So, how should I build my portfolio using tools like mutual funds, ETFs, stocks, bonds and money market accounts to achieve the asset allocation plan I desire?
Many financial columnists advocate, for good reasons, that once the asset allocation of a portfolio is determined, one can simply purchase passively managed index funds for each asset class. The reasoning? Majority of actively managed funds fail to beat the index (read: market) after fees, so one will save time AND achieve market performance by simply picking the lowest-cost index fund.
I have to admit there is some wisdom in this line of thinking. For most individual investors who have no time nor interest in learning how the market works, it will be a challenge to differentiate between the thousands of funds in the market, and to appreciate those that are consistently beating the index. Therefore, a plain-vanilla solution of index investing is a great solution.
However, the truth is in every asset class, a number of funds are consistently delivering market-beating returns. These popular shops include Oakmark, Dodge & Cox, Longleaf, Legg Mason and Third Avenue in equity and PIMCO and alike in fixed income. (One may argue that the sheer number of equity funds in the market ensures that there will always be a few funds will have the lucky streak to beat the market over a decade. However, the fact that among the market-beating pros there is a concentration of fund managers with similar value investing mindset seems to support that some schools of thought can consistently deliver the alpha.)
Therefore, instead of holding index funds for market average return, I plan to own a number of actively managed funds -- I do believe I will be rewarded with a few extra percentage points of "alpha." (For our 401(k) accounts, I have to settle to the short list of investable funds.)
In addition, I intend to (continue to) hold some individual U.S. stock positions -- most of them will be large-cap companies. First, I have a vested interest in learning stock market and different lines of business. I also have professional knowledge in understanding corporate finance, and my (post-retirement) life will be boring without looking at the numbers once in a while). Second, investing in individual stocks allows me to better track to my absolute return goal of 10% -- by setting an expected return and allowing enough safety margin, one can largely calculate the rate of return should the price of a stock returns to its intrinsic value.
For the record, I have good success so far in my stock picking: my stock portfolio beat the market in 5 out of the last 6 years, and achieved an annualized rate of return of 17% since April 2000, when the market peaked. Many painful lessons after, I am also conducting more due diligence and consciously moving away from exotic small-cap picks -- all these should improve my batting average moving forward. In addition, I am growingly more patient -- I've held the 12 outstanding individual stock positions I had as of January end for an average of 1.5 years.
To summarize, here is a list of allowable investment vehicles in my portfolio, by asset class:
Domestic Equity (Target Asset Allocation = 45%):
30% in Large-Cap/Mid-Cap Stock Picks
15% in Mutual Funds that Specialize in Mid-Cap, Small-Cap and All-Caps
Foreign Equity (Target Asset Allocation = 35%):
ETFs (When Quality Mutual Funds Cannot Be Found for Particular International Stock Segment)
Cash & Fixed Income (Target Asset Allocation = 15%):
Money Market Account
Certificate of Deposit (CD)
Quality Mutual Funds and ETFs That Specialized In Fixed Income or Bank Loans
Exotic Tools like Prosper.com
MSFT Stock Options (Target Asset Allocation = 5%):
Vested MSFT Employee Stock Options (Of course)
Other MSFT Option Plays in Open Market (to reduce the risk of Employee Stock Options)
In the next few posts, I'll be discussing the process of choosing the individual stocks and mutual funds to build out the portfolio.