Creating a Diversified Portfolio of Stocks with Less Than $500

[I know my images are large and extend beyond the "box" designed to hold them. However, I wanted readers to be able to clearly see/read the information so I purposefully made the images larger.]

Index investing  involves investing in a portfolio of securities that are contained within an index, like the Dow Jones Industrial Average (the DOW). The DOW is a set of 30 very large companies and the index tracks the value of those 30 companies. The S&P 500, another popular index, consists of 500 large mostly U.S.-based companies.  If you owned all 500 companies of the S&P 500 you would have a more diversified portfolio of stocks compared to owning only stocks in the 30 companies that comprise the DOW.  However, even owning all of the S&P 500 is not going to get you a well diversified portfolio. There are many, many indexes, but the DOW and S&P 500 are two of the most well-known as they are among the oldest indexes and contain very large U.S. companies.

To have a well diversified stock portfolio you need to invest in companies of all sizes (market capitalization), in all the major sectors, and in all the major (and minor!) markets of the world. Thankfully, it is very easy to do so nowadays.  You can do this via exchange-traded funds, or ETFs. ETFs typically have very low management fees. And, some brokerage firms let you trade a limited set of ETFs without a commission. This post explains how to form a well-diversified equity (stock) portfolio that includes companies from all over the world by purchasing either two or four ETF commission free. At the time of this blog post, the total cost for all four ETFs is less than $500.

Open a Brokerage Account

The first step is to open a brokerage account.  I happen to use TD Ameritrade so that is the one I will discuss because I am familiar with it. As far as I know, TD Ameritrade does not require a minimum amount to open an account. Create an account and transfer $500 to it (although you can do this process in stages with even less than $500). TD Ameritrade offers commission-free trading for 100 ETFs, including the four I am suggesting below.

To open account on TD Ameritrade, click on OPEN AN ACCOUNT in the upper right corner of TD Ameritrade's home page. You'll need a few bits of information, including a social security number (or tax ID number).  You will need to choose an account type. I've included a screen shot of the most common account types below.

Why does this matter? It will impact whether or not you have complete access to withdraw/add funds at any time. If you open an IRA the amount you can add each year is limited and subject to a specific set of restrictions. One big restriction is that you must generate EARNED income (as recognized by the IRS) and the absolute max you can contribute annually (as of 2017) is $5,500 if you are under 50 years of age. You can also only withdraw money from an IRA for very specific reasons. If you want unlimited access to your money and the ability to add/withdraw with no legal restrictions based on tax laws, you should open an Individual account (or Joint, if you are opening an account with another person). Make sure you read about each type of account. When you click on an account type the verbiage to the right will describe the account type.

You will also need to choose whether you are going to actively trade stocks and other securities or only occasionally trade stocks, mutual funds, ETFs or bonds.  If you are new to investing (and I am presuming you are because you are reading this post), choose the first option.

Complete the account opening process and transfer funds to the account.  To purchase all four securities I am recommending, you will need about $500 at the time this post was written.

Enroll in Commission-Free Trading

With TD Ameritrade you have to sign-up for their commission-free trading. It's free and I am not sure why they make you register for it, but you must for your trade to actually be commission free. To access the commission-free ETF trading platform, after you login to your TD Ameritrade account, you should click on the RESEARCH AND IDEAS menu.  It is under the ETFs section as shown in the screenshot below.

Clicking COMMISSION-FREE ETFs will take you to this screen:

Once you are enrolled in their commission-free program, you should see the "Congratulations! You are enrolled in commission-free ETFs." That will allow you to trade any of the ETFs from the commission-free list free of charge. Otherwise, you will have to pay a commission of $6.95 for every ETF trade you make. 

Buying ETFs

Now it is time to actually purchase your ETFs.  I am going to recommend four, but you do not have to purchase all four.  

1. First I would purchase VTI.  Vanguard Total Stock Market ETF invests in the stocks of about 3,500 publicly-traded corporations based in the U.S. About 72% of the companies are classified as Giant or Large Caps, 19% as Mid Caps and 9% as Small or Micro Caps. It is a broad, passively-managed index fund that diversifies the investor across U.S. publicly-traded corporations. 
2. Next, I would add some foreign stocks to diversify my portfolio, in the form of shares in VEU. Vanguard FTSE All-World ex-US Index Fund ETF invests in stocks of mostly larger publicly-traded corporations across the world (except the U.S.).  At the time of this writing, VEU owns stocks in about 2,500 corporations, including Nestle, BP, Bayer, Toyota, Unilever and Anheuser-Busch. The majority of the stocks are from Giant or Large Caps (about 90%) and the remainder are Mid Caps. This ETF will diversify the investor in terms of foreign equity investments, although it does not contain any significant amount of Small Caps.
3. Third, I would suggest adding some foreign Small Caps via VSS--Vanguard FTSE All-World ex-US Small-Cap Index Fund ETF.  VSS invests mostly in Mid Caps non-U.S. stocks (66%) and about 34% in Small and Micro Caps.  The fund owns stock in nearly 3,400 smaller publicly-traded corporations that you would probably not recognize. I suggested adding this fund because VEU does not contain any small caps and adding foreign small caps will boost the diversification of your portfolio.
4. Finally, if you want to add some more Small Cap U.S. corporations, you could buy some shares of VB--Vanguard Small-Cap Index Fund ETF which owns stock in about 1,500 smaller publicly-traded corporations based in the U.S., including Domino's Pizza, JetBlue Airways and Vail Resorts. VB is made up of about 58% Small and Micro Caps and 42% Mid Caps.

