Investing 101 | Investing Winner

Building a Starter Portfolio

Building a portfolio can be overwhelming. There are thousands of mutual funds, ETFs, and stocks to choose from. There are also various ways to allocate your money between stocks, bonds, real estate, gold, and other investments. But there is also a simple allocation that will work for most people and get their portfolio up and running.

This simple starter portfolio is a mix of US and international stocks, US and international bonds, and real estate. In fact, this starter portfolio covers nearly all US and international stocks and bonds that are worth owning — using Vanguard total market mutual funds and ETFs. And then I like to add a healthy dose of real estate investment trusts (REITs) to round out the portfolio.

The five funds that make up this starter portfolio are:

Vanguard Total Stock Market
Vanguard Total International Stock Market
Vanguard Total Bond Market
Vanguard Total International Bond Market
Vanguard REIT Index

Why Vanguard?

I’m a huge fan of Vanguard because of their low fees, high quality funds, and clients as owners. To clarify the clients as owners: you (the client) own the funds, and the funds own Vanguard. If you’re interested, you can read more about “Why Vanguard?”.

Vanguard Total Stock Market

ETF: VTI
Investor Mutual fund: VTSMX
Lower-cost Admiral fund: VTSAX

This fund provides investors with exposure to the entire US stock market – including small, mid, and large-cap growth and value stocks. It is very broad and diverse, totaling over 3600 stocks!

This fund includes all the big names such as Apple (AAPL), Google (now Alphabet) (GOOGL), Microsoft (MSFT), Exxon Mobile (XOM), Amazon (AMZN), JPMorgan Chase (JPM), and thousands of other big and small companies.

Vanguard Total International Stock Market

ETF: VXUS
Investor Mutual fund: VGTSX
Lower-cost Admiral fund: VTIAX

The Vanguard Total International Stock Index funds offers investors a way to gain exposure to global markets, including both developed and emerging economies, such as those of Europe and Asia.

Because this fund invests in global markets, there can be a lot of volatility, as some parts of the world have less stable economies than the US. But over the long term, having some international stock market exposure adds some diversification and potential benefits, especially when you look at emerging superpowers such as China and India.

The Vanguard Total International Stock Market index fund invests in over 6000 stocks, including household names such as Royal Dutch Shell, Nestle, Samsung, Toyota, HSBC, and Unilever.

Vanguard Total Bond Market

ETF: BND
Investor Mutual fund: VBMFX
Lower-cost Admiral fund: VBTLX

The Vanguard Total Bond Market provides exposure to US investment grade bonds, including both corporate bonds and US government bonds. It also invests in bonds of varying maturities which helps to stabilize the fixed income this fund provides.

The Vanguard Total Bond Market fund invests in over 8500 different bonds, the majority of which are US government.

This broad US bond fund is a perfect complement to the US total stock market fund, providing fixed income and generally stable asset price, which can help when the stock market experiences a decline.

Vanguard Total International Bond Market

ETF: BNDX
Investor Mutual fund: VTIBX
Lower-cost Admiral fund: VTABX

The Vanguard Total International Bond Market index fund offers broad exposure to global (non US) investment grade government and corporate bonds. It operates similar to the Vanguard Total Bond fund covering US bonds, except the focus is on international bonds.

The majority of the bonds in the Vanguard Total International Market fund are from more stable European countries and companies, but it also has exposure to the rest of the world. In total, it invests in over 4000 different international bonds.

Vanguard REIT Index

ETF: VNQ
Investor Mutual fund: VGSIX
Lower-cost Admiral fund: VGSLX

The Vanguard REIT Index fund invests in real estate trusts, which are companies that purchase office buildings, hotels, apartment buildings, and other real estate property. This fund will provide exposure to the real estate market, without you having to become a landlord yourself.

There are two main types of REITs: Equity REITs and Mortgage REITs. Equity REITs generate income through the collection of rent on, and from sales of, the properties they own for the long-term. Mortgage REITs invest in mortgages or mortgage securities tied to commercial and residential properties.

