Building a Portfolio

One study that I wrote about last December revealed that between 1996 and 2002, the weighted-average returns for equity funds sold by advisers to individuals were 2.9 percent per year on average, while do-it-yourself investors earned 6.6 percent per year with funds they bought on their own. That's a huge margin of superiority over the so-called experts.You Can Do Better, TooJohn C. Bogle, founder of Vanguard Group and author of several investing books, makes the point that financial "helpers" are like vampires that suck the lifeblood from fund returns. He doesn't use that particular imagery, but that's what he means."Yes, after the costs of financial intermediation -- all those brokerage commissions, portfolio transaction costs and fund operating expenses; all those investment management fees; all those advertising dollars and all those marketing schemes; and all those legal costs and custodial fees that we pay, day after day and year after year -- beating the market is inevitably a game for losers," he says in his latest mini-tome, "The Little Book of Common Sense Investing." Financial croupiers, he calls these intermediaries. "Indeed, when we add the costs of ... self-help investment books into the equation, it becomes even more of a loser's game."

But don't pay attention to that last bit and go right ahead and splurge on his latest book. It's less than $20 and well worth the investment. In it he presents so many compelling arguments that you will likely be converted to his way of thinking. So-called "Bogleheads," who refer to their leader as "St. Jack," already know his mission: Abandon the search for the needle in the haystack -- the next best-performing fund -- and instead buy the haystack, or the entire market itself. Buy it as cheaply as possible through low-cost index funds.A compelling exampleBoglelooks at the 25-year period from 1980 to 2005, when the Standard &Poor's 500 Index gained 12.5 percent on average per year. The averagemutual fund gained 10 percent -- a 2.5 percent difference inperformance attributable mainly to expenses. "Never forget: Marketreturn, minus cost, equals investor return," Bogle says.A$10,000 initial investment over that time frame in an index fund withexpenses of 0.2 percent would have grown to $170,800. The averageequity fund's value at the end of the period was $98,200. Which pile of money would you rather have? "Whatyou see here -- and please don't ever forget it! -- is that over thelong term, the miracle of compounding returns is overwhelmed by thetyranny of compounding costs," Bogle says of actively managed equityfunds.

Bogle figures investors actually didn'tearn 10 percent during that time frame but rather 7.3 percent (andindex investors only earned 10.8 percent) because of their tendency totrade in and out of funds. They often sabotage themselves by gettinginto a hot fund at precisely the wrong time -- just before it freefalls.The beauty of the indexing strategy, says Bogle, is that after the initial setup no further action is required. In fact, too much investment activity results in transaction costs that further erode returns. In Chapter 10, Bogle cites several studies (including the one mentioned above) that show that advisers aren't particularly adept at selecting funds which beat the market. He says he has a hard time imagining they add much value -- unless they select low-cost funds with low turnover (which have lower transaction costs and are more tax-efficient). "If they put those two strategies together and emphasize low-cost index funds -- as so many advisers do -- so much the better for their clients," says Bogle.Butmost advisers are reluctant to follow an indexing strategy because --hey -- where's the added value there? Why should individuals hire anadviser to buy cheap index funds (and then pay the adviser a percentagepoint a year from portfolio assets for the privilege) if they can dothis for themselves?

How to set up your portfolioIf you're young and just starting out, begin investing in an index fund that mimics either the Standard & Poor's 500 or the Dow Jones Wilshire Total Stock Market Index. The latter fund covers a larger segment of the market (nearly 5,000 stocks). The historical returns for both indexes are similar because the S&P 500 constitutes roughly 80 percent of the Dow Jones Wilshire Index since both are weighted by market capitalization. You may also want to invest in a fixed-income fund to a much lesser degree to provide some stability to your portfolio.If you've accumulated some assets and want to construct a portfolio using expert advice, check out the asset allocation chart in Bankrate's Retirement Guide. Use it as a basis to determine how your money should be allocated to the various asset classes according to your age group. Notice that the younger you are, the higher the allocation to domestic and foreign stock funds, with only 10 percent going to fixed income. As you get older, capital preservation becomes important, so you allocate more to fixed income.Onceyou have the percentages straight, buy index funds representing theappropriate asset classes to fill out your chart. It's as easy as pie.We provide a table of Vanguard index funds that can be used in your portfolio's construction. Of course, other fund firms offer index funds as well. Check out the ones at Fidelity Investments, T. Rowe Price, Charles Schwab or the discount brokerage where you may already have an account. Make sure you select funds with low costs (less than 0.3 percent) so the earnings and dividends of the corporations you own will benefit you rather than those ghoulish financial intermediaries.

Onceyou make your fund purchases, you can focus on other stuff going on inyour life. After a year, rebalance if your assets go out of whack fromtheir original allocations. That's really all there is to it. Not toomysterious, right? Investing can be simple, not unlike buying a new sound system that requires you to spend some initial setup time. After that, you can sit back and enjoy the compounding returns. A sampling of funds to useVanguard index funds vs. their respective benchmarksNameTickerTotal Return 5 Year* Total Return 10 Year*Total Return 15 Year*Net Expense RatioInception DateVanguard Pacific Stock IndexVPACX14.734.245.190.276/18/1990MSCI Pacific 15.044.545.33         Vanguard European Stock IndexVEURX17.3211.1912.090.276/18/1990MSCI Europe  17.4111.1111.95 12/31/1969       Vanguard Total Bond Market IndexVBMFX4.656.086.470.2012/11/1986Lehman Brothers Aggregate Bond 5.066.356.69 12/31/1975       Vanguard Small Cap IndexNAESX11.9211.2212.170.2310/3/1960Standard & Poor's Smallcap 600  11.5612.68  12/30/1994       Vanguard Emerging Mkts Stock IdxVEIEX24.779.65 0.425/4/1994MSCI EM (Emerg Mkts)  25.43   12/31/1998       Vanguard Large Cap IndexVLACX   0.201/30/2004Standard & Poor's 500SPYZ8.548.0510.98 1/30/1970       Vanguard Mid Capitalization IndexVIMSX12.73  0.225/21/1998Standard & Poor's Midcap 400 11.4714.3314.41 7/31/1991       Vanguard Inflation-Protected SecsVIPSX6.79  0.206/29/2000Lehman Brothers U.S. Treasury TIPS 6.986.93  2/28/1997       Vanguard Prime Money MarketVMMXX2.523.763.990.296/4/1975Vanguard Tax-Exempt Money MarketVMSXX1.982.592.750.136/10/1980U.S. Treasury Bill 3 Month 2.743.764.01 2/28/1941*Returns are annualized 2007 Morningstar, Inc. All rights reserved. Past performance is no guarantee of future results.

Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning. If you have a comment or suggestion about this column, write to Boomer Bucks.Bankrate.com's corrections policy-- Posted: May 9, 2007Bankrate.com is the Web's leading aggregator of information on financial products including mortgages, credit cards, new and used automobile loans, money market accounts, certificates of deposit, checking and ATM fees, home equity loans and online banking fees. .