If you bought all four of these ETFs, it would give you a diversified portfolio of domestic and foreign equities.  You would indirectly own shares in about 11,000 publicly-traded corporations of all sizes across the world. You would be invested in every sector of the market, as well. Learn about different ways to classify stocks (by company size and geographic region or by sector and type of market).

How Many Shares Should I Buy?

You cannot purchase less than one share of an ETF. I am writing this post for people who do not  have a great deal of money to invest so I am going to assume that you will probably only purchase one share at a time.  That is the main reason the "commission-free" nature of this strategy is so important. Right now the cost of one share of VEU is about $50. If you had to pay a $6.95 commission to buy one share, that is a hefty fee to pay relative to the price of the ETF. 

Here's my recommendation.  First buy one share of VTI.  It currently costs about $125. If you just did this and nothing else, you would own a portfolio that is nicely diversified across 3,500 publicly-traded U.S. corporations. My next recommendation would be shares of VEU, but VEU only costs about $50 per share.  If you bought one share of VTI and one share of VEU, it would cost about $175, but VTI (U.S. stocks) would be a greater proportion of that $175 (VTI would be $125/$175 or 71%) and VEU (foreign stocks) would be 29%. So I would buy TWO shares of VEU for a total cost of $100. That would bring your portfolio up to $225, with VTI being $125 of the $225 (56%) and VEU being 44% (or $100/$225). You do not have to buy all three shares the same day. You could buy one share of VTI today, next month buy one share of VEU and the following month another share of VEU.  Just note that the prices of the shares change over time (although not necessarily by HUGE amounts from day-to-day). Finally, after you have bought those three shares, add one share of VSS. Then, if you want to add even more Small Cap U.S. stocks you could add some VB.  However, because the price of VB is about $135, buying one share in conjunction with the few shares you own of VTI, VEU and VSS will really boost your proportion of Small Cap U.S. stocks.  You should be aware of this because Small Caps are generally a riskier subset of stocks.  

As time passes and you want to add more money to your portfolio, I would continue investing in this order:  VTI, VEUx2, VSS, but no more VB this rotation.  I would only buy more shares of VB maybe every third rotation.  I'll explain how to evaluate your entire portfolio in a bit and you will see why.

How Do I Actually Purchase Shares?

To purchase your share (or shares) in specific ETFs, after logging into your TD Ameritrade account, click on RESEARCH AND IDEAS, then COMMISSION-FREE ETFs as I showed above. At this point, you will see four tabs under the "Commission-Free ETF List"--Category, Fund Family, Market Cap and All Funds.  You should be on the FUND FAMILY tab which organizes the commission-free ETFs by the investment company that manages them. Click through to VANGUARD.  See the image below.

Note two things:  First there is a second page and you will have to go to the second page to access VTI. To access the second page, scroll to the bottom of the list and click NEXT.

The second thing to notice is there is a link to the right of each ETF that says Buy or Sell. Since you want to purchase a share of VTI, click on the BUY link. It will open a small trading window on the bottom of your screen that looks like this:

Under QUANTITY enter 1 (or more, if you want to purchase more than one share at a time), and under ORDER TYPE select "Market." Your screen should show this:

Click REVIEW ORDER to see the following screen:

Make certain you check the "Estimated total" amount because that is about how much your order will cost and you need to have at least that much in your account available for trading.  If everything looks correct, press PLACE ORDER.  Your order will be placed when the stock market is open for trading. If the market is open when you place your order, the order will occur within a minute or so.

Follow the same steps to buy the other ETFs.

Analyzing Your Portfolio

As you add more shares to your portfolio, it is good to know how diversified it is. If, for example, you own one share each of VTI and VSS along with two shares of VEU and you decide to add one share of VB, how does this impact the overall make-up of your portfolio in terms of foreign vs. domestic stocks, and Giant vs. Large vs. Mid vs. Small vs. Micro Cap stocks?  Morningstar.com offers a free Instant X-Ray that shows how your portfolio is allocated. For instance, if you own one share of VTI, two shares of VEU, one share of VSS,  and one share of VB, you would enter the following information into the X-Ray, your portfolio's total value would be $467.01 based on the following prices for each ETF as of 7/10/17:

ETF	Number of Shares Owned	Current Value Per Share	Total Value
VTI	1	$124.61	$124.61
VSS	1	$107.53	$107.53
VEU	2	$49.94	$99.88
VB	1	$134.99	$134.99

You can track the value of your portfolio on Morningstar or Yahoo! Finance, among others. Entering the ETF's "Ticker Symbol" and the Total Value into the X-Ray as shown below:

and clicking SHOW INSTANT X-RAY results in the following output.

