For over 25 years, AAII’s major emphasis has been on investment education and information. Our preferred function has been to prepare individual investors to be their own advisors, and to provide the necessary data and systems to help them in that effort.

Over the years, however, we became increasingly aware that many of our members wanted more specific help. We responded to this need gradually, and last year took the major step of offering a complete portfolio advisory service (our Stock Superstars Report; ssr.aaii.com) for those members who wanted it.

From conversations with members, we have found that there is a need for an intermediate level of support—not a complete stock advisory letter, but some specific guidance for individuals in developing an effective investment program. Over the next months, you will see this initiative develop in a number of ways, including in my A Matter of Opinion column.

The Individual Investor’s Shadow Stock Portfolio

In this column, you will see two changes. First, the Beginner’s Portfolio coverage will be expanded, with more specific direction as to how this model portfolio, and variations on it, fit into an investment program. This real portfolio has beaten the S&P 500 by over 4% a year for the past 10 years with lower risk, a fact I reported in this column in the April AAII Journal. And it is beating the index by even more this year.

This year, we are changing its name to the Individual Investor’s Shadow Stock Portfolio, and we have made a few changes based on our experiences. This portfolio has always reflected my investing philosophy, which holds that:

• The best stocks for individual investors are not the same stocks that are best for institutions;
• Ultimately, the best returns come from giving major consideration to risk; and
• Success comes from more concern for the overall portfolio than for individual stocks.

These three principles will continue to guide the strategy in future expanded coverage and, as my column name says, it is “my opinion.” But what I will be showing and discussing is AAII’s own Shadow Stock portfolio.

The Individual Investor’s Fund Portfolio

The second change in my column involves the creation of a model mutual fund portfolio. This portfolio, although not intended as a complete advisory service, will serve to illustrate approaches to mutual fund selection that follow the same philosophy as that of the Individual Investor’s Shadow Stock Portfolio: The emphasis will be on consistency, risk control, and the selection of funds that follow approaches that an individual investor, rather than an institution, should follow.

Over time, I will examine the different selection criteria, discuss variations that can affect risk, and show how these stock funds can be combined with low risk holdings to match a desired overall risk profile. Once again, however, it is “my opinion.”

This sample portfolio will be called the Individual Investor’s Fund Portfolio. [Please be aware that these funds are also in my personal portfolio—see the note at the bottom of Table 1.]

Selecting the Funds

I will get right into these new initiatives by briefly describing the criteria for the Individual Investor’s Fund Portfolio. In-depth discussion of the criteria will follow in future columns.

To make it into the Individual Investor’s Fund Portfolio, a fund must meet the following criteria:

1. It must be a pure no-load fund. While it may charge a penalty for short-term redemptions, the penalty must be paid to the fund and benefit the shareholders. I feel this type of penalty is desirable particularly for small-cap and mid-cap funds to offset the transaction costs caused by short-term traders.
2. It must have been in existence for at least 10 years. In the future, I will discuss how it might make sense to make exceptions to this rule in certain circumstances, but I want to first examine long-term volatility.
3. It must have had higher returns than the S&P 500 index on both an absolute and risk-adjusted basis for the most recent five-year and 10-year periods. I am interested in future performance, and the funds with the highest returns in the past are not necessarily those that will perform best in the future. But I feel that better funds always outperform the market (S&P 500 index) in the long and intermediate run.
4. It can’t have been down for two calendar years in a row. This reflects my belief that past consistency, given the requirements of rule 3 above, is a better indicator of future returns than past returns.
5. It must never have had a three-year period with negative returns. Once again, this requirement seeks consistency. In addition, I feel an investment horizon of three years is the minimum for equity investing. This rule emphasizes the importance of never having to sell your portfolio holdings at a loss.
6. It must be primarily a domestic common stock fund, although it may have some other investments in its portfolio. I have never believed that the risk reduction that might come from international investing justifies the severe reduction in long-term returns—look at the average returns of international funds compared to domestic. However, a good stock need not be eliminated simply because it is foreign.
7. It must have net assets of less than $2.5 billion. I believe it is too difficult to invest in areas that offer unusual opportunities with a cumbersome amount of assets. Funds with larger net assets become closet index funds with higher expenses. The exact cut-off point perhaps should vary with a fund’s objective, and this is another area for future discussion.
8. It must have an expense ratio of less than 1.25%. Many of the selected funds will be smaller in size, and I can therefore justify this level, which is somewhat above the average for stock funds. However, I believe that a higher expense ratio not only will cost in the future (past expenses are reflected in past returns), but says something about management’s attitude. There may be justifiable exceptions here and this is another area for future discussion.
9. It must currently be open to individuals. However, I will follow openings and closings of otherwise qualified funds.

The current list of funds is presented in Table 1. I am not suggesting that these 10 funds will be the best-performing funds in any future time horizon. What I am saying is that, in my opinion, a portfolio of these funds will outperform the market over the intermediate term and the long term with lower risk. And, in fact, I have put my money where my mouth is because I just bought all of these funds.

Other Criteria

It is not necessary to have a portfolio of 10 funds. As you will note in the table, all of these funds are so effectively diversified that their average risk is reduced only slightly by the portfolio effect.

If you buy mutual funds through a discount broker, having 10 funds is easy enough. If you want fewer funds, you can apply your own criteria to reduce them. For instance, eliminating funds with more assets would eliminate T. Rowe Price Capital Appreciation and Ariel Fund. Eliminating Thompson Plumb Fund and Meridian Growth Fund would reduce portfolio risk the most (although the overall reduction would be very little). You could use expense ratio, returns, or a personal feeling that comes from reading a fund prospectus.

On the other hand, you do not want to winnow your selection down to just one fund. While these funds in the past have had similar diversification benefits, changes specific to each fund may alter its level of diversification—for instance, a fund may get a new manager who changes direction, or there may be a change in philosophy. For that reason, you should hold at least four different funds.

Mutual funds like these, that are well diversified, do not have to be changed very often, so I will only perform the screen twice a year.

In addition to providing information on individual funds, I will also look at the problems of maintaining a portfolio of funds. These include fund changes, rebalancing of holdings, and dealing with fund openings and closings.

I look forward to a more “hands-on” approach to discussions of the Individual Investor’s Fund Portfolio and the Individual Investor’s Shadow Stock Portfolio over the coming months.

TABLE 1. The Individual Investor’s Fund Portfolio