Once you have decided to open an investment account like an IRA or any other brokerage account, the next step is to plan out your strategy. Curious if a Roth IRA is right for you? Check out my other article at https://www.pioneerfinances.com/post/is-a-roth-ira-right-for-you
This can be easier said than done, as the market is unpredictable and studying its habits is an entire profession. If you're like me and want a hands-off approach with a decent return on your investments and without a lot of risk, a three-fund portfolio is a great way to start.
A three-fund portfolio consists of mutual or index funds for short term returns, along with bonds for long term returns. Mutual funds are investments that are split apart into multiple holdings. This diversity of holdings helps mitigate the risk of investing because if one holding fails to perform well, the fund may be backed up by its other holdings. Bonds are essentially loans you give that are paid back with interest.
What are mutual and index funds and how do they work?
For example, let's say you were to invest in a hypothetical broad "tech" fund. This hypothetical fund consists of holdings in Apple, Microsoft, and Medtronic (a medical technology company). This means a certain percentage of your investment is allocated to each of these three holdings, and these percentages are decided by the manager of the mutual fund. If during a particular day Apple shares tank, your Microsoft and Medtronic holdings can help soften the blow if they stay stable or go up in value, thus stabilizing and minimizing the risk involved in investing to an extent. Keep in mind that investments are not FDIC insured and there is NO way to completely prevent losses.
All index funds are mutual funds but not all mutual finds are index funds. Index funds are mutual funds that track an index, such as the S&P500, which consists of 500 large companies in the united states. This means that your investment is divided into a portion of shares within each of those 500 companies.
Mutual funds can be actively or passively managed. The advantage of an actively managed mutual fund is that the fund manager can try to maximize your returns by periodically reapportioning the amount of your investments put into each holing. Actively managed funds typically require a fee, as the fund manager needs to be compensated for their work. Passively managed funds are not reapportioned and follow the tracked index.
Putting the Plan into Action
Now that we have a better understanding about the advantages of investing in mutual funds, let's use them to our advantage. As mentioned before, the basic three-fund portfolio consists of two mutual funds. Typically the two mutual funds consists of a domestic and an international fund that track the overall domestic and international markets respectively. Each brokerage manages their own versions of each fund and it is best to stick with your own brokerage's versions as they will usually incur no fee. Mutual funds can also be pretty expensive, which also makes Exchange Traded Funds (ETFs) a viable option as well.
Below is a table listing possible options offered for three popular brokerages. (ETF's not listed for Fidelity due to their ETF's not being traditional and may carry more risk. See Fidelity's website for more information: https://www.fidelity.com/etfs/different-types-of-etfs)
Similar to deciding which funds to invest in, deciding how much of your allocated cash that you set aside for investing that will go into each third of your portfolio is a personal choice. One strategy used in making this decision is based on your age and how close you are to retirement. Younger investors farther away from retirement may choose to allocate more of their investment money towards mutual funds since there are often greater returns, however more risk, thus being younger allows for more time to recover from losses. Older investors may want to allocate more funds toward bonds that are typically less risky but have lower returns.
Below are some possible bond options for your portfolio. (ETF's not listed for Fidelity due to their ETF's not being traditional and may carry more risk. See Fidelity's website for more information: https://www.fidelity.com/etfs/different-types-of-etfs)
As you get older and your financial situation changes, you can change the amount of cash allocated towards each fund to fit the needs of your financial goals. Starting out young, a portfolio could consist of 60% domestic, 30% international, and 10% bond and gradually change to 30% domestic, 20% international, and 50% bond.
Ultimately, you alone are responsible for assessing your goals and risks. The percentages above are not gospel and can be tweaked in any way that you believe is best for you. You could even add a fourth or fifth fund such as a high dividend yield fund. Or you could opt for a two fund portfolio with just domestic and international market funds. With these strategies, a solid foundation can be established for you to begin investing in your future. As you manage your budding portfolio you will learn what is best for your financial health and understand what is necessary to reach your goals.
Disclaimer: This article is not financial advice and is intended only for educational purposes. Investments are not FDIC insured and carry risk. Please check with your brokerage for more information.