How to Build Your Index Fund Portfolio (Choose The Best Asset Allocation for You)

Transcript:

On this episode of the Personal Finance Podcast, we're going to talk about how to build your index fund portfolio and choose the best asset allocation for you.

What's up everybody? Welcome to the Personal Finance Podcast. I'm your host, Andrew, founder of mastermoney.co. And today on the Personal Finance Podcast, we're going to teach you how to build up your index fund portfolio and choose the best asset allocation for you.

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So we are getting very close to the new Master money.co website launching. And when that website launches, we're going to have a lot of things coming out. One of which is we're going to have a free debt course releasing for you guys. And it's an 8 video course teaching you the fastest ways to get out of debt and putting together a debt plan for yourself that's going to be absolutely free.

So that you guys have that available to you. I never want to charge somebody for anything that is related to paying off their debt because you're already struggling enough as it is. So I want to make sure that you guys have that free resource available to you. Now. We tried to make it as high quality as possible as well with this free resource of a lot of people would charge for something like this, but we would never do that here in Master Money.

We want to teach you how to build wealth on that end. Then we have our premium course coming out. It's called Index Fund Pro. An Index Fund Pro will be releasing sometime in September. So pairing with this episode, we have a free CHEAT SHEET for you guys.

And the free CHEAT SHEET is like all my favorite index funds and ETFs from the different brokerages and all the best ones that I think are out there. So with that CHEAT SHEET, you're also going to be notified when Index Fund Pro is releasing. And in addition, you may be able to access it a week or two early and we're going to be sending out a bunch of discount codes and things like that.

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We break it down all the way down from the basics all the way up to really advanced strategies. So that's the cool thing about Index Fund Pro that's going to be coming out. So stay tuned. We're going to be talking a lot more about Index Fund Pro when it's ready to go, but make sure you grab that CHEAT SHEET. And if you grab that CHEAT SHEET, you're going to be a part of our new e-mail newsletter that's going to be coming out.

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So today we're going to be talking about what is an asset allocation, why you want to diversify your portfolio, what is a three fund portfolio and how your portfolio should adjust as you age. And then we're going to be talking about Warren Buffett's portfolio. We're going to be talking about some other portfolios as well and target a retirement funds, robo advisors.

This episode is packed with all kinds of stuff on how to build out your index fund portfolio. So I am super excited to share this episode with you guys. And without further ado, let's get into it. All right, So the first thing we're going to be talking about is what is asset allocation?

If you never heard the term asset allocation, it's just figuring out how much money you want to put into different investments. It's just a fancy way of saying how much money am I going to put in stocks? How much am I going to put in bonds? How much am I going to put in some different things? And it's essentially how you can build your portfolio.

Now to do this, you got to figure out two things. The first one is your risk tolerance. So what is your risk tolerance? Well, your risk tolerance is how do you react to high risk investments and how do you react to low risk investments? So for example, if you can't sleep at night when the S&P 500 drops 2 or 3%, then you have a very low tolerance to risk, meaning you can't handle much risk, you can't handle much volatility.

Whereas if you're like me and you sleep like a baby, even if the S&P 500 drops 50%, then you have a very high risk tolerance. Now you can build up your risk tolerance in a number of different ways and we're going to talk about that here in a second. So the second thing you need to figure out is how long your time horizon is or how long you have until retirement, because this is going to matter when it comes to choosing your investments, specifically when it comes to risk tolerance.

But in addition, if you're very close to retirement, maybe you want to adjust your portfolio a little bit to de risk that portfolio because you're going to be living off that money for a while. So there's a number of things that you want to do to be able to do that. We're going to talk about that in this episode as well. So let's talk about risk tolerance for a second.

So the thing about risk tolerance is if you panic every time the market takes even a slight dip, you don't want to be in something like high growth stocks or crypto because you will literally pull your hair out. You'll be stressed all the time, you'll be anxious all the time, you'll never sleep. It's not worth it for you.

You will never be successful investing either because your emotions are going to be driving your investment decisions. And we talked about this in this podcast before. You want to keep your emotions out of investing as much as possible. The reason being is that you can't make rational decisions when your emotions get involved.

And investing is keeping your emotions out of the equation, which is why we love index funds so much because all you have to do is just index and chill, brah. But in all serious, you just have to index every single month. Invest your dollars into your index fund portfolio. And you don't have to think about it because you're investing in a very large diversified pool of stocks.