Examining your X-Ray as you add more shares is helpful to ensure that your portfolio's asset allocation (the balance of foreign vs. domestic stocks and different sized companies, etc.) is right for you. 

Recommended Reading

For new investors a book I strongly recommend is The Bogleheads' Guide to Investing. It covers the basics and explains the reasoning behind diversification. It discusses stocks, bonds, mutual funds, ETFs, fees and taxes among other things. It's the book I require for the Personal Investing course I teach and the one book on finance I really hope my kids read.

Other Recommended Portfolios

Paul Merriman, a respected financial adviser (now retired), offers a recommended list of commission-free ETFs that form an even more diversified portfolio than the one I have suggested. He offers a specific recommendation for commission-free ETFs available on TD Ameritrade.

Analyzing an Equity Mutual Fund (Part 2)

Today's post continues with the analysis of WAAEX and VTSMX. Again, all screenshots are from morningstar.com.

More about Market Cap

The last post talked about the Holdings Style of the two funds.  WAAEX is focused on small cap growth stocks (but has a fair amount of mid cap growth stocks in its portfolio) while VTSMX is more broadly diversified across all levels of market cap stocks.

Since VTSMX is based on the CRSP US Total Market Index, I would like to evaluate how it compares to that index. To choose that particular index for comparison, on the PORTFOLIO tab on www.morningstar.com, click on the dropdown box right below the word "Benchmark." This allows you to select a specific benchmark for comparison.  Select the "Primary Prospectus Benchmark" and then CRSP US Total Market TR USD."

Now, when Morningstar displays comparison information for the benchmark for VTSMX, it will be for the index VTSMX is attempting to emulate (the CRSP US Total Market Index).

The screenshot below shows how well VTSMX compares to its benchmark in terms of market cap.

VTSMX contains a smaller percentage of Giant cap stocks than the CRSP US Total Market index (41.89% vs 45.87%) but it contains a greater proportion of Small cap stocks than the index (6.44% vs 1.82%).  You can see that it doesn't perfectly match the benchmark for any of the market cap categories.  The fact that it doesn't perfectly mirror the index means that VTSMX may not earn the exact return as the CRSP US Total Market Index.

WAAEX does not attempt to emulate an index but it the prospectus it states that the Russell 2000 Index will be the comparative index.  In the screenshot below we can see that WAAEX contains a smaller proportion of its assets in small cap equities compared to that benchmark.

As I mentioned last week, though, for WAAEX it is perhaps more important that, according to its prospectus "we will invest at least 80% of the Fund’s net assets (plus borrowings for investment purposes) in the equity securities of small-capitalization companies." Also from the prospectus, "the Fund considers a company to be a small-capitalization company if its market capitalization, at the time of purchase, is less than the larger of $3 billion or the market capitalization of the largest company in the Russell 2000 Index as of its most recent reconstitution date." Some of the giant, large and medium cap companies in WAAEX's portfolio may have been considered small caps at the time of purchase, but have since risen in value to become higher-cap companies.  Thus, the finding that about one-third of WAAEX's portfolio is invested in larger-cap companies doesn't go against WAAEX's strategy.  However, if you wanted a mutual fund that currently invests in almost all small-cap equities, this fund isn't it.

Sector Evaluation 

[See my previous post on sectors if you don't know what they are.]

VTMSX's goal is to emulate a broad US market index, so you should expect VTSMX to have some portion of its assets invested in each sector.  However, WAAEX's focus isn't on a specific sector, but on a specific market cap size.  You should not necessarily expect WAAEX to have investments in every sector.  

VTSMX's Sector Weightings

Don't forget to choose the CRSP US Total Market Index from the Benchmark drop-down box so that you are comparing VTSMX to the appropriate benchmark. We can see from the screenshot below that VTSMX does a good job at weighting its portfolio in the same manner as the benchmark. However, because VTSMX does not maintain the exact sector weightings as the benchmark, this may result in VTSMX generating different returns than the benchmark it is designed to emulate.

We can also see that the U.S. stock market is heavily weighted in the Technology Sector (it makes up 17.46% of the CRSP US Total Market index) and the Utilities Sector is the smallest sector in the US at 3.04%. Over time this weighting scheme will change as stock prices change.

WAAEX's Sector Weightings

Even though the Russell 2000 Growth index contains stocks from every broad sector of the market, WAAEX does not.  Notably, it doesn't contain equities from the Basic Materials, Real Estate, Communication Services or Utilities sectors.  This isn't necessarily a failing of WAAEX.  However, if you are expecting WAAEX to fairly represent every sector of the market, it doesn't.

