No gardener in his right mind expects to plant and then walk away. Without reasonable maintenance, even the best gardens will slowly turn to weeds, or be overrun by bugs and critters. Your portfolio will also need periodic tending in order to realize its maximum potential. This maintenance need not be burdensome in order to be effective, but it must be done with some regularity. By now, you have examined your financial situation, objectives, and risk tolerance. You have used this information to design an appropriate asset allocation plan, and you have selected funds for each asset class.

Finding the Right Home

Your next step in executing your plan is selecting the custodian. Whether you are using a financial advisor, or going it alone, there are lots of good, economical choices. For our purposes, the two main candidates are no-load mutual fund families and discount brokerage houses. Another possible candidate is an independent trust company.

The first obvious consideration is to only use institutions of impregnable financial solvency. You don’t need the additional risk that some rinky-dink little outfit will go toes up on you. There are too many great choices to use.

Keeping It Simple

If you are just starting out with your investment plan, you can keep things simple by just using one family of no-load funds. Keeping things simple increases the probability that you will actually do the maintenance. If you are anything like me, as things get more complex, there will be a greater tendency to put things off. Using one fund family will give you many conveniences like telephone switching, consolidated monthly statements, and an annual consolidated tax statement. For instance, Vanguard Funds have all the tools necessary to build a first-class, globally diversified, low-cost asset-allocation plan within their family. They will even provide you with information showing you how to index just about the whole world’s tradable economies. While personal preferences may vary, I can’t imagine a better starting point.

Whatever your decision, avoid funds with high turnover, high expenses, high minimum investment amounts, or annual account charges.

As your account grows, at some point you may wish to venture outside the walls of a single family of funds. After all, even Vanguard doesn’t have every fund you might care to own. You may reach that point somewhere between $25,000 and $250,000, or even higher. You can still keep things simple by using the facilities of one of the discount brokerage houses like Fidelity, Jack White, or Charles Schwab. The discount brokerages open up hundreds of funds with the convenience of a single account. Of course, you will have to pay nominal transaction charges for the low cost funds, but you will have access to entire families of NTF funds that you can use as required.

You can avoid any initial purchase charges on existing funds you wish to keep in your portfolio by transferring title to your discount brokerage account. This process may take a few weeks while the transfer clears, but should result in considerable cost savings. It has the further advantage of keeping you fully invested during the transfer process. And, a transfer of existing funds will not result in any adverse tax consequence, which a sale and re-purchase might trigger. The brokerage house will supply you with transfer forms that will go a long way toward making the whole process painless. Now that we have found a safe home for our assets, it’s time to purchase our funds.

Get a Grip

A few simple tools will make it easy to manage our portfolio as we go along. First, build a simple spread sheet that assigns a percentage for each asset class and fund in your asset allocation plan. You want to be able to plug in the total value of the account and have the spread sheet calculate both the desired asset class and individual fund values for you. But, for now, we will just use it to place our initial orders.

Place your orders and wait for the confirmations to arrive. When they roll in, check them against your orders and keep them for your records. You should also receive a prospectus for each fund you purchased. Normal humans do not find this exciting reading, but you should make the effort. (Actually, you should have read it before you purchased.)

As a minimum, always check and save all of your confirmations and monthly statements. Once a year, you should get a consolidated tax statement. It goes without saying that you will wish to keep the tax statement. Don’t be too surprised if the first tax statement isn’t followed by a letter from your brokerage apologizing for an error that they claim not to have been able to anticipate. (Sometimes they will blame unspecified computer problems.) This letter will shortly be followed by a corrected statement. I have even seen the process repeated. With all the hundreds of funds reporting tax information to the brokerage houses, it would be unusual if someplace along the line some human didn’t make a mistake. If you are the kind who files his taxes on January 2, you will find this annoying, if you are like me you will just find it amusing. Relax, it always gets sorted out.

Take a Break

You have accomplished a lot. Mellow out for a while. You have done the very best you can, and now you will have to rely on the market forces to do what they have always done. Unless history abruptly reverses itself, your superior portfolio will deliver very satisfying results over the long haul. Many of you will find this a very hard step indeed. Resist the temptation to tinker endlessly, and to second guess yourself. Turn off Wall Street Week, cancel your subscription to Money Magazine, and refuse to be sucked into predictions of interest rate changes or market corrections. Spend that time you would have wasted by taking someone you love to the beach or reading a great book. Get a life!

Not more than once a quarter, but not less than once a year, you should take time to evaluate your progress. The evaluation does not have to be complex or burdensome, but will involve several distinct steps.

Being normal and human, you will first zero right in on the bottom line. You would be a very strange cat indeed if you were not interested in whether you made or lost money. However, this is not important information. We know in advance that about 30 to 40 percent of the quarters or years we evaluate, an equity portfolio might have lost money. The success or failure of our plan does not depend on any particular year or quarter. But we will allow ourselves a brief distracting moment to feel either good or bad depending on the bottom line, and then move on to the important part.

As a first step, pull out the spread sheet you constructed, and plug in your new capital value. See if your assets still are close to the asset allocation goal. If not, it may be time to reallocate back to your goal.

Reallocation accomplishes two objectives. First, it keeps our original risk profile. We know that over a long period of time, some of our assets will grow faster than others. If we did nothing, then the mix of assets would change after a while. When the mix changes, the risk changes. The resulting portfolio will neither be optimum, nor within our risk tolerance.

The second big thing that reallocation does for us is to force us to sell high and buy low. Depending on the mix of assets we hold, a periodic reallocation could add as much as 1 to 2 percent to our annual average performance. In the portfolios illustrated in Chapter 13, the average benefit was about three-quarters of one percent. While we are not going to attempt to time markets, it makes intuitive sense that last year’s fastest growing market segment is not likely to be next year’s. Last year’s dog will not be a dog forever either. So, the discipline of reallocation will generally add value to a portfolio. Remember, of course, that nothing is going to work every year, but that this tactic has proven itself consistently over the long haul.