Now, you can tolerate risk at a much higher level, and you can actually build up this skill. It's actually like building up your muscles. And there's a couple of ways to do this. The first one is knowledge. So the way that I built up my risk tolerance was reading a lot of books and understanding how the market ebbs and flows. And it'll leave living through it for the last 15-17 years.

See, I started investing when I was a teenager, so I've seen a ton of market fluctuations during that time. At the beginning, I would panic. I would let my emotions get involved. I would do a lot of stupid things. But I learned from all of those mistakes, which leads me to #2 which is experience. So between your knowledge and experience, if you read a lot of investing books, every investing book tells you the same thing.

Do not look at what the market is doing today, today. Worry about what the market is doing long term because over the long term, the market goes in One Direction. Look at any stock charts you have ever seen in your entire life and pull it back 50 years. What direction does that market go?

You can pull it back 80 years. You can pull back 100 years. The market has gone in One Direction historically. Now there's going to be a lot of pushback where people will say, well, not this time. Well, every single time people have said, well, not this time. And it's come back again. We have for 100 years of data and it's gone in One Direction.

Now, could it go down forever? Absolutely. There's always risk involved, but there are a ton of stats out there. Like for example, if you invest in the S&P 500 for 20 years or longer, you'd lose money 0% of the time. Historically, you make money 100% of the time in the S&P 500 if you stay invested for 20 years or longer.

So understanding this, having knowledge like that on a bunch of different stats and facts and looking at historic charts, listen, history is not going to repeat itself every single time. That's not what I'm saying. But what I'm saying is history is going to help you understand what very well could happen in the future.

And now if the future is very different, then we'll figure that out as we go. But it's highly likely that the market will go in One Direction. And the second one is time horizon. So the longer the time horizon you have, the riskier your assets can be. Notice I did not say should be, I said can be because if you have a really bad risk tolerance, you don't want riskier assets because you're just going to pull your hair out.

But if you have a very long time horizon, you have more time to recover if you make a mistake. So This is why the longer the time horizon, the more you should have invested in stocks because stocks people claim are a riskier asset. Now, in my book, stocks perform better.

So it's a less riskier asset in my book because I know which direction the stocks go in. Whereas bonds are a less risky asset. But historically, bonds have underperformed stocks within the last 20 to 30 years. And as you get closer to retirement and your time horizon shrinks, you want to start to de risk that portfolio a little bit.

So we're going to talk about that here in a second. And the next thing I want to talk about is why you want to diversify. So the goal of diversification is to reduce the risk of loss. So let me explain with an example. Let's say for example, that you invest in a stock, say Johnson and Johnson for example, and there's a bunch of news that comes out and you put your entire net worth into Johnson and Johnson and there's a bunch of news coming out all of a sudden that Johnson and Johnson has fraudulent accounting.

This is not true. I'm just using this as an example as fraudulent accounting and does all these different things. Well, guess what's going to happen? That stock is going to tank and your entire net worth is going to tank with it. But if you are well diversified, meaning you own a number of different assets, it doesn't have to be just stocks.

You can own real estate, you can own bonds, you can own dividend stocks. There's going to be a bunch of different things that you own all at one time. Well, if you're well diversified and let's say for example you own 20 stocks, well Johnson and Johnson tanking is only going to be 5% of your net worth instead of your entire net worth.

So the impact is going to be minimal in comparison to putting all your eggs in one basket. This is why we like to diversify, especially if you're not a professional investor, which even as we know from stats we talked about in the past, even professional investors aren't that great of investors when it comes into comparison with the S&P 500.

But This is why you want to diversify to protect your downside. And if you're new to investing, you absolutely want to be diversified because you need to understand how the market works, how it ebbs and flows, and what's more important is your money psychology over anything else, making sure your emotions don't get involved. And you know, month in and month out, I'm going to do the same exact thing.

Guess what I'm going to do? I'm going to stick to my investment plan. Now, if you've made mistakes in the past, do not beat yourself up because I've made a million mistakes in the past to get to the point that I'm at now. And the reason why mistakes are important is because you learn from those mistakes and you're not going to make them again. Now, the thing about mistakes is, and Warren Buffett talks about this all the time, is that the mistakes don't have to be your mistakes.

