At this point, you should have developed an asset allocation for your portfolio.  To learn more about that, go back to the previous parts of this series.

It's now time to implement the asset allocation.  This involves not only selecting the actual investments to fulfill the asset allocation, but also deciding what types of accounts to use and determining where you should locate each investment within those accounts.

Selecting Investments

You've basically got three choices when you select investments.

  1. Select individual securities yourself
  2. Pay someone else to select investments for you through traditional mutual funds or ETFs.  If you pay someone else, you can have them manage the investment actively (trying to beat the market), or have it done passively.

Passive vs Active Investment Management

I favor passively managed mutual funds for three main reasons:

#1 Active Management is Really Hard

If this is news to you, I suggest a quick read of Rick Ferri's The Power of Passive Investing.  He puts together academic studies done over decades that demonstrate that while beating the market is possible, it is highly unlikely, and becomes more unlikely the longer the investing time period and the more investments that need to be selected.

#2 Active Management is Really Expensive

In fact, that's a big part of the reason why passive funds outperform active funds.  (The other big reason is primarily behavioral.)  Years ago, the only funds available were actively managed.  That provided a benefit to investors since they could get wide diversification at a much cheaper price than they could get themselves.  There was little focus on “beating the market” since you couldn't buy the market.

When index funds showed up, other mutual funds had to focus on beating the market, and it turned out it was much harder to do than anyone imagined.  The expense ratio on funds easily available to any investor is less than 0.1% per year, or less than $1 per $1000 invested.

#3 Passive Management is Really Easy

You select a fund based on only three factors:

  1. Which index does the fund follow
  2. How well does it follow the chosen index
  3. Price

You don't have to learn all about the manager's background, evaluate his track record, and constantly monitor his activity so you can get out quickly if he ever “loses his touch.”  You just buy it and forget it.  Passive investors get mad when their fund doesn't have a return within a few basis points of the benchmark index, which is a pretty rare event for most popular index funds.

Traditional Index Mutual Funds vs ETFs

Some people spend a lot of time worrying whether to use traditional index mutual funds or ETFs.  The truth of the matter is that it doesn't matter all that much.  Expenses are similar and true advantages of one over the other for most investors are minimal.  Mutual funds are generally easier to use since you don't have to interact with the market, but in some of the more obscure asset classes an ETF is markedly better than a fund.

How to Get Started

The process for most of us goes like this:  If I want say 5% of my portfolio in REITs, I look for a passively managed REIT fund and put 5% of my portfolio in it.   I want 5% of my portfolio in emerging markets, so I look for the best passively managed emerging markets fund and put 5% of my money in it.  It's pretty simple.

If you're not sure where to start looking for passively managed funds, go to Vanguard.  You don't necessarily have to have all your investments at Vanguard, but you probably ought to have a pretty good reason to invest somewhere else.

The hard part is the asset allocation, not the selection of the investments.  But too many people don't do these steps in order, and that's where things seem confusing and complicated.

Choosing Accounts

This step can make a big difference.  I'm often surprised to see people not using the appropriate type of accounts for their situation.  For example, a resident who isn't investing for retirement in a Roth IRA.  Or parents saving for their children's college in a taxable account instead of their state 529 plan.  Or a doctor at the peak of his earnings career choosing a Roth 401K or even a taxable account instead of maxing out his tax-deferred 401K contributions.  Everyone's situation and outlook is a little different, but using the right accounts for the right reason can make a huge difference in your after-tax returns over the years.

Tax-Efficient Placement

If all your investing accounts are tax-protected (like mine currently are) this step doesn't matter so much.  If you have a significant taxable investing account however, you need to pay attention to this step.  As a general rule, you should use tax-protected accounts as much as possible, and when you have to invest in a taxable account, you place your tax-efficient assets there first.  So if only 50% of your investments are within tax-protected accounts, and your desired asset allocation is:

  • 20% Total US Stock Market
  • 20% Total International Stock Market
  • 20% Small Value Stocks
  • 5% REITs
  • 15% TIPS
  • 20% Total Bond Market

Then you'd want to rank the assets in order of tax-efficiency.  Here's that list in order from most efficient to least efficient:

  • Total International Stock Market
  • Total US Stock Market
  • Small Value Stocks
  • REITs
  • Total Bond Market
  • TIPS

So you would then place your assets like this:

Tax-protected accounts 50%

  • 15% TIPS
  • 20% Total Bond Market
  • 5% REITs
  • 10% Small Value Stocks

Taxable account 50%

  • 10% Small Value Stocks
  • 20% Total Stock Market
  • 20% Total International Stock Market

There are a few subtleties to this process, but in general, it's pretty straightforward.  If you're not quite sure you're doing it right, consider posting your desired asset allocation and how you're planning on implementing it on the forum or Facebook Group.  You'll have valuable feedback within minutes and some reassurance that you're doing it right.  Next time, in the final post of this series, we'll discuss maintaining the portfolio as the years go by.