Now THIS is the kind of investment research you should be doing

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My friend, “E,” who’s in his mid-twenties, writes me:

I quit my job last week, and I’m loving my new focus on [my own business].

One scary thing about being an entrepreneur is that it’s easy to lose discipline with investing (no automatic opt-in of 401(k) for example). I’m in the process of sorting out my investments and I was hoping to get your help. I plan to roll over my old Fidelity 401(k), which is about $40K, to a mix of Vanguard index funds. My Fidelity account currently has the following mix:

  • 70% Fidelity Contrafund
  • 30% Fidelity Diversified International

I want to roll over these investments to the following Vanguard investment mix, slightly modified by Swensen’s suggested asset allocation (see below)

  • 30% – Domestic Equity- S&P 500 Index
  • 15% – Foreign Developed Equity – Total International Stock Index
  • 15% – Emerging Market Equity – Emerging Stock Index
  • 10% – Real Estate – REIT Index
  • 15% – Long-Term Teasury Index
  • 15% – US Treasury Inflation Protected Securities

In terms of my own investment profile, I seek a somewhat aggressive portfolio since I plan to invest for the long-term. I would also like to copy this asset allocation to my personal Vanguard investments that are not tax sheltered.

A few questions:

  • Your thoughts on the diversification and balance on my suggested asset allocation?
  • Am I maximizing my ROI?
  • Anything you would change or modify?

e-asset-allocation

Two points from E’s email to me:

  • What would you tell him? (Note: Here’s a quick collection of links on asset allocation.)
  • Lots of people say they want to invest for themselves, but this is the bare minimum amount of research you should be doing. It’s kinda like when people say they want to write a book, or get 6-pack abs…yes, I want two twins in the back of a limo feeding me grapes (that’s all, Mom!!!) but I don’t necessarily want to do all the work to get them back there.

That’s why, when you invest, you can choose convenience or control. Here’s an excerpt from Chapter 7, “Investing isn’t only for rich people”:

amazon-logo-small barnes-noble-small-logo

When you order the book, forward your receipt to iboughtthebook@iwillteachyoutoberich.com so I can send you spreadsheets, bonuses, a signed nameplate, etc.

* * *

I’ve sent out 3 long, detailed emails to my newsletter in the last 24 hours. If you’re not on the list, you’re not seeing stories where I rant about my stupid friends (and include stuff that I never post here). Sign up at the top of the blog.

mike-book-has-greatest-advice-ever

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34 Comments

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  1. I would recommend a pull-back on the US Treasuries (10% each) and foreign equities while adding investment-grade US bonds. Vanguard offers an Intermediate-Term Bond Index Fund that would work well int the strategy laid out above.

    One broad recommendation is to have a plan on what you expect to do with your dividends. Its good to have an idea on whether you’ll have them automatically reinvest in the funds from which they came or manually reinvest them into whichever asset seems the most undervalued at the time (for example, US equities right now).

  2. Mid twenties and he wants to put 30% in bonds? Maybe he should go back and read this post:
    http://www.iwillteachyoutoberich.com/blog/bonds-arent-for-young-people/

    If he’s in his mid-twenties, I wouldn’t put more than 5% of my portfolio in Cash or Cash Equivalents (i.e. Gov’t Bonds)

  3. Regarding “maximizing rate of return”:

    It’s impossible to know now if you’re maximizing your return of the future. The best thing you can do is try to make your portfolio as “efficient” as possible. This means maximizing *expected* returns with the least amount of risk.

    What you should do is determine what your tolerable risk is (which happens to be the hardest part of determining asset allocation). The SP500 was 60% off from its high. Is that tolerable to you as an investor (i.e. can you take a 60% loss if you were 100% equities)? Think about this and choose a stock/bond mix. That’s going to give you the most return for your risk tolerance.

  4. It’s worth having a look at Vanguard’s tax-exempt bond funds and working out the math – they often offer higher returns on a post-tax basis than their non-exempt analogs. You have to weigh this against the risk profile, though (e.g. tax-exempt municipal bonds are less credit-worthy than Treasuries – how much so is the million-dollar question).

    Also, for what it’s worth (although admittedly inconsistent with the principle of not trying to time the market), many people would have you believe that Treasuries are over-valued at the moment (compared to other bonds) as a result of high risk aversion in the markets and the resulting flight to safety. If you 1), believe this dynamic will unwind as financial markets return to normalcy, and 2), are comfortable with some “active” management, you should probably tend toward other investment-grade bonds over Treasuries in the near term.

