Introduction

As I explained in Market Risk, the central challenge to long-term investing is not how to increase returns. Instead, it is how to manage risk. The solution is to use an asset allocation to construct a diversified portfolio tailored to your particular investment goals, risk tolerance, and time horizon. Asset allocation is your personal investment policy that determines what percentage of your savings are allocated to specific asset classes.

After costs, over 100 percent of your portfolio returns are determined by your asset allocation policy. Roger Ibbotson breaks it down:

Asset allocation policy gives us the passive return (beta return), and the remainder of the return is the active return (alpha or excess return). The alpha sums to zero across all portfolios (before costs) because on average, managers do not beat the market. In aggregate, the gross active return is zero. Therefore, on average, the passive asset allocation policy determines 100 percent of the return before costs and somewhat more than 100 percent of the return after costs.1

Diversification

Diversification is the practice of investing across capital markets. That requires that you invest in multiple asset classes simultaneously so that your financial exposure to a particular asset class’ downside risk is limited. Just like you shouldn’t concentrate all your investments in a single stock, you shouldn’t invest in a single asset class. Diversification will give you a higher return for a given risk level or a lower risk level for a given return. However, diversification will neither guarantee you a profit nor prevent you from suffering a financial loss.

Don’t obsess about the perfect asset allocation. Looking back after 20-40 years, it will be possible to identify a particular asset allocation (and funds representing each asset class) that outperformed all others.2 Since you cannot predict the future, you should instead select an asset allocation that you understand best and can stick with in good and bad times.3

Your investment strategy must reflect your time horizon, your individual financial situation, your non-financial assets, and your risk tolerance. Do you have the “ability, willingness, and need” to take on risk?4 If you are too conservative at a young age, then you lose much of the benefit of compounding You also run the risk of your investments failing to keep up with inflation. If you are too aggressive when you are older, then you run the risk of your investments suffering a significant loss in value; and you may not have enough time left to recover from that loss.

The models below represent starting points for your retirement journey, not fixed destinations. Every strategy is personal. Your asset allocation will likely change about every ten years. Any changes that you make to your asset allocation should always be in response to stages of your life, not current market conditions.

An Equity Bias

Equity asset returns will exceed fixed income returns over time. Therefore, you should have an equity bias to your asset allocation until you retire. In your asset accumulating years, domestic equities, foreign equities and real estate should receive a higher allocation than domestic bonds and inflation-indexed bonds.

Further, your portfolio’s fixed income allocation may be reduced5 by the following:

• The amount of capital that you have to meet your long term expenses
• Your home equity67
• Your potential income from life insurance

Ultimately, the percentage of your portfolio allocated to equity versus fixed income will make the biggest difference in your long term total risk/return.

Where to Begin

Since most individuals don’t hold a diversified portfolio, I recommend starting with a simple two or three fund portfolio. I also provide an overview of David Swenson’s model portfolio with six asset classes.

As you consider more advanced portfolios, ask yourself these questions:8

Is it easy for you to understand?
Is it diversified?
Is it low-cost?
Is it tax-efficient including minimizing asset turnover?
Is it easy for you to maintain, including annual rebalancing?

Ideally, you should pursue the following asset allocation based on the years left until you retire:

8 years or greater	an equity oriented, diversified asset allocation.
2 to 8 years	combine long-term and short-term investments, progressively selling risky assets and buying riskless assets
less than 2 years	cash and cash equivalents

Two Fund Portfolio

Malkiel and Ellis recommend a portfolio with two asset classes as a starting point:

1. Either a U.S. total stock index fund —or– a world total stock index fund, and
2. A U.S. total bond index fund

U.S. Total Stock Index Fund

Many observers assume that the S&P 500 is the same thing as a U.S. total stock market index fund. However, an index fund that mirrors the S&P 500 reflects only 85% of the market value of all U.S. stocks.

However, the broadest possible U.S. stock index is the ideal metric for assessing the aggregate value of the U.S. companies. A U.S. total stock index fund based on the Russell 3000 or the Wilshire 5000 gives you exposure to smaller, higher growth companies as well as those companies in the S&P 500. The Russell 3000 index tracks the 3,000 largest U.S.-traded stocks, which represent approximately 98% of all U.S equity securities. The Wilshire 5000 index tracks 3582 components.9 They necessarily include real estate companies and commodity producers. The Russell 3000 and Wilshire 5000 best represent the aggregate value of U.S. stocks.

All of these indices are cap-weighted, meaning that they automatically adjust to changing company market capitalizations.

World Total Stock Market Index Fund

A world total stock market index fund provides even broader exposure because the U.S. only makes up about a third of the world’s total market capitalization. However, even a U.S. total stock index fund provides global exposure due to the reach of U.S. multinational corporations.