We know real estate and home prices can dramatically rise and fall, so this fund can see some volatility, but real estate investments have often performed differently than stocks and bonds. This REIT fund can offer additional diversification for a portfolio made up of stocks and bonds, and also adds diversification of asset classes, since this fund covers the real estate market.

Portfolio Allocation

Deciding how much money to allocate these mutual funds or ETFs as part of your total portfolio is an interesting problem. The general recommendation by experts and analysts is that the closer you are to retirement age, the greater percentage of your portfolio should be fixed-income or bonds.

In this example we will use a recommendation for younger people (20s-30s) with an 80/20 split, meaning 80% of the portfolio will be allocated towards stocks and 20% towards bonds. We will include real estate in the 80% stock mix.

Here is an example 80/20 portfolio mix with the portfolio leaning more heavily towards US stocks and bonds, but keeping a sizable amount allocated to international markets.

Vanguard Total Stock Market Index: 50%
Vanguard Total International Stock Market Index: 20%
Vanguard Total Bond Market: 15%
Vanguard Total International Bond Market: 5%
Vanguard REIT Index: 10%
Total: 100%

The Power of Compounding Interest

Compounding interest is one of the core principles of long term investing. The basic is the more often your investment compounds, the greater your investment will become, and your investments will grow at a faster rate over time.

Compounding interest is also one of the basic ideas of the phrase “It’s about time in the market, not timing the market” — over time, as your investments compound interest, you will see greater and greater accelerated gains.

What is Compounding Interest?

Compound interest is interest added to the principal of a deposit or loan, so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding.

To put this more simply, compound interest is “interest on interest” which means your deposit will grow at a faster rate than with simple interest.

Compounding Interest Formulas

Here are two formulas you can use to calculate compounding interest yourself.

Basic formula — for compounding once per year:

V = P (1 + r)^t

Where:
V = the value of investment at the end of the time period
P = the principal amount (the initial amount invested)
r = the annual interest rate (note: this is a decimal, so 5% becomes 0.05)
t = the number of years the money is invested
^ means raise to the power of

Example for compounding $1 initial investment at 5% over 50 years:

V = 1*(1+0.05)^50 V = 11.467

Advanced formula — for compounding multiple times per year, such as daily, monthly, or quarterly:

V = P ( 1 + [ r / n ] ) ^ n * t

Where:
V = the value of investment at the end of the time period
P = the principal amount (the initial amount invested)
r = the annual interest rate (note: this is a decimal, so 5% becomes 0.05)
n = the annual frequency of compounding (how many times a year interest is added)
t = the number of years the money is invested
^ means raise to the power of

Example for compounding $1 initial investment at 5% compounding monthly over 50 years:

V = 1*(1+0.05/12)^(12*50) V = 12.119

Important: Notice how compounding more often per year yields higher returns.

Example of Compounding Interest

Here’s a quick example of compound interest:

You have invested $1 at a 5% interest rate which compounds once per year.

Next year, the $1 investment would be worth $1.05 — a gain of $0.05.
In 2 years, the initial $1 investment would be worth $1.1025 — a gain of $0.0525 over the previous year
In 3 years, the initial $1 investment would be worth $1.158 — a gain of $0.0555 over the previous year.
In 10 years, the initial $1 investment would be worth $1.623 — a total gain of $0.623.
In 20 years, the initial $1 investment would be worth $2.653 — a total gain of $1.653.
In 50 years, the initial $1 investment would be worth $11.467 — a total gain of $10.467!

Important: Notice how the gains are increasing year over year and accelerating!

Compounding Interest Over Time

Here are two graphs that further demonstrate the power of compounding interest.

The first graph shows compounding interest of $1 initial investment and a 5% return rate over a 52 year period:

The next graph shows the compounding interest power of the same $1 initial investment and 5% return rate but over a 104 year period:

These graphs demonstrate the accelerating return rate you receive with compounding interest. The interest you’re making on your initial $1 investment is making its own interest — and it’s making more and more money over time — accelerating the returns.