World Regions & Market Classification

VTSMX Breakdown

Since VTSMX does a good job emulating the CRSP US Total Market Index, we should expect it to be nearly entirely focused on the United States.  The CRSP index does allow companies headquartered in U.S. Territories, Tax Havens or "Domiciles of Convenience" to be included in the index which explains the small percentage of non-North American companies. Additionally, the bulk (99.81%) of the fund's assets are invested in Developed Markets rather than Emerging Markets.

Given the name of the Vanguard Total Stock Market Index, you might expect this fund to cover the entire stock markets of the world.  Obviously, it does not.  It does, however, do a good job of emulating the underlying CRSP index.

WAAEX Breakdown

WAAEX stated in its strategy section that it would invest up to 20% of its assets in foreign securities.  From the screenshot below, we can see that WAAEX does keep about 20% of its assets in non-North American equities, since 79.35% of its assets are in North American equities.  Additionally, some (10.18%) of those foreign equities are in Emerging Markets.

Thus, based upon this portion of the analysis, WAAEX does appear to be following this aspect of its strategy (as mentioned in the previous post).

Questions?  Comments?  Post them below or send me an email.

Analyzing an Equity Mutual Fund (Part 1)

I've been busy grading papers because it was the end of the quarter and then I took a much-needed break, but I'm back!

As promised, I will now analyze several equity mutual funds.  There are literally thousands of funds to choose. For my first fund, I opted to choose a fund that Morningstar.com decided to highlight today--the Wasatch Small Cap Growth fund, or WAAEX. The fund is highly rated by Morningstar. For my second fund I chose the Vanguard Total Stock Market Index Investor fund (VTSMX).

My goal for today's post isn't necessarily to state whether I think these funds are good or bad choices. My goal is to show you how to evaluate the fund in terms of diversification so that you will feel comfortable evaluating this aspect of mutual funds yourself. I'll also talk a bit about fees, to serve as a segue to a few posts about mutual fund fees.

All the information I will be using comes from Morningstar's free website. Morningstar does offer a premium service, but I will not be using it.

The Funds' Summaries

WAAEX

According to Yahoo's! Finance site, WAAEX's summary is:

The investment seeks long-term growth of capital; income is a secondary consideration. The fund invests primarily in small growth companies. It will invest at least 80% of the fund's net assets in the equity securities of small-capitalization companies. Equity securities include common stock, preferred stock and securities convertible into common stock, warrants and rights, and other securities with equity characteristics. The fund may invest up to 20% of its total assets at the time of purchase in securities issued by foreign companies in developed or emerging markets.

I bolded several important bits.  First, WAAEX has set a floor for the percentage of the assets that must be invested in small cap companies--no less than 80% of the firm's assets.  That means no more than 20% of the fund's money can be invested in non-small cap equities. Also, no more than 20% of the fund's assets can be invested in securities of foreign companies.  WAAEX is an actively-managed fund.  It is trying to find small cap growth stocks that it believes will generate high returns in the future.

VTSMX

According to Yahoo's! Finance site, VTSMX's summary is:

The investment seeks to track the performance of a benchmark index that measures the investment return of the overall stock market. The fund employs an indexing investment approach designed to track the performance of the CRSP U.S. Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq. It invests by sampling the index, meaning that it holds a broadly diversified collection of securities that, in the aggregate, approximates the full index in terms of key characteristics.

Again, I have highlighted some important bits. First, VTSMX is a passively-managed fund--an index fund. Its goal is not to seek out equities that will outperform the market. Rather it attempts to emulate the market as measured by the CRSP U.S. Total Market Index (an index that contains nearly 4,000 companies). Secondly, VTSMX invests mainly in equities from U.S. based companies--we shouldn't expect it to contain many foreign stocks. Also, it invests across essentially all levels of market cap.  It does not focus on small cap companies like WAAEX does. The objective also states that VTSMX invests by sampling the index. This means that it may not hold every security contained in the CRSP U.S. Total Market Index. Even if it does hold all the securities, they may not be weighted exactly the same as the CRSP U.S. Total Market Index.

Obtaining Information for a Mutual Fund

To obtain information for a mutual fund from Morningstar, access the website and enter the name (or a portion of the name) or the mutual fund symbol into the quote search box as shown below.

WAAEX

Below is a screenshot of a portion of the landing page for the quote search. It shows the tabs of information available. Most of the data I'll discuss today will come from the PORTFOLIO tab. Premium features are denoted by the '+' symbol in the purple arrow.