  5. @elmariachi On the bonds – He’s rolling these funds from a 401(k), presumably to an IRA. So wouldn’t the taxation on the bond returns be immaterial?

  6. The research I’ve read has shown that the most important thing is finding a reasonable asset allocation and sticking to it; you might be able to eke out a few more percentage points by finding The Perfect Allocation, but you’ll never know what exactly it was until after the fact.

    That said, I would take a look at some other folks besides Swensen, just to get an idea of what’s out there. I’m a fan of William Bernstein (Intelligent Asset Allocator/Four Pillars Of Investing); he might suggest that you:
    -ignore long-term bonds (focusing on intermediate and short instead)
    -diversify domestic equity into large cap blend v. large cap value v. small cap blend v. small cap value, since small cap and value stocks (both small and large) tend to have higher returns (with somewhat higher risk, of course)
    -as mentioned above, take a hard look at the tax consequences

    But really, that looks like a perfectly fine mix — depending on when you’re planning on retiring.

  7. A 30% bond allocation seems high for someone in his mid-20′s saving retirement; I would pull it back to 10 or no more than 20%.

  8. @Amy: Good point. Taxation shouldn’t really be a consideration in this scenario.

  9. Is it okay that you invest in the same allocation mix for both your IRA and your un-tax sheltered investments? Doesn’t it seem kind of redundant?

  10. I agree with SimpleSimon; moreover, maxing ROI is almost always a recipe for disaster. I prefer not to reach for the last marginal dollar. Make sensible investments that will return well over the long term. Maximizing ROI usually means taking too much risk, something the professionals have a hard time quantifying, and the amateur has no hope of measuring accurately.

  11. I meant to say in my original comment “you should determine what your maximum tolerable loss is” rather than “tolerable risk”.

    Regarding bonds:
    First of all, the link to “bonds aren’t for young people” doesn’t even say anything, it’s just a picture. I clicked on the link on that page that’s supposed to lead to another article about stocks and bonds but it doesn’t work.

    Secondly, I like the timing of the article and comments. The article was written during a bull market (9/2006), and bull markets make many people feel invincible. Unless these investors had crystal balls, many people took huge losses if they didn’t have bonds to ballast their portfolio. Sure, you can take on more in equities because you’re young, but *expected* returns of stocks being greater than bonds shouldn’t be the main reason (the last 10 years have certainly shown that).

    Chew on this: having bonds make a portfolio more efficient than having 100% equities.

    If all your money is spent outside of investing for retirement, saving for a down payment, filling your emergency fund, bonds within the portfolio will help you rebalance and “buy low” when you want to. (Changing your allocation due to emotions is a different story.)

    When figuring out bond allocation think about risk of loss tolerance. Think about human capital (your future earnings).

  12. VGTSX already has some exposure (20%-ish) in emerging markets. Also, VEIEX has a purchase and redemption fee on top of a higher expense ratio than VGTSX. So my real thought is, why include this at all?

    Also, why not look into the Vanguard Target Retirement 2045 fund (or whatever year you were interested in retiring)? It seems kind of similar to what you’re trying to do with your mix of fund. Maybe you could have a Target Retirement fund plus one or two others you were interested in adding weight to? As a bonus, the Target Retirement expense ratio is much lower than the funds you have listed.

  13. History teaches us the market goes up when everybody buys, and down when everyone sells. The secret is obvious with equities: buy when the doom and gloom reaches a fevered pitch and sell when everyone is fully exuberant. We are at a crossroad. Buy quality now; watch and wait.

    Real Estate will come back, but not until people feel confident about their own issues and banks are old news. Look to the spring of 2011 for real estate, although that might be optimistic; that’s my call for now…

    Bonds are boring wealth protectors for those with millions they can’t spend in the current decade. Bank CDs pay a better rate; a better choice for those with small (less than $100k) money, or for those willing to spread it out like jam on scones.

    It’s all about circumstances and expectations. It’s all about the one thing that works in life: ‘Observe and Adjust’. That should be a mantra, ‘observe and adjust, observe and adjust’… chant it in the shower tomorrow – it’ll be a better day.

  14. Personally I would never invest in an index fund. Most managed funds can significantly outperform the market, especially with a significant time horizon. That being said, be sure to check the internal expense ratio on the funds. I won’t go over a 1% expense especially when there are numerous good funds out there with a .5 to .7% ratio (I prefer American Funds).

    That being said, I would not put anything into government bonds. They’re too safe (IE too low of a return). Many of the mid term bonds are set for an equity like recovery when we come out of this down market, and although my portfolio has no bonds in it, someone in their mid 20′s shouldn’t have anything more than a 80/20 portfolio.

