Easing into Upgrading

You can launch a fully-diversified Upgrading portfolio with as little as $10,000. There are two ways to Upgrade in smaller accounts. We'll look at both briefly, beginning with the easiest.

• Invest in the Sound Mind Investing fund (ticker: SMIFX). For those with less than $10,000 (or any size account for those who simply don't want to handle the Upgrade task themselves), SMIFX is the easy alternative. The minimum initial investment is only $2,500 and the fund managers do the Upgrading for you.
• Invest through a discount brokerage account. We recommend Scottrade, Fidelity, and Schwab. Let's walk though an example of how this might be done using the lineup of recommended funds from our August 2011 issue.

*(The funds shown in the table were the #1 recommendations in each risk category as of SMI's August 2011 issue. Naturally these funds will change over time and are used here for illustration purposes only.)

We'll assume you have an IRA account at Scottrade with $10,000 available to launch your Upgrading portfolio. Follow along in Table 1 as we explain how you would proceed.

1. Ideally we want to diversify among all the stock risk categories, and invest in the highest-ranked fund that's available at Scottrade. In this case, all five are available and open to new investors. They're shown in column 3 in the table.
2. Note that we are not including any bond funds. We omit them on the assumption that most people launching a portfolio with only $10,000 are fairly young and therefore have quite a long time frame in which to invest. That means they can afford the higher-risk, higher-reward profile of an all-stock portfolio.
3. We initially divide our $10,000 equally among the five funds (column 4). This is a slight deviation from SMI's annual allocation suggestions (see Table 2 on the "Easy as 1-2-3" page in any issue of the newsletter), but is a reasonable tradeoff for the simplicity it offers to beginners.
4. Next we compare our initial dollar allocations with the minimum purchase requirements for each fund as required by Scottrade (column 5) . (The minimums can vary from broker to broker and change from time to time.) If the amount we have allocated for a fund is higher than the minimum required, that's good — we've got a "cushion" (column 6).
5. If the initial allocation is less than the required minimum, then we will need to increase our initial allocation in order to invest in that fund. To do this, we will "borrow" from one of the funds that has a cushion.
6. In Table 1, you can see that the initial allocation of $2,000 for Kirr Marbach Partners is $500 below the required minimum. We will need to look to one of the funds that has a cushion and reduce that fund's allocation so we can increase that of the Kirr Marbach fund.
7. The recommended way to decide which fund to "borrow" from is to find a fund with a similar volatility profile (column 2). Generally speaking, stock funds in the two risk categories that invest in larger companies are 5%-10% more volatile than the overall market. Moving $500 from the Touchstone Sands allocation to the Kirr Marbach fund (column 7) moves money from one large company category to another with similar volatility. This helps maintain the balance in the portfolio.
8. The final allocations for investing $10,000 in the five funds (the amounts shown in column 8) are equal to or greater than each fund's minimum shown in column 5.

Occasionally the minimums of the five selected funds may, in combination, exceed the amount available to invest. Look at Table 2. It's the same lineup of funds at the same broker, but this time we're investing in a regular taxable account (rather than an IRA). Such accounts often require higher minimums. To invest in all five funds at the higher minimums would require $11,500, so obviously something has to give. You have two options.

First, you could look at the funds ranked second in each risk category and see if one of them has a sufficiently lower minimum. If so, you could invest in that fund rather than the highest-ranked fund as is usually recommended.

Or second, you could decide to omit one of the risk categories altogether. In the Table 2 example, one of the higher-risk small-company funds is omitted, freeing up $2,000 to invest in other funds. (This choice was arbitrary — if you're feeling okay with more risk, you could instead omit one of the lower volatility large-company categories.) The $2,000 was distributed, first of all, to the three funds that needed $500 each to meet the $2,500 minimums. Finally, since one of the small-company categories was short-changed, the remaining $500 was devoted to the other small-company category to build it up a little. This helps maintain as much portfolio balance as possible under the circumstances.

You now have your new Upgrading portfolio in place. Going forward, you would rely on the monthly "Recommended Funds" report to alert you when one of your funds needs to be replaced.

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a Realtor® in the area.