In Phase 7: Save Outside Retirement Accounts, we talked about investing through the use of a taxable investment account. In that article, I strongly advocated for a low-cost, automatically-balancing mutual fund, like Vanguard’s LifeCycle funds.
I’ve been hiding something though: there is a better way to do things. It takes a little bit more work, but it can save you a decent chunk of money throughout your lifetime. What is this method? Using ETFs. ETF stands for Exchange Traded Fund. It is just like a mutual fund, but you can buy individual shares through a brokerage account, just like it’s stock from a specific company. In this post, we’re going to go over how to create an ETF portfolio.
As you can see, fees can add up quickly. It is highly probable that you could save well over this $9,396 figure for two reasons: a) most mutual funds have a higher expense ratio than 0.2% b) you may join the ranks of the stealthy wealthy and have more money than $100,000 in a mutual fund over the course of your life.
Picking your ETFs
The three examples of ETFs mentioned in the infographic above are the Vanguard Total Stock Market (VTI), Vanguard Total International Stock (VXUS), and the Vanguard Total Bond Market (BND). These three ETFs give you broad exposure across three asset classes: US stocks, international stocks, and bonds.
These three picks also have very low expense ratios which means you save money. The VXUS has a higher expense ratio at 0.14% because it’s an international ETF, but BND is a nice 0.07%. The VTI is an impressive 0.05%. All of these are much lower than the average actively-managed mutual fund which sits at 0.79%. The beauty of Vanguard’s ETFs is if you sign up through them, you don’t need to pay commissions on trades. Which brings me to my next point…
ETFs trade like stocks, so beware of trading fees!
Ever seen how certain brokerages advertise $7.99 trades? This means that the brokerage charges you $7.99 to execute a trade–either buying or selling shares of stock. ETFs are often subject to these same fees since they trade like individual shares of stock.
Don’t fret though. There are a few big brokerages that have commission-free trades. Vanguard is one of them. If you can’t afford the $3,000 minimum balance for a Vanguard account, there are other brokerages that have commission-free trades on select ETFs. They may not be the same exact ETFs mentioned in the infographic, but they can be close enough. Some of them even have better expense ratios! Here are two other brokerages with commission-free ETFs to get you started. I’ve also included funds that are equivalent to the Vanguard funds named in the infographic above.
Charles Schwab (minimum $1,000 to open)
- Total Stock Market (SCHB) – Compare to Vanguard Total Stock Market
- Emerging Market Stock (SCHE) – Compare to Vanguard International Stock
- Intermediate Broad Market Bond (SCHZ) – Compare to Vanguard Total Bond Market
TD Ameritrade (no minimum)
- iShares Core S&P 500 (IVV) – Compare to Vanguard Total Stock Market
- Vanguard FTSE Developed Markets Index Fund (VEA) – Compare to Vanguard International Stock
- Vanguard Total Bond Market (BND)
If you have to choose an ETF that is different from some of the ones mentioned earlier in this post, make sure to double-check the expense ratio. There is no point in buying an ETF that has an expense ratio that is higher than 0.15%. You can get a nicely diversified mutual fund for that price. A mutual fund will automatically rebalance for you. ETFs on the other hand do not.
Rebalance, rebalance, rebalance
Having to rebalance your portfolio is the biggest downside to ETFs, though it isn’t that big of a deal. Basically, your asset allocation can get out-of-whack over time depending on how different ETFs perform. For example, if you wanted a 50% stock and 50% bond allocation, put equal amounts of money into each ETF, and stocks ended up having a great year, your portfolio could end up looking more like a 70% stock and 50% bond allocation. To fix this, you sell enough shares of your stock to buy bonds in order to bring it down to 50% of your portfolio value.
If you sign up for Personal Capital, it will automatically calculate your asset allocation (and show you your fees!). It’s a totally free service and can help compile all of your investment data into one spot for easy interpretation. This takes some of the arithmetic out of rebalancing.
If you’d prefer to figure it out on your own, check out this article from BogleHeads. If you really want to get into the nitty-gritty and rebalance your portfolio for maximum efficiency, check out Vanguard’s 16-page guide, Best Practices for Portfolio Rebalancing. Don’t try reading it at bed time.
Rebalancing your portfolio doesn’t need to happen every week or even every month. If you can muster up the strength to do it two times per year, that would be great. One time per year is an acceptable minimum, though.
What do I do with my dividends?
One other thing that can get tricky with ETFs is dividend reinvesting. You’ve got to make sure to reinvest your dividends. How important is this? Extremely. Let’s look at an example: From January 1990 to January 2016, the total return of the S&P 500 without taking dividend reinvestment into account was 459%. Not bad. What if you take into account a portfolio with reinvested dividends? A whopping 860% return.
So… what about reinvesting those dividends? If you’re interested in running your own scenarios, here is a pretty cool calculator that will let you see the effect of reinvesting dividends.
Vanguard will allow you to set up dividend reinvestment automatically, but I can’t speak for other brokerages. Worst case is that you just have to click “buy” when you get a dividend payment. No biggie! If you’re willing to put in the effort, there is potential for big savings.
- Open up a brokerage account through Vanguard, Schwab, TD Ameritrade, or any other brokerage
- There is seriously no excuse for not getting this going. TD Ameritrade has a $0 minimum if you can’t scrounge the $3k for Vanguard or $1k for Schwab! Take some action, here!
- Select your asset allocation and start buying. Refer back to the infographic for help determining this.
- Buy shares of the ETFs you’d like to invest in
- Set up automatic dividend reinvestment and automatic buying. As we discussed in Dominate Savings with Automation, consistency is key!