The above screenshot tells us a few things about WAAEX. First, it currently costs about $52 (down $0.44 from yesterday, or a drop of 0.83%) to buy a single share of WAAEX. It is possible to purchase a fraction of a share of a mutual fund. Thus, if you already had an account with Wasatch and you already owned some shares of WAAEX, you could add $100 to that account and purchase nearly (but not quite) two additional shares of WAAEX.  WAAEX currently has about $2.4 billion under its management. It's considered a small cap growth fund (see my Stock Classification posts if you don't know what that means) according to the Investment Style matrix. WAAEX charges an annual expense ratio of 1.21% (more on that in a later post) and if you wish to purchase shares of WAAEX for the first time, you'll need at least $2,000 to make that initial purchase. Unfortunately, WAAEX has a "limited" status, which means that its shares are currently not available to new investors. If you are an existing investor (you already own shares of WAAEX) you can purchase more shares. Funds typically limit their availability if the assets under management have grown substantially and the manager(s) of the fund believe it may be difficult to continue to achieve the fund's objective if the fund grows much larger.

VTSMX

VTSMX costs about the same per share as WAAEX--$52. However, there are quite a few differences between the two mutual funds! First, VTSMX manages quite a bit more money than WAAEX--$404 billion vs $2.4 billion. Secondly, VTSMX has a much lower expense ratio of 0.17% compared to WAAEX's 1.21%. Remember that WAAEX is an actively-managed fund while VTSMX is a passively-managed fund. That's the main reason for the different expense ratios--more on that in a future post. 

VTSMX requires a minimum initial purchase of $3,000 compared to WAAEX's $2,000. However, while WAAEX had a limited status, VTSMX is OPEN. This means new investors are welcome to open an account and existing investors may invest more in the fund. Also, while WAAEX is has a Small Growth "Investment Style," VTSMX has a Large Blend style.

Broad Asset Allocation

WAAEX

WAAEX is an equity fund--about 95% of the fund's assets are invested in stocks. Most (73.79%) of the stocks are in U.S. based companies while the remainder (20.83%) are non-U.S.-based companies. Notice that the 20.83% is slightly above the 20% in foreign securities as mentioned in its objective at the top of this post.

From PORTFOLIO tab of Morningstar.com's WAAEX search results.

About 4% of the fund's $2.4 billion in assets is held in the form of cash. This isn't necessarily unusual. When a person wishes to sell shares of a mutual fund (called redeeming one's shares) the mutual fund must exchange the shares for cash. Thus, a mutual fund needs some cash on hand because basically every day it will be redeeming some investors' shares. Most mutual funds tend to keep their cash balance around 5%, so WAAEX is fairly normal.

VTSMX

VTSMX is also an equity mutual fund so we should expect nearly all of its assets to be invested in equities. Based on the screenshot below, we can see that this is true.

From PORTFOLIO tab of Morningstar.com's VTSMX search results.

However, since VTSMX is designed to emulate the CRSP U.S. Total Market Index we should not expect it to contain many non-U.S. stocks, and it doesn't. The bulk (98.16%) of VTSMX's investments are in U.S. stocks.

Holdings Style

WAAEX

According to its objective, WAAEX is a small cap growth fund. Let's evaluate WAAEX's Holdings Style to see if it really is a small cap growth fund.

The Holdings Style box contains the percentage of assets that are invested in each type of equity. Thus, WAAEX has 55% of its stocks invested in small growth stocks, 30% in mid cap growth stocks, 8% in large cap growth, 6% in small cap blend stocks and 1% in small cap value stocks. While WAAEX does not have ALL of its money invested in small cap growth stocks, it is fairly focused on that area. However, WAAEX's objective stated that the fund would invest at least 80% of its assets in small cap stocks. It is not meeting that objective. Indeed, 8% of the firm's assets are invested in large cap growth stocks. The dark blue dot in the Ownership Zone shows that most of its stocks are considered small cap, high growth stocks. The lighter blue circle around the dot shows the makeup of the bulk (75%) of the fund's equity investments. The light blue circle is fairly small. This is a stark contrast to VTSMX.

VTSMX  

As VTSMX is more broadly diversified across the market caps and WAAEX is focused on small cap growth stocks, their Holdings Style and Ownership Zone matrices are much different. Notice how large VTSAX's light blue circle is, and how the Holdings Style contains percentages in each cell of the matrix.

VTSMX's weighted holdings (the dark blue dot) fall under the category of large cap, core stocks, making it a Large Blend fund. However, it contains a broader mix of stocks than WAAEX. VTSMX contains stocks across all the market cap sizes and it also contains value stocks, growth stocks and blend stocks.

For the next post, I will continue comparing these two funds in terms of the make-up of their portfolios.

Stock Classifications (Part 2)

To continue with the different ways in which stocks are classified...

Sector/Industry

Different data sources segregate businesses into a variety of sectors. I’ll be using the sector classifications from Morningstar.com, which is a well-known source for data on mutual funds. Morningstar uses eleven broad sector classifications which it breaks into three "super sectors."

Cyclical Super Sector: Includes industries “…significantly impacted by economic shifts. When the economy is prosperous these industries tend to expand, and when the economy is in a downturn these industries tend to shrink.” [Source:  www.morningstar.com] There are four sectors included in the broad cyclical category.

