“Core” can mean good things or bad things depending on the context. An apple core certainly isn’t something you want to keep or consume, but the good part of the apple can’t become what it does without it. Your investment portfolio also needs a good core if it’s going to grow to its full potential.
There’s good news and bad news about what should be the core of your investments. First the bad news: it’s probably not going to be the most exciting part of your portfolio, if you build it correctly. The good news is that it won’t have any seeds to accidentally swallow, and the even better news is that it should provide a great deal of stability in building a solid long-term portfolio to meet, and hopefully even exceed your financial goals and dreams.
Here is what I would use to build the core of your investment portfolio: index mutual funds. I told you it’s wasn’t exciting! But it is the right way to invest. I have managed portfolios for clients that have had hundreds of millions of dollars, and most have had a solid core of index mutual funds. And the good news is that you need look no farther for this than the creator and king of the index mutual fund: Vanguard.
Vanguard has top-of-the-line index funds for just about every investment category and style imaginable, and with very low fees. Schwab and Fidelity also have some outstanding index choices; in fact, these three fund families pretty much dominate the index fund world these days.
There is even more good news about the core of your portfolio: it shouldn’t be difficult to construct. And it won’t require a lot of money. In fact, you can start with just three funds if you wish (I think it would be a great start): A US Stock Total Market Index Fund, a US Total Bond Market fund, and an International Total Market Index fund. You can add more to your core as your portfolio and your available investment money grows (which is also a great idea).
But how to choose these funds you ask? I’m glad you asked! There is yet even more good news about this (so much good news today, and there’s no extra charge!): index funds are very easy to analyze. In fact, I will tell you everything you need to know about index funds in this post. What you are looking for is: low fees and low tracking error.
“Low fees” should be pretty self explanatory. You don’t want to pay a high expense ratio for an index fund (you don’t want to overpay for any kind of fund, but more on that in future posts). So look for index funds with the lowest fees in their category. The other thing you need to look for is low tracking error.
Without going too deeply into it, tracking error measures how well an index mutual fund follows, or tracks, the index is it trying to follow in terms of return and risk level. The whole point of buying an index fund is to gain exposure to the return and risk characteristics of the index without having to buy every investment (stock or bond, depending on the type of index/fund) in the index, which is beyond what most people would be able to do.
Why do you want low tracking error? Because high tracking error means the fund is not doing what you are paying it to do. You absolutely do not want an index fund that outperforms its index. Yes, you read that correctly! For other types of funds, outperformance is very desirable, but not index funds. An index fund that outperforms its index over a certain period of time is doing something wrong, and will inevitably start underperforming at some point, probably in the not-too-distant future. This means increased volatility, which means increased risk, which means you’ve bought an index fund that is doing the exact opposite of what you want it to: control risk.
So that’s it: low fees and low tracking error. Choose the funds with the lowest among these two metrics, and you’re on your way to building the core of a solid, successful long-term investment portfolio!
But should you stop at the core when it comes to building a portfolio? You can, and many people successfully do. My preference though it to build on the core, using what is known in the investment industry as a “core/satellite” approach. The satellite portion of your portfolio is designed to enhance your returns while still managing risk.
I will be talking a lot more about enhancing the core and building the satellites in my second book, called Building Lifetime Wealth (yes, just like the blog!), which should be released in January or February 2021. I also present additional information about building your portfolio in my first book, which will be available in eBook form in a few days (the print copy will be available early in December). And stay tuned for much more on portfolio construction in future blog posts!
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