    Lastly, don’t confuse a bull with brains.

  15. In the past 19 years I ran a little experiment with $10,000. I put it in a retirement IRA and never contributed to it again. After 10 years there was $50,000 in it. After 12 years only $22,000. At that time I converted it to a Solo 401K plan so that I could borrow $10,000 from it, that was three years ago and I’ve repaid the $10,000. A few months ago the fund plummeted to $17,000 and yesterday it was at $15,000. I have a friend who has been putting a great deal of money into an IRA for the past 5 years and he has lost half of the principal. Isn’t it true if I had put the $10,000 in a savings account even after taxation I’d have more money on it today?

  16. I like the allocation but agree with others that at your age you should probably be shooting for 75-80% in equities.

    Watch the expense ratio on those funds.

    If you’re dead set on T-bills, consider opening an account directly with TreasuryDirect.gov. You can buy T-bills, notes, TIPS, and savings bonds directly from the government with no fee, and fund the purchases automatically from an outside account. Getrichslowly.com has (I think) some tutorial posts on how to set up an automatic ladder with 4 week Treasuries.

  17. If E has the option to leave funds in his old plan, should he just do that? By rolling over and switching funds entirely, I’d assume he will sell those old shares at a pretty big loss, and then he’ll have to approximate the previous funds in terms of cost/share and areas of coverage if he wants to rebound with the market over the long term. Or is there something to starting fresh that I’m missing?

    E, if you weren’t already planning on this, I would open an individual 401(k) if you are a sole proprietor and meet the other criteria. You can automate deposits into it and shelter a ton more cash than you can with a SEP IRA.

    If you are looking for principal protection or partial principal protection, you might consider structured CDs or notes, although these are subject to the credit of the issuer. Still, I find some of them to be somewhat less of a gamble than some direct investments since you can hedge on the downside a bit. I wouldn’t do more than 10-15% of my total investment in an area like that.

  18. @Scott:
    “Personally I would never invest in an index fund. Most managed funds can significantly outperform the market, especially with a significant time horizon.”

    They can, but they don’t necessarily. There’s research out there that says that good funds are more a matter of luck than skill, and of course as you mentioned the expense ratio is all-important — many managers beat the market, but not by enough to justify what they charge you. Google turns up a few random articles to chew on, if you don’t want to read Bernstein, Fama, French, or one of their ilk:

    http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm

    http://seekingalpha.com/article/84916-percentage-of-active-fund-managers-that-can-beat-the-market-shrinking-rapidly

    http://allfinancialmatters.com/2008/01/04/when-an-active-mutual-fund-manager-beats-the-market-is-it-luck/

    http://www.indexinvestor.co.za/index_files/MyFiles/Study.pdf

    The article in the last link underscores the idea of a “balanced” approach. For myself, I’m an indexer, but that might be because it feels less like gambling (not to mention work) to me than active management.

  19. @Ella: good eye. It looks like he wants a specific ratio between developed and emerging nations — which I think is always good for rebalancing — in which case I think VDMIX, which is specifically developed markets, would work better than VGTSX.

  20. I’m OK with the Asset Allocation — – it’s fairly similar to mine. the bond allocation would normally be a bit high for someone that age, but he also has no regular paycheck to fall back on. If things go badly, he may need the reliable returns of those bonds.

    I switched to ETFs from mutual funds because they tend to have lower expense ratios, and because you don’t have to wait until the end of the day to find out what you paid for them. In a volatile market, this makes rebalancing your portfolio a single-day event with immediate results. Mutual fund rebalancing takes at least two days — one day to get the results of your sales, and another to purchase.

    Two other notes:

    I have yet to find a managed fund portfolio that outperforms an equivalent index fund after expenses — not saying it can’t be done, but I don’t want to spend the time trying anymore.

    My wife and I each have Roth IRAs created at the same time, funded at the same times with the same amounts. She has never moved her funds out of a Money Market fund. Mine have always been broadly diversified (stocks/bonds, domestic/international, small/mid/large-cap). Last summer, my account was worth about 40% more that hers. Right now, hers is worth more than mine. It would be very easy to learn the wrong lessons from this…

  21. EMBARRASSING… This is way to exposed to the market, only in a delusional pre-2008 world is this even remotely considered diversification.

    LOL, the comments in here. Look into improving your performance with a more market neutral strategy… I bet many are getting very over exposed right now with no exit strategy.

