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I've long argued that investing is simple, and that you only need a portfolio of a few diversified, low-cost index funds. But simple doesn't always mean easy. I'll confess that my own portfolio sometimes violates the simplicity I advocate. Investing using the KISS principle (Keep It Simple, Stupid) is hard.
Fifteen years ago, I taught my son how to invest using just three index funds. (Index funds simply track a well-known index, such as the Standard & Poor's 500.) Called the Second Grader's Starter portfolio, it became one of the eight Dow Jones MarketWatch Lazy portfolios. It's currently occupying first place and besting other portfolios created by brilliant investors, including Yale University's David Swensen.
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Use 3 kinds of index funds for a simple portfolio:
- A total U.S. stock index fund
- A total international stock index fund
- A total bond fund
You can weight these however you want, but a moderately risky portfolio could be 40 percent U.S. stocks, 20 percent international stocks and 40 percent bonds. Later in life, you many want less in the way of stocks. Either way, I recommend rebalancing to keep a relatively constant amount of risk. When you rebalance, you put your portfolio back to its intended allocation. For example, if, after a few years, the above portfolio were 70 percent U.S. stocks, 20 percent international stocks and 10 percent bonds, you'd move enough out of your stock funds to get your bond fund back to 40 percent of your portfolio.
With these funds, my son owned virtually every publicly held company on the planet, as well as an approximation of nearly every investment-grade taxable bond in the U.S. He got a high-performance portfolio. Nobel laureate William Sharpe, in his paper The Arithmetic of Active Management, proved that owning the entire market at the lowest cost must beat the majority of investors.