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This is a guest post from Dylan Ross, a certified financial planner and a long-time GRS reader.
If you’re new to investing, recognize the merits of using low-cost index funds, but you’re not sure how to allocate your long-term savings among various types of index funds, this information is for you.
Asset allocation basics
While there are many ways to divide investment assets into different categories, there are two main classifications: stocks and bonds.
Here’s what you need to know: Stocks are riskier but have the potential for higher rewards compared with bonds. Also, stocks and bonds don’t always move up or down together. That’s it. That’s enough info to get you started. There’s plenty more to learn about stocks and bonds if you want, but you needn’t wait any longer to start investing.
The starter asset allocation
If you’re just getting started, here’s a fine way to allocate your funds until you’re ready to make things more complex:
- 60% in a total US stock market index fund
- 40% in a total US bond market index fund
The biggest criticism I hear over this approach is that it’s too conservative for younger investors and to aggressive for older investors. My response: Then change it to 80% stocks/20% bonds (for young investors) or 40% stocks/60% bonds (for older investors) if that’s the conclusion you’ve reached.
Another criticism is that there’s no international (or emerging markets, REITs, TIPS, or whatever else you like). Okay, so add them if you want and can satisfy fund minimums. Use the starter allocation as a starting point. As your knowledge, understanding, and comfort level increase, feel free to make changes.
If you’re just starting out without a lot of money, the greatest influence on your account balance will not come from your asset allocation; it will be your own contributions. If having 20% in international stocks would have earned you an extra half percent on your $5,000 portfolio your, you missed out on $25. (And it could just as easily cost you half a percent, in which case you saved $25.)
When your balance is small, what you contribute matters more than what you contribute to. You may even reach the conclusion that the 60/40 starter allocation is works for you long-term.
If you don’t have enough money saved to meet the minimum investments, then save in a high-yield savings account until you do. (For example, you can implement the starter allocation using VBINX with $3,000.)
Next steps
Once you have more money invested for longer periods of time, asset allocation decisions become more significant. Just keep in mind that increased stock market exposure doesn’t always mean a greater chance of achieving your financial goals. The added risk of additional stock may work against you, and in some cases can decrease you chances of achieving your financial goals. I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.
From here, you can continue to educate yourself about the effect of asset allocation on your own financial goals and priorities, or you can seek some help from a professional. And by seek some help from a professional, I’m not necessarily talking about having them manage your money; you can hire a financial planner just to recommend an appropriate asset allocation for you that you can implement yourself.
Previously at Get Rich Slowly, Dylan has written When and how to hire a financial planner, What is a financial plan (and why have one?), How lower fees and expenses with index funds could mean 33% more to spend in retirement.
This article is about Basics, Investing Wednesday, 30th December 2009 (by J.D. Roth)
December 30th, 2009 at 1:13 pm
I would never recommend someone using a mutual fund. They should instead use an ETF. ETF’s are much easier to trade, and typically have much lower costs than mutual funds.
December 30th, 2009 at 1:31 pm
Great intro to asset allocation, Dylan.
@Lizabeeth (#1): There’s not a huge difference in cost between Vanguard index funds and Vanguard ETFs. The trading costs of ETFs can easily outweigh the savings in expense ratios - especially when you first start investing. It doesn’t matter that ETFs are “easier to trade” - you don’t need to be able to sell in the middle of the day if you’re investing for the long term.
December 30th, 2009 at 1:35 pm
Lizabeeth,
Can you please elaborate on the difference between a mutual fund and ETF? I’m not sure what the difference is, and I don’t know what an ETF even is!
Thanks,
Shane
December 30th, 2009 at 1:47 pm
@1 Lizabeeth, ETFs usually have lower expense ratios, but you incur a brokerage fee to exchange them. Also, many retirement plans don’t give participants access to ETFs.
I very much appreciate seeing this basic introduction to asset allocation on the blog. My spouse and I use Vanguard for our Roth IRAs and have been very happy with their low-cost index funds. Right now our allocation is 75% stocks and 25% bonds. We keep 30% of our stock allocation in international stocks.
December 30th, 2009 at 1:50 pm
@3 Shane, ETF stands for “exchange traded fund.” It is like a mutual fund that can be traded throughout the business day. The price fluctuates as the prices of its underlying assets do. With a normal mutual fund, you buy and sell it at the price in place at the close of the trading day. (Disclaimer: I’m not an expert!)
December 30th, 2009 at 2:21 pm
I didn’t think about the trading fees because I do not pay anything for trades. I bank with Bank of America and use their brokerage service. They have free trades if you keep a savings/checking balance of $25,000. Also, I know I was in a mutual fund two years ago that charged about 1.25%. The ETF I am currently using is at .2%.
December 30th, 2009 at 2:21 pm
“When your balance is small, what you contribute matters more than what you contribute to.”
Bravo!
The flip side, of course, is that if you’re 60 and about to retire, you’d darned well better put some serious thought into matching your asset allocation with your goals.
December 30th, 2009 at 2:23 pm
@Shane #3
Look up ishares.com. They are typically who my husband and I use.
December 30th, 2009 at 2:29 pm
“Use the starter allocation as a starting point. As your knowledge, understanding, and comfort level increase, feel free to make changes.”
I really like this.
When I first started out, I got paid 2x a year (graduate stipend) had all our money in a low interest savings account at a local bank. A friend of mine who had worked at a bank told me that was dumb and to stick it in a CD at the very least. A difference of 4% annual interest is a LOT when you’re only making 18K/year. As I gradually got more sophisticated and had more money and longer term goals I gradually added index funds/ETFs, starting with an S&P 500, then adding Nasdaq (50% of each). Now I’ve got the full portfolio with international ETFs and everything at percentages that don’t just equal 1/N. I even rebalance sometimes.
