Choose the Appropriate Investment Vehicle – Part 2

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There is an art to selecting the right investment vehicles for individual portfolios. A good investment advisor will tailor the investments to the specific characteristics of the investor’s situation.

Investment needs can be divided into nine different categories that apply to everyone. First, there are three different types of accounts: Taxable, Retirement, and Roth. Then within these categories, investment vehicles should differ for small, medium and large-sized accounts. Tax bracket, stage of life, cash flow requirements, and other variables are also incorporated into the final comprehensive financial plan.

There are five factors that should be considered when matching an investment vehicle to a given account. Three will be covered today. Next week, the other two will be reviewed along with some specific advice on how to apply the insights from these three articles.

Expense ratios

Insurance investment products and mutual funds sold by commission are loaded with expenses. Lower cost alternatives can nearly always be found.

No-load mutual funds may offer the efficiency of not having to compensate a salesman, but all funds incur some expenses to manage the assets they have. The expense ratio for no-load mutual funds averages about 1.2%. Sometimes there is an additional 12b-1 fee (for marketing the fund) of 0.25%. The fees for foreign or speculative mutual funds may be higher.

Exchange-traded funds and some Vanguard funds have low expense ratios around 0.2% to 0.4%. Individual stocks and individual bonds have no expenses to hold them.

Keeping expenses low helps keep your return high. Everything else being equal, you should seek the investment vehicle with the lowest expenses. But the expense ratio is only one of four factors to consider.

Transaction Costs

There are transaction costs for many investments. With mutual funds, these transaction costs show up in their expense ratios. For individual stocks, there is a brokerage fee to buy and sell each stock, typically under $15 for discount brokers and more for “full service” brokers. Buying individual bonds is more complex and is mostly paid for in the spread between the price at which you can buy a bond and the price for which you can sell a bond. Individual bonds are sold in large denominations (e.g. $25,000), and transaction costs can be $100 or more.

Because of transaction costs, for very small investment amounts it is better to pay a higher expense ratio if you can avoid paying transaction costs. Paying a $15 brokerage fee on a $100 investment immediately loses 15% of your investment. Our rule of thumb is pay 1% or less of an investment’s value for the transaction to purchase it. So for very small investments, we would use no-load and no-transaction fee mutual funds instead of individual stocks or exchange-traded funds. Avoiding the transaction costs more than makes up for the slightly higher expense ratios.

Diversification

Diversifying your investment over many different types of stocks is an important way to decrease risk without sacrificing return. For accounts with small amounts, no-load and no-transaction fee mutual funds offer the best method of getting a diversified portfolio. As the amount of the investment gets larger, investment vehicles with lower expense ratios can be used. For medium-sized accounts, we recommend exchange-traded funds. For large amounts, there are enough assets to warrant individual stocks. And for very large amounts, individual bonds can be used.

Diversification of your portfolio is critical. That means that diversification is more important than small differences between expense ratios. Diversification using individual stocks should be reserved for larger portfolios. Whatever your portfolio size, we recommend keeping your exposure to any one stock under 5% of your total. On a million dollar portfolio, that means the amount invested in any one stock should be under $50,000. That level of investment will only purchase 20 individual stocks. Smaller amounts such as $10,000 would increase the diversification to 100 individual stocks, but also increase the transaction costs required to purchase them five-fold.

Exchange-traded funds offer a nice compromise for medium-sized portfolios. Exchange-traded funds are collections of stocks like mutual funds, but they have very low expense ratios. A single exchange-traded fund represents a large collection of stocks, but can be purchased with a single transaction.

Next week will finish this three part series with a discussion of capital gains and turnover as well as specific advice on how to apply what you will have learned.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)