1. Basic Materials: Companies that manufacture chemicals, building materials and paper products. This sector also includes companies engaged in commodities exploration and processing. 
2. Consumer Cyclical: Retail stores, auto and auto parts manufacturers, companies engaged in residential construction, lodging facilities, restaurants and entertainment companies. 
3. Financial Services: Companies that provide financial services which includes banks, savings and loans, asset management companies, credit services, investment brokerage firms, and insurance companies 
4. Real Estate: Mortgage companies, property management companies and Real Estate Investment Trusts. 

Sensitive Super Sector: “… includes industries that ebb and flow with the overall economy, but not severely so. Sensitive industries fall between the defensive and cyclical industries as they are not immune to a poor economy, but they also may not be as severely impacted by a poor economy as industries in the Cyclical Super Sector.” [Source:  www.morningstar.com] The four broad sensitive sectors are:

1. Communication Services: Companies that provide communication services using fixed-line networks or those that provide wireless access and services. This sector also includes companies that provide internet services such as access, navigation and internet related software and services. 
2. Energy: Companies that produce or refine oil and gas, oil field services and equipment companies, and pipeline operators. This sector also includes companies engaged in the mining of coal. 
3. Industrials: Companies that manufacture machinery, hand-held tools and industrial products. This sector also includes aerospace and defense firms as well as companies engaged in transportation and logistic services. 
4. Technology: Companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. Also includes companies engaged in the manufacturing of computer equipment, data storage products, networking products, semiconductors, and components. 

Defensive Super Sector: “… includes industries that are relatively immune to economic cycles. These industries provide services that consumers require in both good and bad times, such as health care and utilities.” [Source:  www.morningstar.com] The three broad defensive sectors are:

1. Consumer Defensive: manufacturing of food, beverages, household and personal products, packaging, or tobacco. Also includes companies that provide services such as education & training services. 
2. Healthcare: biotechnology, pharmaceuticals, research services, home healthcare, hospitals, long-term care facilities, and medical equipment and supplies. 
3. Utilities: Electric, gas, and water utilities. 

Some people believe certain sectors might outperform other sectors at a specific point in time. Some mutual funds focus only on specific sectors. For instance, here are some different mutual funds that focus on the Technology sector:

• Fidelity Select IT Services Portfolio (FBSOX)
• USAA Science and Technology Fund (USSCX) 
• T. Rowe Price Global Technology Fund (PRGTX) 

It is possible to find mutual funds that focus on each of the eleven sectors. If you wanted, you could invest all your money in a sector that you believe will outperform the overall market; however, this is an extremely risky strategy.

A heatmap (finviz.com) of the S&P500 that is broken into sectors (and to some degree, industries within sectors) is shown below. This heatmap is for the past month. You can see that the UTILITIES sector has not performed well compared to the other sectors.

The overall stock market is not weighted equally in terms of sectors. For instance, the market cap of companies in the Technology sector is the highest, while the market cap of companies in the Utilities sector is the lowest. This changes over time, as the market cap of companies change. 

Developed vs Emerging Markets

A developed economy is one that has a high level of economic growth and security. Stock in companies that are based in a developed economy are said to trade in a developed market (DM). DMs have a high level of financial regulation, and investors have easy access to publicly-available information. Countries with DMs include the U.S., Canada, England, Japan and most of western Europe.

Emerging markets are markets in countries that do not have the same level of economic security and growth as developed markets. The political climate and exchange rate system may be highly unstable. The country may have only recently moved from a closed economy to an open-market economy. Civil wars may still erupt. The country may be receiving a large amount of donations from other countries. However, growth in these countries may also be high.  

Investing in stock in companies in emerging markets is riskier than investing in stock in developed countries. The following graph shows the returns for the MSCI Emerging Markets Index (an index of stocks in over 800 companies from 23 emerging market countries), the Russell 2000 Index (an index of the 2,000 smallest companies in the Russell 3000 Index—all of them based in developed countries) and the S&P500 (an index of 500 large U.S.-based companies). (Source: Callan Periodic Table of Investment Returns).

You can see that the returns of the emerging market index have higher peaks and lower valleys than either of the other two indices. The volatility of emerging market returns is greater than the others. From 1993 to 2013, the MSCI Emerging Markets index generated a higher average annual return (13.87%) than the other two indices, but the risk was much higher, as shown below.

You might think, “Wow, with average annual returns of 13.87%, I would be willing to accept nearly twice the risk of developed market returns.” The “average return” from the table above only takes each year’s return from the graph and calculates the arithmetic mean—by summing the annual returns and dividing by the number of years. It is NOT a cumulative measure. For a better understanding of what I mean, review the numbers in the table below. These values represent how much a $10,000 investment made in 1993 in each of the three indices would be worth at the end of 2014.

Even though the MSCI Emerging Markets Index had the highest average annual return, the ending value is the lowest of the three.  Thus, the average annual return (arithmetic mean) is not the best way to measure your return on an investment.  The best mean return measure to determine one’s annual change in wealth is the geometric mean. The geometric means for the three indices are:

Although the geometric mean for each index is below the index’s average return, it is the extreme volatility of the MSCI Emerging Markets index that causes its geometric mean to be so far below its average return—making its cumulative change in wealth lower than the other two indexes.

