In earlier steps, you should have defined top level asset classes that have a lack of correlation to one another and a timeless strategy. Then, you should have selected underlying sectors that strategically boost returns and take advantage of leading indicators. Lastly, you determined a system to categorize future holdings to implement your investment strategy.

The next step is to select specific securities you will purchase to implement this strategy. We call this list of securities our “Buy List,” because it is what we would ideally purchase if a client came to us all in cash. We regularly review our Buy List as we are always looking for even better securities to implement our investment strategy. We use three criteria to judge securities.

First, the investment should be diversified within its sector.

Diversification is the means of achieving a rebalancing bonus, a boost in returns and decrease in volatility due to moving between low correlation stocks. This bonus is highest when the correlation is lowest, but even correlated assets which often move in sync over the long run experience different volatility and returns over any given year.

For this reason, your Buy List investment selections should be as diversified as possible within the targeted sector.

Such diversification is not easily achieved with individual company stocks. To use U.S. large cap stocks as an example, you would need over 60 individual stocks to achieve only 86% of the diversification . Diversification via individual stocks is even more difficult for small and mid-cap stocks and impossible to accomplish for foreign stock categories using US stock exchanges.

For this reason, your buy list should be funds — exchange traded funds (ETFs) or mutual funds — rather than individual securities.

There are two methods of seeing how well diversified a fund is within its category.

First, favor funds with a large number of holdings. There is no such thing as “over-diversification.” A fund with 200 small cap value stocks is better diversified than one with only 75.

Second, favor funds where the top ten holdings represent a smaller percentage of the fund. A small cap value fund whose top ten holdings represent 75% of the fund is less diversified than one where the top ten holdings only represents 25% of the fund.

Second, the expense ratio should be low.

The most important selection criterion is expense ratio. Morningstar did a study to see what was a better indicator of a fund having better returns in the future: having a low expense ratio or having more Morningstar stars. They determined that having a low expense ratio was a better indicator than Morningstar stars .

Low expense ratios help you earn more when markets go up and lose less when they go down. Over time, this can significantly affect the value of your portfolio.

The return of an index fund is simply the return of the index plus or minus tracking error minus fund expenses. This is why having a low expense ratio gives you the best chance of having higher returns.

Currently the average asset weighted expense ratio for a stock mutual fund is 0.74%. This cost has been dropping over the past decade as funds have to lower costs in order to compete for market share.

In most cases, a good investment advisor can significantly reduce the cost of the funds used to diversify your portfolio. We regularly build portfolios with low expense ratios, and many of the revisions we make to our Buy List are moving towards lower cost funds. Our online gone-fishing portfolio has an expense ratio of just 0.32%.

Finally, we look for low trading costs.

Trading costs, like expense ratios, can hurt returns. While expense ratios hurt fund returns, trading costs hurt the rebalancing bonus by putting a drag on moving in and out of investments.

Trading costs are tied to your custodian. For this reason, selection of your custodian is extremely important to your investment philosophy.

At Schwab, there are four different types of investments, each with their own type of trading cost.

Most stock and ETF trades are made at Schwab’s $8.95 per trade brokerage fee. There are some ETFs on the Schwab platform for which they wave the brokerage fee and allow you to trade them for no cost. This can be deceptive. Some of the no-transaction fee ETFs are Schwab funds with higher expense ratios or larger trading spreads either of which could be more costly than a trading fee.

For mutual funds, there is a fee between $25 and $50 depending on how much is being traded and how you have negotiated fees for your clients.

Although you should hunt for low trading costs, you should also change your purchasing habits based upon the cost.

First, because of compound interest, larger amounts of money can overcome a small trading cost faster than smaller amounts of money. So, if you have a trading cost, assess the how long different initial investments takes to earn back the fee. We do this by measuring the trading cost as a percentage of the purchase amount. If you are purchasing $30,000 of an investment, a $30 trading fee is only 0.1%, which could be earned back in a week. However, if you are only investing $600 in the same investment, the same trading fee would be 5% of your investment, which may take 1 year to earn back.

Second, we use a simple technique we call “Rocks and Sand” to keep total expenses low without losing the flexibility of diversifying and rebalancing.

Rocks are higher trading cost but lower expense ratio investments. They have a fee when you purchase them as well as a fee when you break them apart but they are cheaper to hold once you have purchased them because of their lower expense ratio.

Meanwhile, sand has a lower trading cost but a higher expense ratio. Sand is easy to move from one investment to another but is not ideal for long-term holding.

Our transaction fee ETFs or mutual funds are Rocks while no-transaction-fee funds are Sand. We fill each asset class with Rocks. Then when smaller monthly deposits come in, we fill in the asset class with Sand around the Rocks. When a significant amount of Sand collects in an asset class, we sell the sand to purchase a Rock in its place.

In this manner, you can identify ideal securities for your Buy List as well as trade them efficiently.

Although it is not easily appraised, we believe a curated list of funds is extremely valuable. Our investment committee meets regularly to reevaluate and adjust our Buy List.

Even if all you use to select funds is expense ratio, the value might be as high as 0.42%. We can only imagine the value of fund selection also based on strategic fit, diversification, index followed, and trading costs.

Your investment strategy is critically important but the implementation requires wise fund selection.

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