This is why it's so important to continue to be learning all the time because you can see other people's stories and what they have done and understand that you don't have to make the same mistakes. You can learn from mistakes, but they don't have to be your mistake. So that's why it's so important to continue continue learning as much as possible so you can diversify in so many different things from stocks, bonds, real estate, crypto, gold, commodities, businesses, boring businesses, farmland.

There's so many different things that you can diversify with your investments that it's incredibly powerful. But in this episode, we're going to be talking about how to diversify with your index funds and ETFs, because that is primarily how we like to invest here at Master Money is really well diversify the low cost funds that have historically been proven.

Now let's get into how to build out your portfolio. And we're going to start with a three fund portfolio. All right. So the first thing we're going to start with is a three fund portfolio. And we really dive deep into this and an index fund pro as well. We teach you exactly how to build out your portfolio step by step.

Well, we're going to look at a three fund portfolio first because this is the most common for most people and I think it's a great portfolio to look at, especially if you're new to investing. So the three fund portfolio means that you are diversifying with three funds and the traditional three fund portfolio is investing in the total U.S. stock market, the total international stock market, and then the total bond market.

You're going to build a portfolio in percentages based on these three types of funds. the US stock market, which can be the S&P 500 or it can be the total stock market index fund, the total international fund and the total bond market fund.

So the cool thing about a three fund portfolio is you can build it any which way you want to to your risk tolerance. So the cool thing about that is, say for example, you like stocks a lot and you really want to have a high percentage of stocks. Well, you can go 80% stocks, 20% bonds. This is a very traditional form of a three fund portfolio for somebody who is younger.

So you could do something like 64% of the total stock market. You could do 16% in international stocks, and you can do 20% in the total bond market. Now this is a little bit passive for my personal thing. I'm going to talk about my personal portfolio as well in this episode, but that's a little bit passive for what I like to do when you're younger.

But if that's you, you need to figure out what works best for you. If you don't like the market moving up and down so much, then maybe you need to add some additional bonds because bonds are less volatile than stocks. That's the thing here is understanding that bonds move up and down far less than stocks do. Stocks can fly all over the place.

Here's another example. So you could do a 6043 fund portfolio if you're risk averse. So you could do something like 48% in the total U.S. stock market, you do 12% in the international stock market and 40% in bonds. You could do equal weights, 34% in the US stock market, 33% international, and 33% in the total bond market.

That'd be a very conservative portfolio. And the more bonds you have, the more conservative you're getting. So you could do something like a 4060 where it's 40% stocks, 60% bonds. This may be somebody in retirement age or somebody who's really, really risk averse, does something like 32% total stock market, 8% total international stock market, and 60% bonds.

So there's a bunch of different portfolios like this that you can do. You can tailor it to your own needs. And I'm going to tell you, you know, after we talked about this three fund portfolio, I'm actually going to show you what the Warren Buffett portfolio is, what he actually does for his children and his wife. But the three fund portfolio is really awesome for people, especially if you get into investing.

Now the thing about the three fund portfolio is to really have a true three fund portfolio, you need to rebalance your portfolio at the end of every year or every quarter or however you want to do it. Now this is a process where what you're doing is whatever is over performing within your portfolio.

Say for example, stocks just take off and bonds don't move at all. Well, what will happen there is your portfolio weight is going to be very different from when you start at the beginning of the year. So if stocks take off and you want an 8020 portfolio, all of a sudden now your portfolio is a 9010 because stocks took off. So the prices are much higher and bonds didn't go anywhere or went down.

So they are a lower percentage of your portfolio. So you're going to have to sell some of your stocks and put them into your lower performing fund, the bonds, to make sure that you have that same diversification. And what this is called is it's called rebalancing your portfolio.

Now you can ask me, do I rebalance My Portfolio? And I'm going to tell you no, because I like simplicity when it comes to my money. And so I'm not going to rebalance My Portfolio just to keep equal weights. I don't think the percentages are as important as other people do.

Now, a lot of people would argue against me on this. There's a lot of people out there like the Bogaheads, which are like the original OG index fund crew that would argue with me about this. And I have no problem if you want to rebalance your portfolio, it's probably healthy to do that. But I know my risk tolerance and I'm a little bit more comfortable with my investing strategy.

