Wouldn’t it be great if investing was so easy a second grader could do it? Believe it or not, second graders invest successfully all the time. In fact, a popular book titled “How a Second Grader Beats Wall Street” follows 8-year-old Kevin Roth’s investment decisions — guided by his father, Allan Roth — after his grandma gave him a $10,000 gift.
You’ll be surprised at just how well little Kevin did.
The good news is that you don’t have to have a finance guru as a dad to invest successfully. The Second Grader’s Starter Portfolio was designed to give young investors an easy way to make their entrance into the stock market.
What Is the Second Grader’s Starter Portfolio?
The Second Grader’s Starter strategy developed by finance columnist Paul B. Farrell is an easy option for young investors to get their feet wet. In fact, when he first introduced the strategy to the public, he gave a scenario much like Kevin’s, where a second grader receives a $10,000 gift from a grandparent, suggesting this portfolio is how the money should be invested.
The portfolio is one in a long line of lazy portfolios, meaning it doesn’t require much work to set up or manage. This simple portfolio strategy only requires you to invest in three different assets within different asset classes.
While the portfolio prescribes heavy diversification through index investing as a way to maintain safety and stability, Farrell is clear that this strategy was designed for the very young investor, not necessarily for investors with a medium to short-term time horizon.
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Portfolio Asset Allocation
The Second Grader’s Starter investment strategy suggests that investors should invest in three assets, all representing different classes. Here’s the allocation breakdown:
- 60% in the Total U.S. Stock Market. The first asset, and the majority of the portfolio’s allocation, is an exchange-traded fund (ETF) that gives broad exposure to the United States stock market as a whole. This fund should invest across all market caps and sectors, giving your portfolio the best representation of the total U.S. market possible.
- 30% in the Total International Stock Market. The portfolio also suggests investors should put 30% of their investment dollars in international stocks. As with the domestic holdings, the international stock fund you use should be heavily diversified, investing in different sized companies across a wide range of sectors. As an international investment, it’s important that the fund also diversifies across both developed and emerging economies.
- 10% in the Total U.S. Bond Market. Finally, the portfolio suggests that the remaining 10% of your assets should be invested in a total U.S. bond fund. This fund should also be heavily diversified, investing across a wide range of maturity dates and bond types.
The Investment Thesis Behind the Portfolio
Much like the Bogleheads 3 Fund Portfolio by Jack Bogle, the Second Grader’s Starter strategy is centered around simple access to widespread market exposure.
First and foremost, simplicity comes into play because there are only three assets to manage. Moreover, with all assets in the portfolio being invested in investment-grade funds, this simplicity comes with unmatched diversification.
After all, the funds you invest in when following this strategy will expose your portfolio to thousands of stocks across a wide range of sectors, regions, and stages of business. Should one of the stocks or an entire sector take a dive, gains in other stocks will help to offset the declines, offering you volatility protection.
Another form of volatility protection involved in this portfolio strategy is its inclusion of fixed-income investments. Sure, stocks have the potential to produce higher returns than bonds, but when a correction or bear market sets in, bonds and similar assets offer a safety net.
Some investors are uncomfortable with the fact that only 10% of the portfolio is invested in bonds, but that’s because most investors need a bigger safety net than this. It’s important to remember who you’re talking about — this is a portfolio designed for children, who have exceptionally long time horizons and an ability to absorb significant risk. In that context, the minimal exposure to safe assets is understandable.
Portfolio Pros and Cons
As with any other portfolio, the Second Grader’s strategy isn’t a one-size-fits-all approach to investing and comes with its own pros and cons. Here are some of the most important to consider.
Second Grader’s Starter Portfolio Pros
Those who take advantage of this portfolio strategy love it because it:
- Offers Simplified Access to the Market. With only three assets in the portfolio, setup and management are a breeze. At the same time, the heavy diversification means that your portfolio will have a quality representation of the market as a whole.
- Is a Great Educational Opportunity for Children. With this portfolio being designed for children, it provides an opportunity for you to teach your kids about the market. You don’t need $10,000 to get started either. Even small contributions as a percentage of allowance would be enough to provide a powerful and long-lasting lesson on what your children can do to build their wealth as they enter adulthood.
- Offers Stability Through Diversification. Although I wouldn’t advise my grandparents to use this portfolio strategy, it is relatively safe compared to portfolios that lack diversification. By spreading money across a wide range of investments, those that perform well will lighten the blow of those that experience losses.
Second Grader’s Starter Portfolio Cons
Although this portfolio strategy is exciting and promising, it does have some limitations, the most important being:
- Low Allocation to Fixed Income. Bonds and Treasury debt securities provide a level of safety that stocks — regardless of market cap or sector — can’t provide. This strategy only prescribes 10% allocation to these types of assets, which makes it far too risky for most investors.
- No Real Estate. Real estate investments have become incredibly popular, and data suggests that with population growth continuing and new home inventory slowing, opportunities in the space will be massive. Unfortunately, this portfolio strategy makes no mention of real property. Mixing in a real estate investment trust (REIT) might prove to be a wise decision if you’re going to invest using this strategy.
