Index Investing: Asset Allocation

|| This article is Part Six in a series on investing with index mutual funds. ||
||   I. SpeculationII. Index FundsIII. John BogleIV. Vanguard   ||
||  V. Moving to VanguardVI. Asset AllocationVII. Maintenance  ||

At this point, hopefully I've convinced you that index mutual funds are a good idea, and maybe even that you should be investing in them at Vanguard.  But when your money hits that account, what, exactly, should you invest in?  This is the question of 'Asset Allocation', which this article will address.

Keep It Simple

In an earlier post in this series, I gave the completely unsupported recommendation to allocate "'your age in bonds' (i.e. 40% bonds for a 40-year-old) and the remainder split 3:1 between domestic and international stocks."  But why?  What are the considerations?

The first, often overlooked consideration is that your time is worth something.  Most of us have things we'd rather do than spend our free time poking and prodding the contents of our investment portfolios (and if you're one of the types that would, please, find a more productive use of your time!).  Index mutual funds already take most of the fruitless nit-picking out of the equation, and the strategies I outline below respect the value of your most precious asset: the time in your actual life.

The second consideration is broad diversification.  We want to spread the net as wide as possible to make sure we don't miss out on any of the growth that occurs across the capital markets.  Varying political, environmental, and cultural trends may cause the value of some investments to go up while others go down, and maintaining a good mix of assets will dampen the effect of a bad day in any particular industry or geographic region.  To accomplish this, we will invest in thousands of tiny slices of debt and equity that are reasonably representative of the entire investable world economy.

The third group of considerations are your investment goals, chief among them your risk tolerance, liquidity requirements, and time horizon.  Are you planning to draw on the proceeds of this investment in five years, or in fifty?  Over that time period, would you rather have a guaranteed +3% annualized rate of return, or a distribution of potential returns between -5% and +10%?  What is the probability that you will need to draw on this money before your planned time horizon, and how accessible should this money be in the meantime?  You can't get something for nothing, so your investment choices will inevitably amount to some degree of compromise on each of these goals.

The Importance of International Stocks

Most sources agree that international stocks should make up 25-30% of the stock (equity) portion of your investment portfolio.  International stocks tend to be a little bit twitchier than domestic stocks in the short term, but there is obviously tremendous room for growth in the world's still-developing countries.  Investments in so-called 'emerging markets', the least-developed contries, can be at more risk of a foreign country's government collapsing, wars erupting, or a poorly-managed currency situation going out of control.  These markets may also have poorer investment protection from insider trading, market manipulation, and other nasties.

Importantly, the international markets don't move (quite) in lockstep with the domestic markets; by holding some of both, this can help to reduce your overall portfolio's volatility:

Blue is domestic; red is international; orange is bonds.  Doesn't include reinvestment of dividends!

The Importance of Bonds

As you can see from the orange line on the graph above, bonds don't really do much in terms of capital appreciation—their value pretty much stays the same over time.  Then why the heck would you hold a bond index mutual fund, especially when inflation is eroding their value every year?

The answer is dividends.  Bond index funds collect the interest paid on the bonds and pay it out to the investors as lots and lots of dividends.  This is a steady stream of income for the investor, unlike the smaller dividends and wild market value gyrations of the stock market.  Even if a company goes completely out of business, bondholders have a claim to some of the money left over after the company is liquidated, whereas the stock usually becomes worthless.  It's therefore not surprising that bond funds typically have much lower volatility and much smaller rates of return than stock funds.

Holding bonds helps to significantly smooth out your portfolio's volatility, at the expense of rate of return.  Bonds are a good choice when reduced volatility is imperative, and an investor will typically shift their asset allocation to increase the percentage of bonds as their investment horizon draws nearer (see below).

The One-Stop Shop: Target Date Funds

Investment management companies know what they're doing, and they know that many potential investors value simplicity and a hands-off approach above all else.  It's for this reason that they've created Target Date mutual funds.  These funds are a premade mix of a domestic and international stocks and bonds, in which the asset allocation is automatically adjusted over time to make your portfolio more conservative and cut down on volatility as your target date approaches.