So I don't rebalance My Portfolio, but to have a true three fund portfolio, you need to be rebalancing every single year. Now here's something that's key about this. The key is you can think through this and say, well, that sounds kind of complicated to have to rebalance My Portfolio at the end of every single year. Well, guess what my friends, there are things and funds that will do this for you.

So two things we're going to talk about here. The first one is we're going to talk about target date retirement index funds. Now, if that sounds like a lot of words and you never heard that before, look at your 4O1K or you can look at your Roth IRA, your IRA and they are the funds that usually have the year that you're going to retire.

So like when you get your first four O 1K, this is almost in every single 4O1K. Now you'll see something like the 2065 target date retirement index fund. And what that is, is it's actually a three fund portfolio that is done for you. So I love these things. I love target date retirement Index fund is the key, not target date retirement funds because those are usually mutual funds and it as we know if you listen to this podcast, mutual funds have much higher fees than index funds too.

But I love target date retirement index funds because the fees are extremely low. Now if they're in your 4O1K or your IRA, you want to look at the fees. The fees are what are known as the expense ratio. If the expense ratio is anything above a half a percent or 50 basis points, then you do not want to be in that fund because the fees are too high.

Now that may not sound like a lot to you and if you've never heard the episode we talk about the impact of fees, I will link it up down below so that you can check that episode out because it's very important to understand how impactful even a half a percent to a 1% fee can be to your portfolio over time.

It is very impactful. So you got to understand that you want to keep those fees as low as possible, which is why I love the Target date retirement index fund because typically the fees are 0.15%, for example. And they are a fantastic option if you don't feel like rebalancing your portfolio, but you want to keep that balance portfolio.

And the cool thing about them is that you can choose which type of portfolio and how aggressive you want to be. So the funds where you're going to be retiring in 2065 are much more aggressive than the funds where you're going to be retiring in 2035. S The funds in 2035 are going to have a much higher exposure to bonds, whereas the funds in 2065 are going to have a much higher exposure to stocks.

So I can take a look at some of these. For example, I'm going to go to the Vanguard site and I'm going to look at a couple of these. So they have, here's the 2065 fund, which has a 0.08% expense ratio. That's absolutely fantastic. So if you are looking somewhere trying to figure out where do I find these target date retirement funds, Vanguard is one of the best places.

Fidelity is also awesome and Schwab is probably another place that has some great ones. So here is how the Vanguard 2065 fund is broken out. It is 90% stocks and 10% bonds. That is exactly where that should be when you look at Target date retirement funds because it should be broken out that far out.

When you have that long of a time horizon, you want to have more stocks than bonds because you have a longer time horizon for compound. Just to start working for you, so if you look at this, this ones called VLXVX is the ticker symbol that I'm looking at here. And with this fund, it's 53% of the Vanguard Total Stock Market Index Fund, which is the all the US funds.

It is 36.4% of the Vanguard Total International Stock Index fund. It's got 6.8% of the Vanguard Total Bond Market Index fund, and it's got 3.2% of the Vanguard Total International Bond Index Fund. This is a fantastic portfolio.

Now, do you have to be retiring in 2065 to get the 2065 fund? Absolutely not. This is all about your risk tolerance. You could be retiring in 2025 and have the 2065 fund. This is all about your risk tolerance. So like I said, the longer the time horizon from when you retire on these funds, the greater the growth potential is, but also the greater the risk tolerance has to be for you to be able to take that on.

Now let's look at one, say for example, the 2035 fund to just show in comparison. So this is someone who maybe wants to retire in less than 15 years. Remember the last one we looked at was 90% stocks and 10% bonds. Well, this fund in 2035 is 70% stocks and 30% bonds.

So it's 42% in the total stock market for the US, it's 28% for the international funds. It is 20% for the total bond market and 8% for the total international bond market. So as you're approaching retirement, it is increasing the bond exposure a little bit so that when you retire, you have a little more bonds and your portfolio is less volatile.

So this one's VTTHX is the ticker symbol that I'm reading off here. So that's just an example of some that you can look at. And you can look at one that's past retirement, for example, there's one that was past retirement in 2020. How much bond exposure does this one have? So this one has 57% in stocks and then the remainder and bonds.