Like everything else, there are tradeoffs. Reallocation may involve a transaction cost, and/or a tax cost. If you are using a mix of no-transaction fee funds at a discount brokerage house, or trading within a single family of funds at a fund family, you may avoid a transaction cost. And, if your account is an IRA or other “qualified” plan, you do not need to be concerned with taxes.

How often should you rebalance? Most studies would indicate that about once a year is optimum. Another approach that may make sense is to rebalance if your asset allocation gets some pre-determined amount off, such as 2 to 5%.

Build Your Own Benchmark

The next step in performance monitoring is to build your asset allocation plan portfolio using only indexes. This is your real base line for comparison. It will help you to understand the total performance of the portfolio and put it in perspective. It’s not enough to know whether you made or lost money, or even how much you made or lost, to evaluate your performance relative to your strategy.

The final step to effectively monitor your performance is to compare each fund to its appropriate index to see if it is performing according to expectations. If not, there may be valid reasons. For instance, international funds that over-weighted Japan had lower performance than the EAFE (Morgan Stanley Europe, Australia, Far East) index for the last several years. You may find that a valid position going forward, and not be too concerned about past performance relative to the index.

Avoid Endless Tinkering

Given what we know about the efficiency of markets, the burden of proof on managers that they can actually add value is becoming very heavy. You may not wish to subsidize poor performance for very long in the hopes that the manager can pull it out. During these performance reviews we must vigorously resist the temptation to replace a disappointing fund with last quarter’s hero. Endless tinkering is unlikely to improve performance, and chasing last period’s stellar achiever is a proven losing strategy. If you believe (against the mounting evidence) that management can add value, you must give your selected manager a little slack and time for his strategy to pay off. Of course, if you invest in an index fund, your concern about not producing very close to the index should be minimal. My preferred solution to disappointing management performance has been to replace them with index funds, rather than try to pick another hero. Picking next year’s heroes has turned out to be a far tougher problem than I ever could have imagined.

The Big Picture

For the most part, fund evaluation and performance monitoring are tactical in nature. At some point we must step back and look at the “big picture.” How often should we evaluate strategy?

Of course, we all understand that we should examine our strategy if any event in our lives changes our financial situation, objectives, time horizon, or risk tolerance.

Barring any life-event-driven change, there are only two times to change the asset allocation plan. Every once in a while new fundamental research shows us a way to build better portfolios. For instance, just a few years ago, the Fama-French study and the follow-up research pointed out the superior results that could be obtained by pursuing a small company and value strategy. This information was fundamental and important enough to justify a total redesign of existing portfolios. But insights like this don’t come along every week.

We don’t want to be reacting to every half-baked theory that comes along. As a rule of thumb, I expect to encounter at least two half-baked, brain-dead theories each week. Money Magazine has no trouble generating four or more per issue. So it’s important to try to distinguish between proven, tested, fundamental, academic, or industry research, and total BS (A highly technical economic term beyond the scope of this book. Ask your parents to explain it to you.). None of us needs to be the first to try out a new idea. Let others blaze the way. Remember, it takes a long time to make up for a dumb mistake. Prudent investors should stick to well proven, well trodden paths. Investing should be rewarding, not exciting!

While the mutual fund industry cranked out over 1,500 new funds alone last year, few new and different opportunities were offered to investors. Most funds are virtual clones of other existing funds. For instance, emerging market funds begin to look pretty much the same. With only minor variations, they invest in the same markets, countries, industries, and stocks. Most emerging countries boast a cement and power plant, telephone company, and several breweries. I have lost track of the number of emerging market funds that hold Siam Cement. A new emerging market fund is most likely not going to add a strong diversification effect to an existing portfolio.

Thailand, Malaysia, Singapore, Hong Kong, Brazil, Mexico, and Argentina are well represented. However, opportunities in India, Pakistan, Hungary, Russia, Poland, Turkey, South Africa, and Jordan are slim pickings. All other things being equal, a fund that concentrated investments in a few of these smaller, less-developed countries might offer a strong diversification effect. So when they become generally available, an investor might want to consider carving out a portion of his existing emerging market portfolio to make room for the new offering.

In a like manner, many funds that claim to invest in small companies have holdings of rather large size. So if a new micro-cap fund were to appear, an investor might seriously want to investigate whether it deserves a portion of the small cap allocation.

Carving out a portion of an existing allocation to make room for a new market or a new approach to a market segment to increase diversification is an evolutionary approach. We haven’t made a fundamental change to the plan, but we do expect to pick up a measurable benefit in either risk or return at the portfolio level. Investors will want to keep an eye out for new approaches that offer these possibilities. Again, normal prudence and due diligence must be exercised. New isn’t necessarily better, and every fund should earn the right to its slot in your asset allocation plan.

Less is More

Good asset management practices are strategic and evolutionary, not stagnant. You must keep your long-term goals and objectives firmly in mind while allowing yourself the flexibility to evolve as new research provides better solutions to the risk management problem, or new market opportunities present themselves. Discipline is the key to success for long-term investors. They must not fall into the trap of managing their holdings by newspaper headline, sound bites, mindless prediction, gut feelings, or last time period results.

A successful investment strategy for the twenty-first century is a lot like gardening. Both require patience, discipline, and faith. Periodic reviews should be viewed as an opportunity for fine tuning and occasional modest course corrections, not radical revision and second guessing.

Coming Up

Retirement and education funding are the two most common investor concerns. In the next chapter, we will expand on specific tactics to meet these needs.