This doesn't mean you should exclude emerging markets from your investment portfolio.  Emerging markets have an interesting quality that I will discuss in a later post.

Next up:  I had originally intended to only include two posts on Stock Classifications; however this post is quite long already.  I'll finish the Stock Classifications post next week and the following week I will analyze several equity mutual funds in terms of all the different classifications.

Stock Classifications (Part 1)

Why am I discussing ways to classify stocks? Because, to understand an equity mutual fund, you need to understand its investments, at least in a broad sense. Many equity mutual funds focus on specific stock classes, although many mutual funds also diversify across stock classes.

There are a variety of ways to classify stocks. I’ll be discussing the main ones.

Size of the Company [AKA: Market Cap(italization)]: The size of the publicly-traded company is one popular classification method. In this case, the size is measured by taking the company’s current stock price and multiplying by the number of outstanding shares of common stock. A company’s market cap is widely available on nearly every stock quote service. Figure 1 is an example of Apple’s stock quote (Apple’s ticker symbol is AAPL; a ticker symbol is the identifier for a specific company’s common stock) from finance.yahoo.com. I've highlighted the market cap in yellow.

Figure 1
Source:  finance.yahoo.com

You can see that at the time I screenshot this quote, AAPL’s market cap was $745 billion. It was calculated by taking the current price per share of common stock of $127.83 and multiplying it by the number of common shares (a value not shown in the screenshot).

There are five common market cap categories, although some include a sixth while others only segregate into three (large, mid and small). The six categories and their current dollar values are:

*The dollar value for each category changes over time.

**some omit this category and just say micro = Less than $300 million

Thus, AAPL’s common stock would currently be classified as a Giant Cap. GoPro’s stock [see Figure 2], with its market cap of $6.46 billion would be classified as a Mid Cap. In October 2014, GoPro’s stock was trading at about $94 per share, making its market cap about $12 billion, or a Large Cap stock. Over five months its stock price has dropped so that it is now classified as a Mid Cap. Of course, if GoPro’s stock price rises substantially, it could eventually be classified as a Giant Cap.

Figure 2
Source:  finance.yahoo.com

Stocks are classified by market cap because historically (over the long run), smaller cap companies’ common stock have generated higher returns than larger cap companies’ stock. This a generalization and it is not always true. You can find some giant cap companies that generate higher returns than some small cap companies and vice versa. During some time periods small cap stocks as a group will underperform large caps stocks as a group. But, generally, over the long run small caps have generated an annual return in excess of large caps at a cost of higher risk. Small caps are typically far more risky than large cap stocks. The table below shows the returns for two different indexes. The Russell 2000 is an index (a collection) of 2,000 smaller cap stocks and the Russell 1000 is an index of 1,000 larger cap stocks.

The standard deviation (SD) is a measure of risk. It measures the deviation about the average return. Since the Russell 2000 tends to have more volatility than the Russell 1000, it has a larger SD. You can see that small caps generated higher returns, on average, over the past ten years, but they did so with higher risk. If I were to use a much longer time period, the difference in return and risk would be far greater.

Geographically: Another common way to classify stocks is by country/region. Not all companies in all countries perform identically. For instance, in 2007, at the beginning of the most recent large financial crisis, the Standard & Poor’s 500 index (a collection of 500 companies that measures the broad U.S. stock market for giant, large, and mid cap companies) earned a return of 5.49%. However, that same year the MSCI Emerging Markets index earned a return of 39.78%--quite the difference! The next year when the bottom fell out of the market, the S&P500 Index lost 37% while the MSCI Emerging Markets Index lost 53.18%. The MSCI Emerging Markets Index is an index that contains about 2,600 companies from 23 countries that are considered to have emerging markets. [As I mentioned in last week’s post, emerging markets are those where financial regulations are not as strict as in the U.S., the political and economic environment is rather unstable, etc.] Countries in the MSCI Emerging Markets Index include China, Brazil, Indonesia, Mexico, and Russia.

A website I enjoy for its graphic displays (called heatmaps) is FINVIZ.com. [Stockmapper also has some neat heatmaps, but for my purposes today FINVIZ shows what I want to demonstrate better.] Below is an example of a heatmap for the S&P500 (again, a measure of the U.S. market for larger cap companies) for Friday, February 19, 2015.

The legend is in the bottom right corner. The rectangles contain the Ticker Symbol for a company’s common stock as well as the return the stock generated that day if the rectangle is large enough. The larger the rectangle, the larger the market cap of the company. The brighter the green (red), the higher (lower) the return. Obviously, given the variety of colors in the heatmap, not all companies in the S&P 500 performed the same. Wal-Mart (WMT) lost 3.21% while Facebook (FB) gained 3.53%.