Vanguard and Fidelity are the two largest passive managers in the financial industry, offering very low cost index mutual funds and ETFs. Vanguard and Fidelity’s index funds are comparable but not identical because they track different indices. Thus, their total returns, equity sector diversification, and expense ratios will differ slightly. For a more comprehensive comparison of specific funds, I recommend using Vanguard’s comparison tool here.10 Both Vanguard and Fidelity offer a $10,000 minimum investment tier (Admiral and Premium) and a higher expense but lower minimum investment tier (Investor). Fidelity also offers free online trades for many iShares ETFs, so that’s a cost effective alternative if you prefer an ETF versus a mutual fund.

If you wish to use another financial institution’s index fund or ETF, then be mindful of both poorly constructed indices and excessive fees. Just because you purchase an index fund, doesn’t mean that it is necessarily a low cost fund. Of course, it should be!

The respective Vanguard, Fidelity, and iShares funds and their expense ratios are:11

	Vanguard Fund	Fidelity Fund	iShares ETF
Total U.S. Stock Index Fund	Vanguard Total Stock Market Index Fund (VTSAX) (0.04%)12	Fidelity Total Market Index Fund (FSTVX) (0.035%)13	iShares Core S&P Total U.S. Stock Market (ITOT) (0.04%)
Total World Stock Index Fund	Vanguard Total World Stock Index (VTWSX) (0.19%) 14	N/A	N/A
Total U.S. Bond Index Fund	Vanguard Total Bond Market Index Fund (VBTLX) (0.05%)15	Fidelity U.S. Bond Index Fund (FSITX) (0.045%)16	iShares Core Total U.S. Bond Market (AGG) (0.04%)

Next, you determine the ratio of the stock fund versus bond fund in your portfolio based on your age (investing timeline):

Age Group	Percent in Stocks	Percent in Bonds
20-30s	100%	>0%
40s	90% to 100%	10% to 0%
50s	75% to 85%	25% to 15%
60s	70% to 80%	30% to 20%
70s	40% to 60%	60% to 40%
80s and beyond	30% to 50%	70% to 50%

In the past, some suggested that you allocate your “age in bonds” (or, alternatively, 100 minus your age in equities). This is a very conservative approach that will result in significantly lower returns. I prefer Charles Ellis’ recommendations, in the table above.

For each age group, you will see a wide band (10-20%). This corresponds to your risk tolerance. More risk tolerant investors will select a higher percentage of their portfolio for stocks, within that band.

From 2009-2018, a two fund portfolio using Vanguard funds including the total U.S. stock fund had the following returns and risk. 2009 was selected because it is the earliest availability of VTWSX, permitting you to compare total U.S. versus total world index funds. However, you should note that it also coincides with a long boom in the U.S. stock market. Such are the limitations of available data.

Equity/Bonds	CAGR	Inflation-Adjusted CAGR	Risk
60/40	10.43%	8.42%	8.16%
70/30	11.56%	9.53%	9.52%
80/20	12.68%	10.63%	10.91%

From 2009-2018, a two fund portfolio, including the total world stock fund instead, produced significantly lower returns with more risk:

Equity/Bonds	CAGR	Inflation-Adjusted CAGR	Risk
60/40	8.38%	6.41%	8.94%
70/30	9.16%	7.17%	10.41%
80/20	9.92%	7.91%	11.91%

Three Fund Portfolio

If you prefer to control how much exposure you have to foreign equities, then you can substitute a total U.S. stock index and a total international (non-U.S.) stock index fund for the total world stock index fund:

1. a U.S. total stock index fund,
2. a foreign total stock index fund, and
3. a U.S. total bond market index fund

The respective Vanguard, Fidelity, and iShares funds and their expense ratios are:17

	Vanguard Fund	Fidelity Fund	iShares ETF
Total U.S. Stock Index Fund	Vanguard Total Stock Market Index Fund (VTSAX) (0.04%)18	Fidelity Total Market Index Fund (FSTVX) (0.035%19	iShares Core S&P Total U.S. Stock Market (ITOT) (0.04%)
Total International Stock Index Fund	Vanguard Total International Stock Index Fund (VTIAX) (0.11%)20	Fidelity Total International Index Fund (FTIPX) (0.10%)21	iShares Core MSCI Total International Stock (IXUS) (0.04%)
Total U.S. Bond Index Fund	Vanguard Total Bond Market Index Fund (VBTLX) (0.05%)22	Fidelity U.S. Bond Index Fund (FSITX) (0.045%)23	iShares Core Total U.S. Bond Market (AGG) (0.04%)

As with the two fund portfolio, you first need to determine the amount of overall stocks versus bonds in your portfolio. Next, you must determine what percentage of that equity will be allocated to domestic versus international. Vanguard’s targeted retirement funds currently allocate 40% of equity to international equities. So, we will use that in our model below.