So you're looking at a much higher bond exposure when you're retired. We're getting closer to that 5050 range. So that is how you can look at some of these target date retirement funds and see how they work and how they impact your personal retirement so that you can build wealth through these target date retirement funds and have it done for you.

The other way is with robo advisors. Now robo advisors are algorithms that you answer a bunch of questions about your risk tolerance and how old you are and all these different things and they're going to spit out a portfolio for you, a three fund portfolio for you and manage it for you throughout time.

Now these charge and expense ratio, except for one I know of doesn't, which is so far doesn't charge one, but Vanguard has one and it's .3% or 30 basis points. Wealthfront has one, it's .25% or 25 basis points and betterment's the same thing .25% or 25 basis points.

So these are places where you can have it done for you. A robo advisor where it's not going to charge as much as a financial advisor that's going to handle some of this stuff for you. In addition, it does some tax loss harvesting and things like that as well. So you can look into that as well. I prefer to do it on my own with less expenses.

I don't want to pay that additional 25 basis points. But if that's the thing you're into and if you want it done for you, you don't have to think about it at all, then it's a great option for you because it's still very inexpensive. Now let's talk about the Warren Buffett portfolio. OK, so now let's look at the Warren Buffett portfolio because his is a little bit different than a three fund portfolio.

So Warren Buffett has children and his wifes inheritance in this exact fund. It's a super simple asset allocation. He has 90% in a Vanguard S&P 500 index fund and he has 10% in a total stock market bond fund. Now he has this as Vanguard. He talked about this in his 2013 letter to shareholders.

So you can read that. And by the way, Warren Buffett's letter to shareholders is a must read every single year because he's talking about what's happening in the economy and what is going on. And you know, he's in his 90s now, so there's not going to be many of these left. But even going back and reading through a bunch of his shareholder letters are absolutely amazing.

If you want to learn about investing, I would read through all of his shareholder letters for the last 20 years because you're going to see what he's talking about throughthe.com bubble, through the 2007, 2008 recession and through this economic boom that we've had for the last 15 years. So you want to look at that and say this is one of the best lessons you could ever learn is reading these letters.

And his letters are usually not too long. It takes you about 30 minutes each one to read. So you could read, you know, one a week and get it done in half a year. So that's something that's definitely interesting. He's been writing these for decades now. So you can even go farther back if you're interested in that. So that is his asset allocation. It's 90% in an SP500 index fund and 10% in a total bond market index fund.

Now, another portfolio that I want to look at is what I call the Simple Path to Wealth portfolio. And the simple path to Wealth portfolio is really what I'm closer to following now. And we'll layout the reasons here in a second. But if you've never read the book The Simple Path to Wealth, it's by a guy named JL Collins, and he also has a great blog as well.

You can just Google JL Collins or The Simple Path to Wealth and it'll come up. And it is a must read if you're new to personal finance and investing because The Simple Path to Wealth is probably the most simple book to read, the most simple book to understand. And in addition, it is the basic principles that everybody should be following because The Simple Path to Wealth has a bunch of principles in there that are really easy to follow.

And if you follow those principles, you will build wealth. It's primarily learning how to pursue financial independence as well. Because he retired very early. I need to get him on this podcast so we can and talk through some of this stuff as well. But the simple path to wealth portfolio is he owns one fund and that's it.

He owns the Total Stock Market index fund or VTS AX is what it is at Vanguard. I think that's the exact one that he owns is VTS AX, which means it owns every single publicly traded company in the US, Every company that's publicly traded on the stock market in the US, you can own it all in one fund.

Now, there's a bunch of reasons for this. First of all, it's at rock bottom cost because it's an index fund. So most index funds like something like VTSAX, when you get into that, it's a expense ratio of 0.05% or maybe 0.04%, somewhere in that range. In addition, it provides broad diversification.

You're owning every single stock within the stock market. Now, people always talk about, well, you don't have any international exposure to international stocks. Well, if you think about every single company in the stock market, in the US stock market, they are operating internationally in a very significant way.

So if you look at the top 10 holdings, for example, of an S&P 500 index fund or a total stock market index fund, they are amazing companies. And if you look at the top 10 holdings of an international index fund, they are less premier companies. I'm just going to be real with you on that. The top 10 holdings of an S&P 500, an index fund, are companies like Apple, Amazon, Google, Johnson and Johnson, Berkshire Hathaway, Facebook or Meta, Tesla.