Here’s a heatmap for the world for the same day. Overall, it looks like stocks for companies based in Japan had a pretty good day, while Brazilian companies did not.

Here are the same two heatmaps, but the data is for an entire year, rather than a day. Generally, larger company stocks have had a good year in the U.S.  Notable exceptions are Google (GOOGL) and IBM as well as a cluster of smaller companies in the Basic Material sector.

S&P500 Heatmap for past year

From the world heatmap we can see that India and Taiwan have had a good year, although Germany isn't doing well, nor is Luxembourg. [These maps are perhaps more interesting if you go to the FINVIZ website, where they are interactive. However, the data won’t be identical to the ones I have posted as it will be for a new time period.]

World Stock Heatmap for past year

By investing in stocks all over the world, we can diversify our portfolio more than just investing in stocks from only the U.S. This can help reduce our risk, since all the stock markets across the world do not move perfectly in tandem.


Next week: More ways to classify stocks (sector and industry, value and growth, developed vs emerging, dividend-paying vs non-dividends)

The following week: Analyze an equity mutual fund and review how diversified it is across various stock classes

What is a Mutual Fund?

What is a mutual fund?

A mutual fund is an investment that uses money from many investors (like you and I) to purchase a mix of securities, such as stocks, bonds, and money market instruments. The fund is managed by a single person or a group of people. As an investor in the fund you will pay a fee for the managers’ services and there may be other fees as well. Fees will be the topic of another post. Many companies have mutual funds, including Vanguard, Schwab, T. Rowe Price, Fidelity, and Blackrock. I have only listed a few! There are literally tens of thousands of mutual funds.

Fund Types

A mutual fund may diversify across different types of securities—for instance, it may own both stocks and bonds (called a hybrid fund), or it may focus only on stocks (an equity fund) or only on bonds (a bond fund) or only on short-term debt instruments (a money market fund). Funds may also specialize in a specific type of security. A small-cap emerging market fund will focus on smaller companies in emerging markets. An emerging market is one that isn’t as advanced as say, the U.S. or Japan. The reporting regulations may not be as strict or well-developed and the country may have only recently developed a stock exchange.

Fund Objective

Each fund must list its objective in its prospectus, which is a document the fund must provide investors explaining their fees, objective, investment strategies, risks, etc. This information can also be found online, either at the fund’s website, Morningstar.com and finance.yahoo.com. As an example, this is the objective for the Vanguard 500 Index fund:

The investment seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs an indexing investment approach designed to track the performance of the Standard & Poor's 500 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. It attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.  Source: finance.yahoo.com

Some years ago there was a movement toward socially responsible investing [SRI] (and there are still many who are interested in this type of investing). SRI involves not investing in companies that generate revenue/profit by engaging in what you may consider irresponsible activities, such as gambling, tobacco use or drinking alcohol. Eventually, a mutual fund was started that ONLY owns stock in companies that operate in the “vice” industries of gambling, tobacco, alcoholic beverages and defense. The fund is USA Mutuals Barrier Investor (VICEX). [The symbol VICEX is the identifier for the USA Mutuals Barrier Investor fund. If you are looking up information about the fund online, you can type in the symbol rather than the entire name. Since I research many mutual funds the ability to search by symbol rather than name is a time saver.] Below is VICEX’s objective:

The investment seeks long-term growth of capital. Under normal market conditions, the fund will invest at least 80% of its net assets (plus borrowings for investment purposes) in equity securities of companies that derive a significant portion of their revenues from a group of industries that have significant barriers to entry including the alcoholic beverages, tobacco, gaming and defense/aerospace industries. It will concentrate at least 25% of its net assets in this group of barrier to entry industries (but no more than 80% of its net assets in any single industry).

Active vs. Passive

A mutual fund can either be actively managed or passively managed. An actively managed fund is one where the manager believes he can, by conducting research, find securities that will outperform the overall stock market in the near future. He’ll buy those securities for the fund (that is called “going long”). He may find securities that he believes will underperform the overall stock market, in which case he may sell (or “short”) those securities with the intention of buying them at a later date once they have fallen in value. This may be the topic of another post. Regardless, an actively managed fund requires that the manager do more work; thus, the fund charges investors a higher fee. VICEX is an actively managed equity fund--its management fee is 0.95%.

A passively managed fund is designed to emulate an index, such as the Standard & Poor’s 500. Perhaps the most famous index fund is the Vanguard 500 Index (VFINX). You can see from the objective I posted above, that its goal is to track the performance of the S&P 500.  As the process of choosing investments is limited by the index the fund is emulating, it is not as difficult to manage an index fund.  Therefore, the management fee for index funds is generally rather low.  The management fee for VFINX is 0.15%.

As this is only my first post, obviously I have a lot more to say!  As the weeks progress I will add posts about why we should consider mutual funds as investments, the fees a fund charges, how to tell how well diversified a fund is, how risky funds are, and what types of returns do funds generate, among other things.