- No Small-Cap or Value Tilt. The best performing portfolios tilt assets toward the types of stocks that pay a risk premium. For example, investing in small companies is riskier than investing in large, established corporations, but historically small-cap stocks have outperformed their large-cap counterparts. Similarly, value stocks have a long history of outperforming growth stocks, which is why Warren Buffett loves them so much. This portfolio offers widespread market exposure, but doesn’t give any emphasis to factors that have the potential to increase the portfolio’s total return.
Who Should Use the Second Grader’s Starter Portfolio?
As its name suggests, the Second Grader’s Starter strategy isn’t for everyone, but it is a great option for a second grader or any other school-aged child with loved ones who want to give them a leg up in terms of financial education.
Although this is a high risk-portfolio due to its heavy allocation in equities and light allocation in fixed-income plays, financial experts often point to the fact that young investors should be more risk tolerant because they have plenty of time to recover if something goes wrong.
On the other hand, this isn’t a strong portfolio strategy for everyday investors.
Even a young investor who’s just out of college and starting a retirement portfolio would likely find only a 10% bond allocation to be a bit too risky for their taste, to say nothing of retirees who live on the wealth they’ve amassed throughout their careers.
All told, this is a strategy that’s best left to who it’s designed for: school-aged children.
How to Duplicate the Second Grader’s Starter Portfolio
If you’re looking for a way to teach your child about investing and want to take a simplified approach, this portfolio strategy is a clear win. However, you may want to make small tweaks to give your child the best chance of turning significant profits with their investing dollars.
Here are a few different ways you can go about building the portfolio:
The Traditional Second Grader’s Portfolio
Building the traditional Second Grader’s Portfolio is as simple as investing in a few low-cost Vanguard funds. Here’s how it’s done:
- 60% in Vanguard Total Stock Market Index Fund ETF (VTI). The portfolio calls for investment in a diversified fund that provides a strong representation of the total U.S. stock market. The VTI fund does just that by investing in companies across all sectors and market caps.
- 30% in Vanguard Total International Stock Index Fund ETF (VXUS). The VXUS fund provides the diversified exposure to the international stock market the portfolio calls for, investing in a wide range of sectors, market caps, and regions. As an ex-U.S. fund, all its investments are in countries outside of the United States.
- 10% in Vanguard Total Bond Market Index Fund ETF (BND). Finally, the portfolio strategy suggests a diversified fund consisting of U.S. bonds ranging in type and maturities. The BND fund does just that.
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The Small-Cap Value Adjustment
This portfolio strategy is based on broad investments in the U.S. and international stock markets with no real tilt toward assets that have the ability to increase your earnings potential. Nonetheless, in just a couple steps, you can adjust the portfolio to provide exposure to assets that will likely generate higher returns.
Start by cutting your holdings in the VTI fund from 60% of your portfolio’s value to 30%. The remaining 30% should be invested in a small-cap value ETF, one of the best being the Vanguard Small-Cap Value Index Fund ETF (VBR). The VBR fund invests in a diversified group of small companies that display strong value characteristics, which tend to be more volatile in the short term but have historically delivered premium returns over time.
The Real Estate Adjustment
Another issue some have with this portfolio is its lack of investments in real assets. The real estate industry is an important part of just about every economy, and it offers incredible opportunities for those willing to tap into it.
Mixing exposure to the sector into your portfolio is as simple as cutting exposure to the VTI fund from 60% to 30% and investing in a real asset-centric ETF. One of the best is the Vanguard Real Estate ETF (VNQ), which invests in a diversified portfolio of REITs centered around several different property types and markets.
The Safer Portfolio Adjustment
There’s one final issue most investors will have with the portfolio: the heavy allocation to equities. While this may be fitting for a second grader, it’s not a great fit for the average investor, making a lack of safety a major turn-off for most.
The good news is that it’s pretty easy to remedy this issue as well.
One way is to use your age as your level of bond allocation. For example, if you’re 30 years old, 30% of your assets should be invested in bonds and 70% in stocks. Therefore, 30% of your assets would be invested in the BND fund.
From there, two-thirds of your remaining investment dollars should be invested in the VTI fund and one-third invested in the VXUS fund. For a 30-year-old investor, that would mean 47% allocation to VTI and 23% allocation to VXUS.
Maintain Balance in Your Portfolio
Prices move from second to second in the market, with some asset prices moving faster than others. No matter how balanced your portfolio is when you set it up, that balance will disappear over time, with the more volatile assets coming to make up more or less than the portfolio’s prescribed allocation, depending on the current cycle of the market.
This creates a big problem.
When imbalance happens in your investment portfolio, your investments will either be overexposed to risk or underexposed to reward, neither of which is a good thing. As a result, regular rebalancing is a must.
Farrell didn’t expect second graders — or their custodians — to rebalance their portfolio every day or even every week. However, it’s important to take the time to check in and make sure everything is balanced at least once quarterly.
Although the strategy behind the Second Grader’s Starter Portfolio isn’t for the average investor, it is a great option for the audience it was designed for: young investors just learning the market.
The best part is that these prebuilt portfolios act like a recipe, which can be changed based on personal preference.
If you like the simplicity of this portfolio strategy but are concerned with risk or exposure to specific assets, consider making small adjustments to align the strategy with your needs. Of course, when doing so, it’s important to do your research and get a detailed understanding of just what you’re buying before you invest.