ll do a rebalance soon after.

OK… what’s a rebalance? Let’s say I go through those investments in order and buy in to my target amount in each one. Obviously, I will have been invested in some funds for longer than others, and when I get done building all of my positions, hopefully some of the earlier funds will have grown a bit. Let’s say, hypothetically, that I finally get my portfolio built in December 2009 with a buy in on VBLTX and the balances look like this:

$13,500 Vanguard 500 (VFINX)
$12,000 Vanguard Total International Stock Index Fund (VGTSX)
$11,000 Vanguard Small Cap Growth Index Fund (VISGX)
$3,500 Vanguard Long Term Bond Index Fund (VBLTX)

My portfolio is now worth $40,000, so I’m really off to a good start here. But it’s a bit out of whack compared to how I wanted things based on percentage. My original goal was this:

30% Vanguard 500 (VFINX)
30% Vanguard Total International Stock Index Fund (VGTSX)
30% Vanguard Small Cap Growth Index Fund (VISGX)
10% Vanguard Long Term Bond Index Fund (VBLTX)

… but the actual percentages are now this:

33.75% Vanguard 500 (VFINX)
30% Vanguard Total International Stock Index Fund (VGTSX)
27.5% Vanguard Small Cap Growth Index Fund (VISGX)
8.75% Vanguard Long Term Bond Index Fund (VBLTX)

Switching back to raw dollars, I actually want is a balance close to this:

$12,000 Vanguard 500 (VFINX)
$12,000 Vanguard Total International Stock Index Fund (VGTSX)
$12,000 Vanguard Small Cap Growth Index Fund (VISGX)
$4,000 Vanguard Long Term Bond Index Fund (VBLTX)

To do that, I have to sell $1,500 in the Vanguard 500 and put $1,000 of it into the small cap fund and $500 in the bond fund. I just sell shares that minimize my capital gains tax incurred and reinvest it so that I again have my target portfolio.

When should I rebalance? To be honest, in reality, I probably wouldn’t rebalance that above portfolio. My rule of thumb is to check the portfolio every six months and if a holding is more than 5% off of my target, I rebalance it so that all funds are at or near the percentage I want. Basically, I just convert the entire portfolio to percentages (like I did above) and then compare each percentage to my target percentage. If there is a more than 5% difference, then I rebalance; otherwise, I let it sit.

Why? Basically, rebalancing leverages risk. At different times, some funds will outperform others - this just ensures that you can take gains out of funds that are very volatile and also buy in when some funds are underperforming. In other words, rebalancing is a way to buy low and sell high, at least in comparison to the rest of your portfolio.

Good luck!

So how do I pick the funds that I invest in? Although I don’t prescribe this list for everyone, I use seven distinct factors for selcting the funds that I plan to invest in. These factors usually tell me everything I need to know about the fund and whether or not it’s a good choice for me to put my money there. These factors are (in no particular order):

The expense ratio The lower, the better. This is actually the biggest factor I look at, though not enough to swing me into investing in a fund with truly poor recent returns. Why? A fund with a low expense ratio is one that is looking for efficiency in investing, because many people merely look at returns. This means that when the market is bad and the actively managed and expensive fund is struggling, the efficient fund will have less baggage. You can find this info on the Morningstar.com page for the fund.

The five year return I basically view five year returns as the real short term, as I’m not in a mutual fund looking to maximize single year growth. Usually, a five year trend shows you most of one economic cycle, so you can get a rough idea of how it’s doing given the recent path of the economy. You can find this info on the Morningstar.com page for the fund.

The ten year return On the other hand, I also like the ten year return, which shows how it did over a full economic cycle (and a bit more). It shows me whether or not the five year trend is a fluke - if the two are far apart, I need to do some research before I invest. You can find this info on the Morningstar.com page for the fund.

The Morningstar rating I place a lot of trust in Morningstar’s rating, and I usually find it to be a nice thumbnail sketch of the state of the fund. I discussed this one in detail yesterday. You can find this info on the Morningstar.com page for the fund.

The investment philosophy of the fund I like to understand the ideology behind the fund: why do they invest the way they do? I like funds that primarily are on the lookout for shareholder value, but you may have different things you’re looking for (”green” investments and the like). You can find this in the fund’s prospectus, usually available from the investment house.

The turnover The lower, the better. High turnover funds might get nice returns, but they also hammer you hard on taxes. A high turnover usually the sign of a frenetically managed fund. You can find this info on the Morningstar.com page for the fund.

All other fees Before I make the leap, I make sure that there are no other fees or expenses that are hidden from my eyes. I do this by giving the site of the investment house a very thorough scouring for such things before I put in my money. I was literally obsessed with Vanguard for a period before finally investing with them. You can find this information on the website of the firm you invest with.

It’s also worthwhile to check out the full mutual fund prospectus before you invest, just to get a broader view of things. I previously wrote a guide to reading a mutual fund prospectus if the task seems daunting.

As the latest issue of Money Magazine just arrived in my mailbox (review forthcoming), it occurred to me that a mention of the Money 70 might be in order during Mutual Fund Week here at The Simple Dollar.

What is the “Money 70″? The Money 70 is a list of mutual funds selected by Money Magazine and followed in each issue of the magazine. You can read the full criteria for selection here, but the basic nutshell is that the funds on the list are generally low cost, focused on shareholder interests, and have a consistent investment strategy. It’s really a healthy list of well-run mutual funds from a variety of investment firms with a variety of goals and strategies.

Does this list match your investment philosophy? As I mentioned yesterday, I generally like index funds because they provide diversity without much expense; however, the Money 70 list contains 43 actively managed funds and only twelve index funds. In my opinion, the twelve index funds they show are stellar and the truth is that there are simply far more managed funds out there than index funds because lots of investors either want to beat the market or want a fund that is really conservative that won’t sink in a down market, two things that index funds don’t really protect you from.

I could repeat the contents of the list here, but a simple link to the Money 70 list saves the effort and provides a nice summary table. If you find a fund on that list that looks really interesting, I strongly recommend looking it up at Morningstar, as discussed earlier today.