One of the problems that people have when it comes to investing is the belief that they know more than they actually know. This self-confidence isn't bad, per se, but when it comes to investing, it can lead them astray. This is why Warren Buffett, the CEO of Berkshire Hathaway, recommends most investors stick to investing in index funds.
It's sound advice, and even income investors can make this work for them with as little as two exchange-traded funds (ETFs). Here's an income-focused ETF plan you can follow with minimal effort.
What is Warren Buffett's advice?
Warren Buffett is famous for the massive outperformance of Berkshire Hathaway relative to the broader market. Although Buffett would tell you he lacks any valuable skills, he's talking about things like painting and athletics. Clearly, he is a very skilled investor. Wall Street hangs on his every word because of his obvious skill and because such skill is so unique.
Image source: Getty Images.
I am not a Warren-Buffett-level investor, and it is highly likely that you aren't either. That's OK, you don't need to be. You can still create material wealth over your life by investing. The key, as Warren Buffett has said, could be as simple as buying an index mutual fund or ETF. He often talks about the S&P 500 as the index to focus on finding a comparable fund. But that may not suit your investment goals. There are plenty of other options.
For example, I'm an income investor. The stocks in the S&P 500 index average only a 1.2% dividend yield today. That won't generate enough income to supplement Social Security in retirement. There are plenty of alternatives, but these two Charles Schwab ETFs are a great place to start.
Just two ETFs and two trades a year get the job done
The ETFs in question are Schwab U.S. Dividend Equity ETF (SCHD 1.23%) and Schwab U.S. Treasury Short Term ETF (SCHO 0.04%). Their expense ratios are ultra-low at 0.06% and 0.03%, respectively.
Using these two ETFs, you can structure a simple and effective balanced portfolio. You will have to pick what breakdown between stocks and bonds makes the most sense for you, with the best starting point for most probably being the 60% stock and 40% bond model that is so prevalent in Wall Street history. More aggressive investors might go up to 80% stocks, while more conservative investors might go down to 40% stocks (perhaps even 20% if you are an older investor).
It will require just two trades to set up the portfolio. Once a year you should bring the portfolio back in line with your target allocation, which will require two trades. That's all you need. If you are saving money throughout the year, you can add it as you save or simply leave it in cash to earn interest until your yearly rebalancing effort. If that's what you do, you might want to shift your weighting a few percentage points toward stocks since cash is more like a bond than a stock. Reinvest the dividends if you are still in the asset accumulation phase of your life and don't need the income.
Why these two ETFs?
Taking the easy fund first, Schwab U.S. Treasury Short Term ETF tracks the performance of Treasury bonds with maturities of one to three years. This ETF will provide income backed by the interest paid on those bonds, and because the bonds are near maturity, they won't be as impacted by interest rate changes as much as longer-maturity bonds would be. In this simple portfolio, bonds are meant to help reduce the volatility posed by owning stocks. Also important is that the bonds in question are backed by the U.S. government, so they are among the highest-quality bonds you can buy. The yield on Schwab U.S. Treasury Short Term ETF is 4.2%.
Data by YCharts.
Schwab U.S. Dividend Equity ETF is a bit more complex. It starts with a universe of companies (removing real estate investment trusts from the mix) that have increased their dividend for at least 10 years. Then, it creates a composite score that looks at cash flow to total debt, return on equity, dividend yield, and a company's five-year dividend growth rate. The 100 companies with the highest scores get into the index, weighted by market cap.
Data by YCharts.
Without getting into the nitty gritty, Schwab U.S. Dividend Equity ETF is trying to buy good companies that pay reliable dividends. That's probably what you would try to do, too, if you picked individual dividend stocks. The yield is about 3.5%.
Could you find ETFs that would provide more income? Yes. However, these two have solid track records and provide a good balance of risk and reward. What could you expect in income here? A $1 million portfolio split 60/40 would produce around $38,000 in dividends per year to supplement your Social Security check.
This is just a model; you can fine-tune it
Some dividend investors might feel that this portfolio doesn't generate enough income. That's fine; buy the stock and bond ETFs that work best for you. I selected Schwab U.S. Dividend Equity ETF and Schwab U.S. Treasury Short Term ETF because they are designed to be lower-risk investments. The trade-off is lower yields. However, both still offer generous income streams, and they will allow you to sleep well at night. And just two trades a year is all you need to keep the portfolio working as expected.
