Portfolio Theory, 7 Investments You Need, & My Own Plans

The most recent issue of Money Magazine had a blaring cover story: “The Only 7 Investments You Need Now.” Those were some tall words, and I was intrigued about what they had to say. Their seven investments:

1. A blue-chip U.S. stock fund
2. A blue-chip foreign stock fund
3. A small-company fund
4. A value fund
5. A high-quality bond fund
6. An inflation-protected bond fund
7. A money market fund

For each one of these, Money offers some specific fund suggestions and came in quite heavy on Vanguard recommendations.

What I found most compelling, actually, is that this lines up at least reasonably well with the basics of portfolio theory and also with my preferred reference on portfolios, Paul Farrell’s excellent The Lazy Person’s Guide to Investing. As a result of the advice of the article and the book, I’m coming ever closer to figuring out my exact plan for investing my money as per our family’s financial plan. Let’s walk through the logic.

Portfolio Theory 101
A lot of sites like to talk about “portfolio theory” and treat it as some sort of arcane science, spoken about in hushed tones by very smart people sitting upon their thrones made out of money.

Nonsense. It’s actually pretty simple.

A portfolio is just a collection of different investments. Those investments each have a certain expected return and a certain expected risk. For example, you might have a portfolio made up of 50% stocks in one company and 50% cash. The individual stocks have a fairly high expected return but a substantially large expected risk, while the cash has a low expected return but very low risk.

Those individual investments in your portfolio will sometimes go up, sometimes hold steady, and sometimes go down, but not all at the same time. For example, one sector in the stock market might be going up like crazy (like tech) while another one is holding steady (like processed foods).

Sometimes those different investments will go up and down at the same time. Sometimes, they’ll do the opposite of each other. Sometimes one will go up, then go down, while the first one remains unchanged. The more similar two investments behave, the more correlation they have.

You can minimize the risk in your portfolio by minimizing the correlation between pieces of your portfolio. So, for example, that above portfolio with just stocks and cash actually has very low correlation and is actually not to bad.

Obviously, you also want diversity. You want a bunch of different investments so that your entire portfolio isn’t at risk when one sector or one stock crashes.

So, your portfolio should consist of several investments that have a low correlation with each other. One quick way to do that is to just buy stocks in different sized companies in different sectors, and also mix in bonds and cash holdings, too. In simplest terms, modern portfolio theory just means “you should be invested in several things that are fairly diverse.”

The portfolio above from Money Magazine is pretty diverse – four stock funds with fairly little overlap, two bond funds with little overlap, and a cash element, too. Thus, as a portfolio, it’s not too bad according to the tenets of portfolio theory.

What Lazy Person Suggests
lazy personAfter reading the piece in Money Magazine, I turned to my preferred handbook on investment portfolios, Paul Farrell’s The Lazy Person’s Guide to Investing. If you haven’t read it, it’s worthwhile. Farrell takes simple investing portfolios from a ton of different sources and analyzes them with a big sense of humor all the way through. I tracked a few of the portfolios for a while and not only are they simple, they’re pretty solid. Farrell focuses on the “lazy” aspect by composing funds that are almost entirely made up of index funds, mostly from Vanguard. You just buy based on that formula, rebalance every once in a while, then use the money when you need to.

The Money Magazine portfolio reminded me immediately of a portfolio from this book, so I opened up my copy and found the Kiplinger’s “lazy portfolio” on page 32:

25% large cap stock funds
25% small cap stock funds
25% foreign stock funds
25% domestic bond funds

It’s even simpler than the Money Magazine suggested portfolio and nearly as diverse. Money’s portfolio has a cash element as well, but aside from that, the portfolios are very similar.

In other words, not only do these two basic portfolios match each other, but they both fall in line with basic portfolio theory. My additional readings point the same way: a simple, diversified portfolio like this is the way to go.

Defining My Own Plan In Detail
For this article, I’m going to focus entirely on my taxable portfolio, which I’m going to start soon in order to build towards my family’s dream home in the country. In order to achieve this, I want a portfolio that earns well, but earns at least somewhat predictably, which means I need to minimize risk while still keeping some high-earning returns.

My goal is to contribute $15,000 a year minimum for eight years to that portfolio, then use that portfolio to buy the land and begin building the house that we want. I would rather have a reliable 7-8% growth than a likely 10% growth with a chance of a complete bust, so I’m going for a diverse portfolio.

In the past, I’ve noted why I’m partial to Vanguard and also why I’m partial to index funds, so I’ve decided to basically take Money’s suggested portfolio and use that for my house investment portfolio. I plan to own the following seven funds:

Vanguard 500
Vanguard Total International Stock Index
Vanguard Small-Cap Index
Vanguard Value Index
Vanguard Total Bond Market Index
Vanguard Inflation Protected Securities Fund
Vanguard Prime Money Market

However, I would like a proportional split like the following, as we saw in the Lazy Person model portfolio:

75% stocks
25% bonds and cash

That means I’m going to have the percentages roughly allocated like this:

15% Vanguard 500
25% Vanguard Total International Stock Index
15% Vanguard Small-Cap Index
20% Vanguard Value Index
5% Vanguard Total Bond Market Index
10% Vanguard Inflation Protected Securities Fund
10% Vanguard Prime Money Market

I have the highest percentage in the Total International Stock Index because it doesn’t overlap with the other elements at all, and I have a fairly high percentage in the Vanguard Value Index because it pays strong dividends and only slightly overlaps with the other two domestic indexes.

How will I buy? My plan, as mentioned earlier, is to pay off all of my non-mortgage debts before beginning to invest. When I start, I’ll buy the minimum amount of each fund ($3,000), then contribute an amount each month ($500-$1,000, depending on our financial situation then) that moves the portfolio closer to the target percentages above. Then I just contribute steadily, sit, and wait.

Aren’t you changing plans a lot? Of course they are. I’m attempting to do as much research and learning as possible before I commit to a plan, but once the cash starts going in, I’m going to stick firmly to the plan. This period of time, as I continue to pay off debts, gives me time to learn and plan and revise that plan, and I think it’s interesting and illustrative to discuss those plans as they grow and evolve as I learn more.

As I study and learn, however, and spend more time discussing our plans with my wife, my actual investing plans become more clear and falls more in line with my actual goals. If I were to start today, this would be my plan – it matches up with everything I’ve learned up to this point.

How does this affect me? There are two big lessons that anyone can take from this.

First, it’s worthwhile to do the research and plan things. Don’t just start investing – plan ahead. My family’s financial plan gives us some breathing room before we start dumping in cash, but I’m not waiting until the day to start investing to plan. I’m thinking about it, figuring out how to minimize my risk and what kind of returns I want, and talking to my wife about things, too. I’m also reading a lot of sources on investing, too, and incorporating various pieces into my overall picture.

Second, don’t accept just one person’s ideas. My plan is coming together as a result of not just my own thoughts, but the input of a lot of reading and research. Before you make a major financial move on your own, make sure you know what you’re doing and make sure you’ve read up on your choices from multiple sources. Don’t just jump into the pool because someone made one suggestion – think it out and find more than one person’s perspective.

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