$5K in “Extra” Savings: Narrowing down the investment choice.

(This is Part 2 of a detailed post that discusses our thought process on what we did with $5K in extra savings. Please refer to Part 1 of this article to see how we arrived at the conclusion to invest in the stock market.)

So, at this point, we have decided that the best thing to do with the $5K “extra” savings we have (after funding our 401Ks, completing payments on investment real estate and paying off the bills) is to invest it in the stock market. That said, we have no clue where to begin or what exactly to do with the money. As usual breaking it into smaller steps helps tackle the problem. Here is how we got started -

Step 1: Determine the investment vehicle

The first thing we decided to do was to eliminate the options that are not right for us. Neither of us possesses the skills to "play" the market -- so that rules out individual stocks. We can afford to be a bit aggressive at this point -- so that rules out bonds and bond related funds. We do not want to share our hard earned earning with fund managers. That rules out actively managed mutual funds. By now our options are kind of narrowed down to Index funds or ETFs. Determining which one of these two to go with was a little harder. But a lot of discussion with colleagues and some excellent blog articles like this and news articles like this swayed us in favor of Index funds. Our specific reasons were -

  • ETF’s trade just like stock. That means, for an ETF, you need to pay a commission each time you buy. In our case, we are starting out with a relatively small amount, and depending on how things look in the future, we want to keep the option open for adding additional small amounts to it as and when we can. If we go for an ETF a lot of our returns will be eaten up by commissions!

  • We are beginners in this area. We do not want to have the option to trade our holdings like stock! The way I see it, the lesser the temptation to chase trends, the better off we will be!

  • The benefits of ETF’s are: lower expenses and lower taxes. By choosing no-load index funds with low expense ratio and low turnaround rate, we could possibly try and achieve similar benefits from Index funds.

  • Index funds have been around for longer than ETFs. So there are more options to choose from and more importantly, there is a lot more information out there about sample allocations for index funds than ETFs. This makes Index funds an ideal choice for newbies like us.

Step 2: Determine the company to open an account with.

Index funds can be obtained either directly from the companies that offer them or from brokerage accounts (unlike ETF’s, for which you *must* have a brokerage account). At this point we have decided to skip the option of opening a brokerage account and to stick with a well-known company that offers index funds. Based on our discussion with colleagues and hours of searching related threads on ask meta filter and fat wallet finance forums we finally decided to go with Vanguard for their large selection of low-cost index funds and minimum entry requirements of $3,000. (By the way, they also have a fund with a minimum of requirement of $1,000 called Vanguard STAR Fund (VGSTX) if your are interested in looking up).

Step 3: Determine the Index fund.

Even after narrowing it down to Vanguard Index Funds we were still quite overwhelmed with the number of choices we had. So, we decided to keep it simple by starting out with the list of index funds in CNN money’s Money 70: The best mutual funds you can buy listing for 2007. Among the 12 Index funds listed (the remaining are actively managed funds, ETFs and Target retirement funds), 9 were from Vanguard, which is great! Among these 9, 2 are bonds funds and so we eliminated them. 1 is a real estate fund, and since our focus is on diversification, we decided to stick with blended funds instead of specialty funds. Among the remaining funds, the one that attracted us the most was the Vanguard Total International Stock Index Fund (VGTSX). Of course the main reason it attracted us is that it has the second best returns among the 6 funds remaining and the lowest expense ratio. So why did I choose this instead of the best performing fund (Vanguard Emerging Markets Stock Index - VEIEX)?

Here are our reasons:
  • VGTSX has a lower expense ratio (0.32%) Vs the VEIEX (0.42%).

  • VGTSX has a Morning Start rating of 4 starts Vs the 3 star rating for VEIEX.

  • VEIEX may have higher returns but it comes with the risk of higher volatility.

    1. VEIEX has a higher alpha than VGTSX in reference to S&P 500 index (13.2 Vs 9.82), meaning that if S&P 500 returns 0, then VEIEX can be expected to return 13.2%, while the VGTSX can be expected to return 9.2%. But this comes at the risk of higher volatility -- VEIEX has a beta of 1.7 compared to 1.03 for VGTSX. This means that VEIEX is 70% more volatile than S&P 500 compared to VGTSX being 3% more volatile.

    2. VEIEX has a higher mean return, but also a higher standard deviation. Based on this, sharpe ratio of VEIEX is less than that of VGTSX. What this means is that VEIEX has a lower reward-to-risk ratio compared to VGTSX. I used this sharpe ratio calculator with the mean and standard deviation for the two funds obtained from the CNN money website linked above (fund details provided by Morningstar) and a risk-free rate of 5% corresponding to the interest rate on my HSBC online savings account.

    Based on these, even though both have relatively high risk, VGTSX seems to be a better option for us.

  • VGTSX is a blend of three different index funds -- European, Pacific and Emerging markets (yes, VEIEX). This gives us better diversification than just owning VEIEX.

So I finally we chose to go with VGTSX. VGTSX (or its component funds) are a staple in many of the sample allocations listed here. I browsed through several sample allocations on the Net and found more portfolios that do not have VGTSX (or its component funds) than those that do. But for a beginner like me the fact that it was used in several of the lazy portfolios mentioned on the site above is still quite reassuring.

Step 4: Look at the big picture.

While this is our first investment into the stock market in a non-retirement account, we do have a bit of money in retirement accounts (401K) that is invested in the stock market. So, before we open an account we need to revisit our 401K and check our allocation there. As it turns out, between the better half and I, we have about 35% of our 401K in international funds. With the addition of this fund, it will take our total allocation in international funds to 37%. That is not so much different from the previous allocation we had and we believe it is the amount of risk we can handle at this point. We did consider splitting the amount into the Vanguard Total International Stock Index (VGTSX) and the domestic index Vanguard Total Stock Market Index (VTSMX). However, this option would require us to raise another $1,000 (since each fund had a minimum of $3,000) and so after going back and forth a few times, we concluded that at this point we will go with just VGTSX. In the future if we do add more money to our investment funds, we will certainly come back and revisit VTSMX.

Step 5: Finally, pull the trigger.

Opening a Vanguard account online was a breeze. In about 10 minutes, I had set up the joint account and placed the purchase order. Vanguard charges $20 per year in fees if your total balance is less than $10,000. However, this fee will be waived if you sign up for electronic statements. I have not done this yet since the account is still in the process of being set up. Must remember to get back to it next week.

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