Vanguard's target date funds have an asset allocation evolution that looks like this:
In financial parlance, you'll hear this referred to as a 'glide path diagram'.  Whatever.
Simply choose the appropriate target date and you're good to go!  The minimum initial investment ($1000) and minimum subsequent investment ($100) are low, and the expense ratios (annual fee of 0.18%) are very reasonable.  There is absolutely no shame in choosing this option, especially if you're just starting out.

A Little More Control: The Three-Fund Portfolio

Vanguard also has a calculator that helps you convert your risk tolerance and investment horizon into an appropriate asset allocation.  If you'd like a little more control, you can buy the individual index funds that hold domestic and international stocks and bonds and adjust the allocation percentages to suite your needs.

For a three-fund portfolio, the relevant index mutual funds are:
  • Vanguard Total Stock Market Index Fund |VTSMX|
  • Vanguard Total International Stock Index Fund |VGTSX|
  • Vanguard Total Bond Market Index Fund |VBMFX|
These funds have minimums of $3,000 each, so it's more expensive to get started this way.  Instead, you might invest in a Target Date fund (minimum: $1,000) and move to a three-fund portfolio once you've accumulated some assets.  If this is still too steep and you're anxious to get started, read the article on Investing With $100.

As discussed in the previous article on switching to Vanguard, other companies offer decent index funds as well.  Make a copy of my Funds and Brokerages Spreadsheet to quickly sort through the offerings of Vanguard, Fidelity, and Schwab.

Adding Additional Flavors

"But wait, you forgot international bonds!"  Yes I did!  Among many, many other things.

This is where you get creative!

Vanguard and other fund management companies recently added international bonds as a recommendation for all investors, and I believe this is a sound decision.  Other investors have pointed out that, historically, smaller companies ('small caps') have tended to be more volatile in the short-term but have experienced faster overall growth and provided higher returns in the long run, while others have cited evidence that suggests investing in out-of-style, down-on-their-luck 'value companies' also pays off.  Some investors obsess over companies that pay out corporate profits as fat dividends to shareholders.  A mania over Real Estate Investment Trusts (REITs), a financial object that essentially allows Average Joe Investor to invest directly in productive commercial, residential, and industrial real estate, has recently erupted.  Maybe you're in this thing for the long haul and you have a good feeling about those currently-small companies in the developing world.

Do you believe them?  Do you want to add additional small cap, value, or emerging markets 'tilt' to your portfolio?  The evidence is far from conclusive, so do your homework and come to your own conclusions!  Make a copy of my Funds and Brokerages Spreadsheet and start digging.

In no particular order, some possibilities:
  • Vanguard Total International Bond Index Fund |VTIBX|
  • Vanguard REIT Index Fund |VGSIX|
  • Vanguard Small Cap Index Fund |NAESX|
  • Vanguard Emerging Markets Stock Index Fund |VEIEX|
  • Vanguard All-World (ex-US) Small Cap Index Fund |VFSVX|
  • Vanguard Mid Cap Value Index Fund |VMVIX|
  • Vanguard Small Cap Value Index Fund |VISVX|
You get the idea.  Various investors have recommended five, six, seven-fund portfolios and more.

Maybe your additional meddling will result in higher returns... or maybe it won't.  If you enjoy this kind of game, dig in and have fun; if it just stresses you out, stick to something as simple as you like.

Either way, do yourself a favor and keep the crazy stuff to less than 5-10% of your total portfolio.

What of Multiple Accounts?

What should you do if you are contributing to your own Roth IRA, a 401(k) through your employer, and a regular old taxable brokerage account on the side?  Does it matter which assets you hold in each of these 'investment buckets'?

I'm glad you asked!  It does, primarily because some of these (IRA, 401(k)) are tax-advantaged, and others (regular old brokerage account) are not.  Tax-efficient asset placement is the game of positioning the different kinds of funds in your available 'buckets' (account types) to minimize the taxes you pay, and the strategy behind this deserves its own article.  Taxes can be complicated: do your homework or consult a professional.

If you only have one account type, or if all of your account types are tax-advantaged (for instance, you only invest in a Roth IRA and a 401(k)), you don't have to worry about this yet.

Whew!  Index investing is pretty much the simplest kind of investing out there, and yet there's still quite a few things to keep track of.  Worry not!  If you've read through the entire series, you know pretty much everything you need to start putting your money to work right away.  As always, hit the contact page or shoot me an email if you run into a question Google can't seem to answer.