Best Index Investment Strategy?

[Adbuster]

Glad I found this forum. Great discussion and advice. Thanks

Here is my first question:

I'm thinking of foregoing active account management and just putting my investments in a portfolio of index funds

Just sold off lots of assets (LVS, DODFX, JAOSX and FLVCX all which have had nice rides) and I'd like to create a strategy with a bit more balance for the long term and one that I can easily fund each month without having to constantly re-tweak the allocation.

Any suggestions for a successful passive indexing portfolio for a $100k chunk and $5k monthly investment?

Should I go with index mutual funds or exchange-traded funds?

I'm 32, OK with some risk, in it for the long term. What percentage of international exposure makes the most sense? Any sound international recommendations?

Thanks!

[jively]

Congratulations on taking the passive approach. You should have a very good long-term investing experience without having to make any forecasts or rely on the forecasts of others.

I am a financial advisor, and recommend passive investments for my clients. I am going to respond to this in a few posts, and perhaps if it is judged good enough could be added to the FAQ, like my 401(k) responses.

The most important decision is how aggressive or conservative you'd like the portfolio to be. You are young and OK with some risk, but you don't sound like you want an extremely aggressive portfolio. The more aggressive portfolios should have a higher average return, but more frequent losing years and larger losing years. The best portfolio is one that you can live with during the bad times - where you can sleep at night and won't tweak/change your allocation.

Take a look at these 6 portfolios, especially the losses, to see how aggressive you want to be (I apologize for the lack of columns that line up):

POTENTIAL ODDS OF WORST WORST
AVERAGE LOSING MONEY YEAR OF YEAR OF
RETURN IN ANY ONE YEAR 80 YEARS 35 YEARS

Portfolio A 11.0% 1 in 3 -47% -25%
Portfolio B 10.5% 1 in 4 -42% -22%
Portfolio C 9.8% 1 in 5 -38% -19%
Portfolio D 8.5% 1 in 6 -29% -13%
Portfolio E 7.5% 1 in 7 -23% -9%
Portfolio F 6.3% 1 in 8 -16% -4%

Column 1 is the portfolio name: Portfolio A is the most aggressive (with the most amount of stocks), and Portfolio F is the most conservative (with the least amount of stocks, and highest amount of fixed income). Column 2 is the expected return for the portfolio after investment expenses.

Columns 3, 4 and 5 have to do with the risk. How frequently does this portfolio have a losing year? Portfolio A loses about 1 out of every 3 years, but Portfolio F only loses about 1 out of every 8 years.

Column 4 is what a really bad year could look like, and it is the worst year in the last 80 years (which includes the crash of '29 and the Great Depression). Portfolio A lost 47% in a year. Portfolio F, with a lot of fixed income, still lost 16% in one year (when interest rates shot up in a big hurry).

Column 5 is what a typical bad year looks like, and it is the worst year of the last 35 years. Portfolio A lost 25%, and Portfolio F lost 4%.

So, concentrating on the loss columns, what kind of losses would you feel comfortable with? Risk and reward go together, and to get a higher return, you have to be willing to accept periodic losses.

When you have an idea of what kind of losses you'd be able to handle, then you can convert the portfolios to target allocations:

Portfolio A: 100% stock
Portfolio B: 90% stock, 10% fixed income
Portfolio C: 80% stock, 20% fixed income
Portfolio D: 60% stock, 40% fixed income
Portfolio E: 45% stock, 55% fixed income
Portfolio F: 30% stock, 70% fixed income

Note: These are all globally diversified portfolio of index mutual funds.

I think for someone 32 who can handle some risk, perhaps portfolio C would be best for you, 80% stock, 20% fixed. You certainly would not want E or F. You might go halfway between C & D, with 70% stock and 30% fixed.

I will continue with the allocation and specific investments in the next post.

-Tom

[jively]

I generally use the same allocation for all clients. The stock allocation is divided into these asset classes:

20% US large cap
20% US large cap value
10% US small cap
10% US small cap value
10% US real estate stocks
20% International stocks
10% Emerging markets stocks

The fixed income portfolio is generally divided as:

50% short-term bonds (high quality)
50% intermediate-term bonds (high quality)

So, someone that chose portfolio C, 80% stock, 20% fixed would have this allocation:

16% US large cap
16% US large cap value
8% US small cap
8% US small cap value
8% US real estate stocks
16% International stocks
8% Emerging markets stocks
10% short-term bonds (high quality)
10% intermediate-term bonds (high quality)

This is based on academic research that show that small stocks and value stocks have higher returns than large stocks and growth stocks, over long investing periods. Taking risk with the fixed income is not properly rewarded. The purpose of the fixed income is solely to reduce the risk in the entire portfolio.

For value funds, the deepest value (if diversified) is the best. For small cap funds, the smallest cap (if diversified) is the best.

For the allocation to International, if there are choices for intl small or intl value, I would definitely use those; break up the 20% intl maybe as 10% intl, 5% intl value, 5% intl small. If available, Emerging markets can also be tilted to small and value.

So, in terms of the "international" question, I like having 30% exposure to international and 70% to the US. Anything in the ballpark will be fine; if you want a little more or less exposure it shouldn't make that much difference.

You can have a successful investing experience with open-ended mutual funds or with ETFs. Since you are starting with $100K and because you are adding $5K per month, I'd suggest using open-end funds held directly with Vanguard. You get low expense ratios, no transaction fees, and no minimum balance fees.

