Simple Rules for Investing in Stocks

January 13, 2011, By Tyler Newton 2 comments

Forget the hype. Investing in stocks is not a game. Unless you are a professional trader or a trained financial analyst on Wall Street, you should be wary about investing in and trading individual stocks. There is an army of well-paid professionals on Wall Street that are paid to trade and analyze stocks for a living, and they don’t beat the market as a whole.

Two rules for investing in stocks: keep it simple and diversify.

The simplest way to invest in stocks is to follow two steps. First, determine how much of your total portfolio to allocate to stocks. Second, invest that entire amount in the Vanguard Total World Stock Fund ETF. (An ETF, or Exchange Traded Fund, is a mutual fund that trades like a stock.)

International versus domestic. The Total World Stock Fund has about 45% of its exposure in North America and 55% elsewhere. Many investment advisors say adding up to 20% international stock exposure adds diversification and that more than this level is considered “aggressive.” A converse way to look at it is the US and Canada account for only 27% of world GDP, but 45% of world equity market capitalization, so it would make sense to expect the rest of the world to catch up with, and outperform, North America over time. The ultimate international exposure depends on your comfort level. If you want to adjust your international exposure level, you can place your domestic stock basket in the Vanguard Total Stock Market ETF and put your international basket in the Vanguard All-world Ex-US ETF.

Small cap versus large cap. Over the long term, smaller capitalization stocks have higher returns (and higher risk) than large capitalization stocks. If you want to increase your exposure to small capitalization stocks, you can add the iShares Russell 2000 Index ETF relative to your position in the VTI. The VTI is roughly 80% large capitalization stocks, so if you wanted to create a 60-40 large cap-small cap ratio, adjust your domestic basket to 75% VTI and 25% IWM. The same goes for international exposure, where you can reduce your holdings of the VEU and add the iShares EAFE Small Cap Index ETF.

Value versus growth. “Growth” companies grow revenue faster than the economy and “value” companies grow slower than the economy. Value stocks tend to pay higher dividends to make up for their slower revenue growth. If you want to add more value stock exposure relative to the VTI (which is about 50-50 growth-value), add the iShares Dow Jones Select Dividend ETF. If you’d rather add more growth exposure, consider the PowerShares NASDAQ 100 Trust, which holds the 100 largest stocks on the tech-heavy NASDAQ stock market.

Rebalance. Based on your risk tolerance, you can use the ETFs above to create a fully-diversified, low-cost stock portfolio of between one and five stocks. Set target percentages of each stock as a percent of your whole investment portfolio. Every six or 12 months, sell shares of those that have increased above their target percentage and buy shares of those that have traded below their target percentage. The discipline to “rebalance” your investments over time will lead you to systematically “buy low and sell high”. Simple as that.