    • Johnny, what does that even mean? What is your specific recommendation for E’s asset allocation? Can you walk us through the advantages/disadvantages of your recommendations, and explain the data on how you chose yours?

  22. I’ll let everyone else duke it out quibbling over asset-allocation ideas – most important thing I tell clients who went from earning a W2 income to self-employed/substantially-lower-income bracket: explore the cost-benefits of executing a Roth Conversion of your Traditional IRA assets!

    It’s the difference between turning your retirement nest-egg into a Tax-Free source of income, or something that gets added to your taxable income upon retirement – a HUGE difference.

    Cost: Conversion Amount is added to current year taxable income. But if you’re freelancing and have little-to-no declared income net of expenses, partial conversions can be FREE, and anything that transforms some of your IRA $$$ into free vs taxable and costs you nothing is definitely worth the execution.

  23. I’m saying that portfolios need to have some short positions in them for protection.

    All this tweaking of percents into various funds and markets do nothing to limit your exposure in a bear market. Even WB, the world’s greatest investor, got hammered last year… So, good equities, sectors, markets are all dragged down. And they tend to take the stairs up and the elevator down.

    If you have a low risk tolerance, like me, learn about market neutrality. Probably more work than most are willing to do. Unless you can find a good fund manager or hedge fund.

  24. The sacred principle of “long term”, ah yes! Might be fine now, but what about the people that lost 50% last year with strategies similar to the OP’s?

    Now their portfolios have to see 100% gains just to break even. It could take 15 years + under decent conditions. Could take longer if the decline is not over. Long term? I’d say so…

    Buy and hold is risky, always have an exit strategy.

  25. Buy and hold doesn’t work if you don’t respect the “hold”.

    For people that lost 50%, should they have been in a position to lose 50% in the first place? If they had the stomach for such a loss and set up their portfolio in such a way, sure. If not, their portfolios were too risky to begin with.

  26. Ramit, regarding your comment above: “…two twins in the back of a limo feeding me grapes…”; is that simply a redundant statement or did you mean two sets of twins for a total of four people? Or perhaps two twins but not necessarily from the same set of twins?

    I ask because it might make a difference to your mom! ;-)

    Really enjoy your writing.

  27. Hey guys this is Ramit’s buddy, ‘E’. A big thanks to Ramit for sharing my story on his blog, and equally big thanks to all of you who have commented. As a follow up, I wanted to share with you guys what I ended up doing.

    Most of the comments suggested that my bond allocation was too high for a guy my age (27)–I agree. I decided to cut my bond allocation in half. Eventually I may decide to cut down even further to 10% of my total allocation, but I want to do some more research first.

    Here’s my current allocation:

    30% – Vanguard 500 Index VFINX
    20% – Vanguard Emerging Markets Index VEIEX
    15% – Vanguard Total Stock Market Index VTSMX
    10% – Vanguard Total Int’l Stock Index VGTSX
    10% – Vanguard REIT Index VGSIX
    7.5% – Vanguard Long-Term Treasury VUSTX
    7.5% – Vanguard Inflation-Protected Securities VIPSX

    Now I know there’s more I could be doing to optimize my allocation as well as my investment channels–but I think any improvement would be on the margins at this point.

    I don’t plan to touch this money for 30-40 years. I’m just a lazy guy who wants to do a little upfront research on asset allocation, settle on something, then just keep dumping money into that allocation without thinking about it any more. I’d rather focus my attention and energy on my new business!

    Thanks again everyone!

    E

  28. [...] Now THIS is the kind of investment research you should be doing Lots of people say they want to invest for themselves, but this is the bare minimum amount of research you should be doing. It’s kinda like when people say they want to write a book, or get 6-pack abs…yes, I want two twins in the back of a limo feeding me grapes (that’s all, Mom!!!) but I don’t necessarily want to do all the work to get them back there. [...]

  29. For those saying that young people should skip bonds, you may want to look at this article:

    http://www.ritholtz.com/blog/2009/03/why-bother-with-bonds/

    At this point, due to the downturn in the stock market, it looks like bonds may have outperformed equities over almost all 20 year periods in the last 200 years.

    Johnny H also makes a fair point about sell-discipline. Even Ben Graham’s “Intelligent Investor” suggests the idea of picking target P/E multiples to sell at and to rebalance between stocks/bonds, ranging from 25%/75% to 75%/25% mixes depending on valuations/multiples.

  30. [...] through investing. Instead, he points out that you should concentrate on asset allocation, doing solid investment research, and creating a plan you can stick with. Choosing investments for the long haul, through reasoned [...]