I mean, these are amazing companies. If you look at the top 20, it's even better. I mean, it's just an amazing compilation of companies and it's by weight, by market cap. So you can look at those companies and say I would much rather invest in these companies than I would some of these international funds. And you can look at the top ten and it's like Nestle on the international funds.

So when you look at these companies, you got to decide, do I really want to have this three fund portfolio or would I prefer to just invest in the total stock market index fund, which does a ton of business internationally? Now, another reason he talks about doing this is because stocks over time provide the highest return of any investment class.

And he's absolutely right about that. Stocks outperform bonds, they outperform hedge fund managers, they outperform mutual funds. If you invest in the market, I mean, they out perform every single asset class when it comes to investing in stocks and over time, stocks are an inflation hedge. So what people forget is that stocks are not just pieces of paper.

Stocks are pieces of ownership in operating businesses, sales, inventory, plants, all those different things, all which rise in value with inflation. So it's a ways to hedge against inflation. And another thing about VTSAX that JL Collins talks about, and this is a very important point to understand, is it's a self cleansing fun and the same thing for the S&P 500, meaning that if a company's not performing well or if a company's not doing well specifically with the S&P 500, while we're talking about this, if a company's not performing well in the S&P 500, you don't have to go down with that company.

The S&P 500 is going to kick that company out of the S&P 500 because the top 500 best companies in the US and they're going to add in another good company instead. So these funds are self cleansing. And when a company doesn't do well, you're so well diversified owning so many companies that it's going to allow you to not really be pulled down much at all.

So those are a bunch of different reasons as to why you should consider owning just one fund. And you do your own research on this to make sure that that's best for you. Because if you don't like the volatility of the total stock market, and that may be not the best option for you, but if you understand that stocks are the highest performing assets, you're going to have the highest returns over the long run, then maybe this is a great option for you as well.

So this is some options for you guys to think through on how to build out your index fund portfolio. Now I land closer to the simple path to wealth because I like to simplify my funds. I like to simplify My Portfolio. I'm either carrying the total stock market index fund or I'm carrying the S&P 500 index fund.

When I'm looking at my index funds now, do I have some old bond index funds and things like that? I absolutely do, but I don't do a three fund portfolio currently. I keep it with the S&P 500 index funds and a total stock market index funds. Now, not having that international exposure, could that bite you in the long run?

Potentially. So it's a risk that you got to think through and you got to think about that is do you want that international exposure? Because a lot of people may want that international exposure because usually when stocks in the US don't do well, then maybe stocks internationally will do well. So it helps you with that diversification.

So thinking through some of that, just making sure that you're making the right decisions for your personal situation is incredibly powerful. Now, if you want more deep dives on this, on how to build out your portfolio, make sure you get that checklist that we have linked up down below and get ready for Index Fund Pro.

Now Index Fund Pro, I'm going to tell you, is not going to be super expensive. We could be charging a hundreds of dollars for this. It's not going to be over $100. I want it to be affordable so that everybody can learn how to invest. And it's going to be over 40 modules. We're going to have over 40 videos on learning how to invest. You can skip around.

You can do it at your own pace. And I'm so incredibly excited to share this with you guys because we put so much effort into this course and I'm so excited for it and I can't wait to share with you guys. In addition, I'm so excited to share with you the Free Debt course. So make sure you stay tuned for that. Get ready for the Master Money newsletter that is going to be really fun.

It's going to hit your inbox only once a week. I'm not going to bother you all the time with it. It's going to have all these wealth building strategies and things that are really just going to benefit you that you can actionably take every single week. I don't want to put any fluff in there. There's not going to be additional stuff in there. I want it to be actionable items that you can take every single week.

So a lot of cool things happening here with Master Money in the Personal Finance podcast and we're just trying to grow so that we can show as many people as possible how they can too build. Well, listen, if you guys have any questions, make sure you hit me up on any of the social medias and don't forget to check us out on YouTube.

We are going to be amping up some of our YouTube content as well. So super excited about that. And thank you to every single person who has been leaving a five star rating and review. I cannot thank you guys enough for doing that. It means so much to me. I read every single one of them, so I cannot thank you guys enough for leaving those five star reviews.

I appreciate each and everyone of you for listening this episode and we will see you on the next episode.