One of the most common questions I get from my peers (people aged 25-35) is how to get started with investing. Here at Seeking Alpha, we've got a generally more educated and mature audience. However for many younger people, investing seems profoundly overwhelming.
It's an interesting question, if I were thrown back to square one, without a dollar of investments, what would I do? If investing weren't my passion, I'd buy index funds. They work for most people.
However if my friends keep badgering me wanting individual stocks rather than index funds, then what?
The following portfolio, the Ian's Million Fund (NYSE:IMF) is my answer. This portfolio is not designed for active trading. It's a long-term portfolio for compounding wealth at a rate moderately faster than buying an index fund and holding. And for any of my friends not wanting to do their own work, they can easily replicate my purchases with just a few mouse clicks.
Here at Seeking Alpha, we will go from the creation of the IMF as a new account, opened earlier this year, over the span of a few decades, to reaching a million dollars (hopefully more). Every trade will be recorded and discussed along the way.
Strategy For The IMF
This is a long-term account focused on compounding over the span of decades. Short-term trading and active management are not the main priority.
In essence, I'm running a no-fee index fund, by buying positions in dozens (eventually hundreds) of quality companies and letting them compound over the span of my adult life. (We'll discuss commissions in a bit, fear not.)
I aim to deposit excess funds on a monthly basis into the account, initially targeting somewhere between $500 and $2,000 per month of new capital. These contributions will then be invested, on a monthly basis, in the 15-30 best stocks available at that present time. Regardless of the overall market level, I will buy stocks monthly in a sort of dollar-cost averaged (NYSE:DCA) approach.
Quality is a top priority, I want to accumulate large positions of great firms over the years. However, price is also a big counter-balancing point. Since I'm buying regularly, monthly pricing fluctuations play a big role in determining what I do with each infusion of new capital.
My goal is to beat the benchmark S&P 500 (NYSEARCA:SPY) by 1 to 2% a year. To do so, main tools will be better stock selection, and favorable entry points. If you manage to buy a diversified basket of stocks while they are mostly near their 52-week lows, you will (to a moderate degree) outperform blind investing in an index fund where you're buying stocks in a price indiscriminate fashion.
The Problems With Index Funds
Index funds are a great product. For most people seeking to accumulate long-term wealth, index funds are the best option. If you don't find investing interesting or have financial acumen, better to put your money in an index fund and get a reasonably good return. On average, index funds beat mutual funds or uninformed single stock speculation by a significant margin.
However, I don't believe index funds are quite optimal for informed investors that have the time and skill to manage their own funds. The first set of problems come from efficiency. There are several drags on index fund performance that slowly degrade performance.
Various of these are related to taxes. For one, when you buy a preexisting index fund, it's likely that the fund will have large unrealized capital gains - particularly at the end of huge bull markets. Were the fund to sell a stock (say in the event of a takeover) you may now owe a capital gains tax bill on gains that weren't made by you. That's highly unfortunate.
Index funds are also forced to turn over shares to match the index' changes. For example, since 2009, 17% of the S&P 500 has been replaced. Since 1999, fully half of the old S&P 500 constituents are gone, replaced by newcomers.
On a couple of occasions, you have had 10% of your index involuntarily turning over in just one year. That adds up to quite a significant tax bill. Also trading costs and arbitrage start to hurt you.
According to this Bloomberg Views article, the average new S&P 500 constituent runs up 7% (!) in the two weeks prior to being included in the index. When hedge funds discern that a company will be added, they frontrun the index funds, making money at your expense.
Given the low importance of any one stock to an S&P 500 index fund, getting frontrun by 7% occasionally isn't going to kill your returns, but it is a drag on performance. This effect is often even worse in less liquid indices/ETFs.
Speaking of turnover, with an index fund, you're at the mercy of the people who run the index. The S&P 500 is continually tweaking its rules, kicking out international companies a decade ago, and now making a push to include many more REITs. Each of these types of changes causing more drag on your returns via increased taxes, trading costs, and front-running.
The IMF: A Better Index Fund
My portfolio is intended to be a better index fund. It doesn't face the same obstacles listed above, and it also doesn't face an annual management fee. Beyond relatively minor trading costs (more on that later), there shouldn't be much slippage to fees.
The IMF won't take concentrated positions; like an index fund, it will own hundreds of stocks in small quantities. However, I can derive outperformance from buying on weakness and by overweighting sectors that typically outperform.
Please see my article that discusses more than 80 years of US equity market performance by sector. Buying traditionally strong sectors (energy, alcohol, health care, consumer staples for example) and underweighting the losers (commodities, cyclicals and so on), you are likely to beat the market to a degree.
Add to that exposure to small-caps, value stocks, emerging markets, and other such factors, and it should be possible to beat the S&P 500 by 1-2% a year compounded.
Many of the critics of DGI here at Seeking Alpha cite the lack of transparency as a concern. There's lots of discussion of dividend and value-driven long-term investing, but relatively few tangible success stories. The publicly available DGI portfolios have generally underperformed the broad market, leading to considerable skepticism of the broader investing approach.
I will very clearly contrast my performance with the broad market . I will also compete against the Vanguard Total World Stock Market ETF (NYSEARCA:VT). (Thanks to SA commenter Varan for the suggestion of using VT as a benchmark to my portfolio.)
I personally believe US stocks at present are quite overvalued, so I expect international diversification to provide substantial outperformance over the next few years. If I'm right, I should beat the SPY handily, but VT may be a more worthy competitor.
In the next part of this article, we'll discuss how to buy dozens or hundreds of stocks at a reasonable price, along with what I purchased in my first tranche of buys.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.