I will get to the specific investments in the next post.

-Tom

[jively]

If you are going with portfolio C, 80% stock, you might consider:

16% Vanguard Total Stock Mkt Idx Inv
16% Vanguard Value Index Fund Inv
8% Vanguard Small-Cap Index Fund Inv
8% Vanguard Small-Cap Value Index
8% Vanguard REIT Index Fund Inv
8% Vanguard European Stock Index Inv
8% Vanguard Pacific Stock Index Inv
8% Vanguard Emerging Mkts Stk Idx Inv
10% Vanguard Short-Term Bond Index Inv
10% Vanguard Inter-Term Bond Index Inv

The Total Stock market fund is mostly large cap, is more tax efficient that the other large cap funds, and the extra exposure to small does not hurt you.

If you are in a high tax bracket, you might consider a municipal bond fund instead of these taxable fund, although it should still be short or intermediate term.

Since you are starting with $100K, each of the purchases will be over Vanguard's $3,000 minimum. (For people starting with less money, you could start a similar but simpler allocation with fewer funds, and use the full allocation when your portfolio is large enough.)

Since you are in this for the long term, you could buy your initial allocation in one lump sum. The market may move up or down over the next 1, 3, 12 months. Since I advocate not making forecasts, I won't consider any forecasts. However, if you think you might feel "stupid" if you buy the whole lump sum, and the market moves down over the next few months, you could buy your initial allocation over some period of time, using an unemotional dollar-cost averaging. Maybe buy 1/3 today, buy the next 1/3 in 2 months, and the last 1/3 in 4 months. That's really up to you.

I'll talk about the $5K monthly and rebalancing in the final post.

-Tom

[jively]

Since you are able to invest $5K more each month, you are in a great position where you can keep your portfolio allocated without having to sell funds and generate capital gains.

When it is time to invest your new $5K contribution, you should take a look at what % each of your funds is in your total portfolio. The funds that have done the best will be "overweighted." For example, if emerging markets are doing particularly well, instead of 8% of your portfolio, it might now be 10%. The funds that have done the worst (by declining or by increasing the smallest amount) will be "underweighted." For example, if large cap value stocks are doing poorly, instead of 16% of your portfolio, it might be 14%.

When you are ready to invest more, you should add to the funds that are the most underweighted. By doing this, you will more the portfolio closer to the original target allocation.

Keeping the allocation the same, over a long term horizon, makes sure that your portfolio aggressiveness is the same as what you originally intended. It also allows you to "buy low" as you buy more of the asset classes that are performing poorly.

After some time, your portfolio may be significantly out of balance. For example, if stocks go up a lot over a few years, instead of an 80% stock portfolio, you may now have 90% stocks and only 10% in fixed income. Even though you are adding $5,000 per month to fixed income funds, you can't bring the allocation back to the target. In this case, you should consider a "rebalance," and actually sell some of the overweighted funds. You definitely want to wait at least one year and one day so that any sales are considered long-term capital gains.

Just as before, see which funds are overweighted and which are underweighted. You then want to exchange shares from the overweighed funds into the underweighted ones so that it is back to the original allocation. You might to move your fund balances to a spreadsheet to help with the calculation.

By making a rebalance, you are able to "sell high" and "buy low." You generally will not need to do this very freqently, maybe once every year or two. By doing this infrequently, your low-turnover portfolio will have only a small amount of capital gains.

There you have it. You can have a low-cost portfolio of index mutual funds that are globally diversified, and tilted to small and value stocks. This portfolio should do very well over a long period of time, with low turnover.

-Tom

[edtost]

great posts, this should definitely be linked from the FAQ.

[hlacheen]

If we do this in an IRA we don't have to worry about long term vs short term gains, or any other tax matter, correct?

[wdcbooks]

Excellent post. The only quibbles would be around the margins of the allocation, or whether there shoulld be other asset classes represented. The quality of this advice is far higher than usual message board quality and provides a simple easy to follow recipe for the great majority of people.

Good work. Link this.

[Adbuster]

Tom,

Thanks for all the great information and level of detail. This is very, very helpful.

Can you elaborate a bit on what you mean when you say "you might consider a municipal bond fund instead of these taxable fund, although it should still be short or intermediate term." I'm in a high tax bracket, combined with my wife's income, and I have absolutely no idea how that should, if at all, alter our strategy today.

Also, when you mention "tax efficient," in relation to the Total Stock market fund, what does that mean? How can I judge the "efficiency" of a fund and is it an important consideration for an investor in my shoes?

Also when you say "you definitely want to wait at least one year and one day so that any sales are considered long-term capital gains," pardon my ignorance but, does this mean that tax rates are different on a sale of a fund or stock held a month versus one held for over a year? If so, how different?



Regarding forecasting, although your against it I have to ask if it is a bad idea to touch REIT's right now.

Again, great, great information. Thanks.

[edtost]

[ QUOTE ]
Can you elaborate a bit on what you mean when you say "you might consider a municipal bond fund instead of these taxable fund, although it should still be short or intermediate term." I'm in a high tax bracket, combined with my wife's income, and I have absolutely no idea how that should, if at all, alter our strategy today.

[/ QUOTE ]

muni coupons can be triple-tax-free, which is a huge boost to returns if you live in a locality with high state and/or city taxes.

i think this might be moot if you are in the amt, but if you have enough investments for this to be a big issue, you should be asking a tax attorney or a real financial adviser or something.