Visual example of compounding frequency differences

Compound Interest with Varying Frequencies

In this graph you will see compounding more often yields higher returns. Over time, the $1000 initial investment compounding yearly will return significantly less than $1000 compounding quarterly or monthly.

Takeaway: Interest compounding more frequently will ultimately yield greater returns.

Learn More about Compounding Interest

If you’d like to learn more about compounding interest and it’s benefits on investing, I’d recommend these three books:

The Richest Man in Babylon

The Compound Effect

A Beginner’s Guide to Investing: How to Grow Your Money the Smart and Easy Way

How to Create a Budget

Defining your financial goals, creating a budget, and reducing expenses is the first step to becoming financially secure and investing in your future.

So how do you create a budget? You can start with these five simple steps:

Set realistic goals
Figure out where your money is going
Identify your income sources
Combine your income and expenses to determine your monthly savings
Reduce your monthly expenses

Set realistic goals

To get started, you’ll need to determinine your short term and long term financial goals. Are you paying off a car loan? Saving for a house? Planning on early retirement? Once you have defined your goals you can start organizing your finances and working towards completing your goals.

Figure out where your money is going

Before you can manage your money, you need to know how you’re spending it. You can use excellent tools such as mint.com or spreadsheets to track your monthly income and spending.

I personally use and recommend mint.com. What’s great about mint.com is that you can import all of your transactions from checking, savings, and credit card accounts, and then you can see all of that data in one place.

With mint, you can also set up your monthly income and expenses, and easily track if you’re exceeding your defined budgets. You can see great detail on exactly what you’re spending money on each month and how much you’re spending. Want to know how much you spent on fast food last month? Or the last year? You can easily visualize that spending over time data with mint!

Once you have a good tool for tracking your expenses, you can break your expenses down in to three common categories:

Fixed needs – those necessary expenses that stay the same each month, such as your rent or mortgage payments and cell phone bills.
Variable needs – expenses that will vary from month to month, sucha s gas, electric, water, and food.
Wants – these are non-essential expenses that are not needed, but nice to have once in a while, such as going out to the movies, eating out, entertainment, lattes.

Identify your income sources

Knowing where your income is coming from and how much you can expect each month is also important. You’ll want to create a detailed list such as paychecks from work, dividend income, bonuses, and any other way you’re making money.

Combine your Income and Expenses to find Savings

Now that you know your monthly expenses and monthly income, you’ll combine them to see if you’re spending more than you’re making each month, or how much extra you’re expecting to have left over. Here are the steps:

Add up your income
Subtract your expenses from the income
Allocate the remainder of your income — your monthly savings — to your goals.

Reduce your monthly expenses

If your expenses are greater than your income (negative cash flow), you’ll want to look for ways to decrease your monthly expenses so that you can increase savings and complete your goals.

Start by examining your “Wants” category. Do you find yourself spending a lot of money each month at Starbucks on cappuccinos that you don’t really need? If so you can start working on cutting down that cost and using that money elsewhere.

Think of it like this, would you rather spend $50 a month on coffees or have $600 extra at the end of the year? I’d rather have the $600! If you then invested the extra $600 per year, then after 10 years you’d have $7,500! Not only would you have your original $6,000 you saved, you’d have an extra $1,500 from compounding interest. If you scaled this up and saved even more money each month, and invested that money, you could potentially be able to retire younger, buy more property, or significantly increase your investment portfolio.

There are many other ways in which you can reduce your monthly expenses. Start by cooking meals at home rather than eating out and by buying necessities such as toilet paper, laundry detergent, etc. in bulk. A big savings for me was to cut out cable TV and instead stream my TV with Netflix. By cutting out cable TV, I’ve saved over $100 per month!

Putting it all together

Defining your budget and setting goals for yourself is the first step towards financial security and smart investing.

Now that you’ve created goals and a budget, you can easily track where your money is going, how you’re spending it, how you’re making it, and what you’re going to do with your savings.

You’re also actively thinking about ways to reduce your monthly expenses in order to save more money, and investing those savings so that you can have a lot more money in the future.