For comparison with two fund portfolios above, from 2009-2018, a three fund portfolio had the following returns and risk:

Equity/Bonds	CAGR	Inflation-Adjusted CAGR	Risk
60/40	8.92%	6.94%	8.68%
70/30	9.81%	7.81%	10.11%
80/20	10.68%	8.67%	11.57%

Using the earliest available data, from 1997-2018, a three fund portfolio had the following returns and risk:

Equity/Bonds	CAGR	Inflation-Adjusted CAGR	Risk
60/40	6.75%	4.51%	9.14%
70/30	6.83%	4.68%	10.67%
80/20	7.07%	4.82%	12.23%

Notably, this table captures both the dotcom tech bubble as well as the 2008 real estate crises. So, compounded annual returns are lower and risk is higher. To get even those returns, you must have had the emotional detachment:

1. to annually rebalance,
2. to not deviate from your asset allocation when others were buying hyped tech stocks or overpriced homes, and
3. to buy and hold when others were panic selling.

As of 2013, Vanguard has advocated the concept of four fund portfolios: the primary difference being the addition of an international bond index fund. For the reasons discussed here, I recommend sticking with a portfolio with three asset class. In short, if you are investing in corporate bonds, then use U.S. bonds to limit your exposure both to foreign currency exchange and to legal issues.

David Swensen’s Six Fund Portfolio

My personal portfolio is based on David Swensons’s recommendations in Unconventional Success: each asset class should be a minimum of 5-10% of your portfolio in order to have an impact on your portfolio. But, in order to achieve diversification, no single asset class should be more than 25-30% of your portfolio.24

Swenson has an alternative perspective regarding fixed income assets. He prefers a mixture of REITs, U.S. Treasury bonds and TIPS over corporate bonds. This is because he doesn’t believe investors are adequately compensated for the additional risk they take on with corporate bonds. He also recommends that investors who wish greater protection from inflation increase their TIPS exposure.

Swenson’s six-asset class portfolio for an individual investor, as of 2015 is:25

U.S. equity	30%
Foreign developed equity	15%
Emerging market equity	10%
U.S. Treasury inflation protected securities (TIPS)	15%
U.S. Treasury securities	15%
Real estate investment trusts (REITs)	15%

As with the two and three fund portfolios above, Swenson’s model must still be tuned for each individual investor’s timing, financial circumstances, and risk tolerance–mindful of the 5% and 30% boundaries.

The respective Vanguard, Fidelity, and iShares funds and their expense ratios are:26

	Vanguard Fund	Fidelity Fund	iShares ETF
U.S. equity	Vanguard Total Stock Market Index Fund (VTSAX) (0.04%) 27	Fidelity Total Market Index Fund (FSTVX) (0.035%)28	iShares Core S&P Total U.S. Stock Market (ITOT) (0.03%)
Foreign developed equity	Vanguard Developed Markets Index Fund (VTMGX) (0.07%) 29	Fidelity International Index Fund (FSIVX) (0.06%)30	iShares Core MSCI EAFE (IEFA) (0.08%)
Emerging market equity	Vanguard Emerging Markets Stock Index Fund (VEMAX) (0.14%)31	Fidelity Emerging Markets Index Fund (FPMAX) (0.13%)32	iShares Core MSCI Emerging Markets (IEMG) (0.14%)
U.S. Treasury inflation protected securities (TIPS)	Vanguard Inflation-Protected Securities Fund (VAIPX) (0.10%)33	Fidelity Inflation-Protected Bond Index Fund (FSIYX) (0.09%)34	iShares Barclays TIPS Bond Fund (TIP) (0.20%)
U.S. Treasury securities	Vanguard Intermediate-Term Treasury Index Fund (VSIGX)(0.07%)35	Fidelity Intermediate Treasury Bond Index Fund (FIBAX) (0.06%)36	iShares 3-7 Year Treasury Bond (IEI) (0.15%)
Real estate investment trusts (REITs)	Vanguard Real Estate Index Fund (VGSLX) (0.12%)37	Fidelity Real Estate Index Fund (FSRVX) (0.09%)/38	Fidelity MSCI Real Estate Index ETF (FREL) (0.084%)

From 2010-2018, Swenson’s model portfolio had a CAGR of 8.10%, an inflation-adjusted CAGR of 6.24%, and a risk (standard deviation) of 8.88%.

Other “Lazy” Portfolios

There are several similar “lazy” portfolio models that you may read about:

• “Coffeehouse” Portfolio
• Dr. Bernstein’s “No Brainer” Portfolio
• Dr. Bernstein’s “Smart Money” Portfolio
• “Second Grader’s Starter” Portfolio

You can use Portfolio Visualizer to backtest your preferred portfolios, including specific funds, here. You can also test adding additional asset classes. However, there is little incremental value to having more than seven asset classes in your portfolio.

Targeted Retirement Funds

Alternatively, you can buy a single fund like the Vanguard’s Target Retirement series, which is comprised of 4-5 asset classes and automatically adjusts its underlying asset mix over time. Select the fund matching your desired retirement date. If your risk tolerance is higher or lower, you should select a later or earlier retirement date to make the asset mix more aggressive or conservative. respectively.

Summary

Coming soon!

For More on this Topic

 

Updated on January 31st, 2019