If my friend had told me to start with the full asset allocation rather than a small increase in interest power, I probably would have been overwhelmed and wouldn’t have done anything for years. Saticificing is so much better than doing nothing while intending to optimize.
December 30th, 2009 at 2:35 pm
@6 Lizabeeth, 1.25% is a high ER. Vanguard’s total stock market mutual fund has an ER of .18%. Whether you use ETFs or mutual funds, you are right to keep an eye on expenses.
December 30th, 2009 at 2:42 pm
If you are starting out, keeping things simple is key. However, this is a bit of an oversimplified approach. When you are investing money, it is crucial to know how much risk you are willing to accept and what the chances are that you will need this money in a year, two years and so on.
Giving yourself a time line will change many things. To begin with you will know how risky you can be. If you are young and going to keep the money in the account for the long haul then just invest it all in the stock market: small cap companies, tech, etc.
However, if your investment horizon is shorter, it would not make much sense to invest much money in the stock market. Bonds might and treasuries might be much more suitable.
One thing, I do agree is the investing in index funds is the best way to go as they are already diversified for you and not that many professional investors ever beat the market returns. Matter of fact, only about 20-30% will be able to do that for you.
December 30th, 2009 at 2:43 pm
corporate bonds seem to be a pretty bad asset class, almost certainly unworthy of a 40% allocation for any investor at all. There is a reasonable body of evidence that suggests a smaller (half) allocation of cash (federal short-term debt, not actual federal reserve toilet paper) produces all the salutary effects of the corporate debt, with a much lower opportunity cost. _Bull’s Eye Investing_ (Mauldin) discusses this, and i am certain i have encountered it at various other places in my public library (though i can come up with no other citations off the top of my head)
luck to ya.
December 30th, 2009 at 2:59 pm
I would like to hear more about this VBINX…
December 30th, 2009 at 4:07 pm
Dylan: I’m no expert, but it feels like something is missing.
Do you put cash and near-cash (everything from MMAs and CDs to T-bills) in a separate category? What about gold? During the recent financial craziness, some friends did better than average b/c of funds moved to cash-like accounts or gold (I didn’t know until recently that that was an option!)
Would be interested to know your thoughts on whether other categories than stocks and bonds should come into play in asset allocation.
December 30th, 2009 at 4:31 pm
There are many different ways to allocate and many legitimate opinions supporting them. The point of the starter allocation is to provide one example of one sensible way to get started with asset allocation that is easily implemented. There is a lot of available information and tons of articles about asset allocation, but few present an actionable starting point. That was the goal of this post.
@ Lizabeeth:
“They have free trades if you keep a savings/checking balance of $25,000.”
If the interest you could be earning on that money is over 1% less there than some place else, it would actually be costing you over $250 per year to have “free” trades.
@ misanthropope:
Corporate bonds are only a piece of the total bond market.
December 30th, 2009 at 5:03 pm
I often hear the “80/20″ figure quoted for individuals who are younger with a greater risk tolerance and longer investing timeline. Is there a general consensus in the investing community regarding this ratio?
I am 26 and have about 95% of my investment in stock. (About 20% in ETF, about 40% in value investments with dividend distributions and about 40% in riskier small cap investments.)
I understand I have a long investment timeline, so is 95% stock allocation too much in your mid twenties?
December 30th, 2009 at 5:14 pm
One thing to consider when deciding on asset allocation is whether this is going to be your primary source of income in retirement. I have mutual funds through a state employee deferred compensation plan, which I expect to be a supplement to my defined-benefit pension (and social security). Since it’s not expected to be my primary source of income, I feel I can be less conservative - I am 50, expect to work to ~65, and have about 70% of my deferred comp account in stocks.
December 30th, 2009 at 5:19 pm
I just don’t see why people who are very far away from retirement need to be in bonds. If you have the stomach to live through the wild ups and downs of equities, I would ask you to add bonds only as you reach around 10 years close to retirement.
I am 35, and I am invested 100% in stocks. I had no problems seeing my portfolio plummet in 2001-2002 and in 2008; in fact I DCA every month into my 401K, IRA and taxable accounts. I am far ahead with my 100% equities as opposed to holding any bonds at all. Thus, since I acknowledge the high risk-reward ratio, I don’t need bonds to diverisify at this point in my life. BTW, as for the 100% equities split-up, I am 60% US and 40% Foreign, with a goal to reach 50-50 by end of 2010. IMHO, the days of US being the center of economic activity is over; the global economy is here to stay.
One last thing. For those touting ETFs over MFs, sure, there are advantages. But ETFs are a bad choice for someone who is DCA-ing or regularly investing since the commissions can add up.
December 30th, 2009 at 5:53 pm
Dylan, and JD,
I’d like to see a post and discussion on tax-efficient investing for those of us who have already maxed out our contributions to the tax sheltered accounts.
I know Vanguard has different categories of tax efficient stock mutual funds, and tax free muni-bond funds.
Any thoughts?
December 30th, 2009 at 6:12 pm
Hello Dylan,
“I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.”
It’s the same old story.
The investor does not have to take the chance that there will be an unfavorable outcome. The investor can protect his/her stock market investments by adopting conservative option strategies.
It’s far safer than hoping asset allocation works as well as it did in the past.
I’ll trade limited upside for a guaranteed limited downside. Most conservative (frugal) people should feel the same.
Regards,
December 30th, 2009 at 6:57 pm
I think the point this author is making is that it doesn’t really matter what stock/bond allocation you start with. Just start with one.
Dave Ramsey is similar– he suggests a 1/N strategy with four different indexes/ETFs… something like 1/4 growth, 1/4 blue chip, 1/4 international, and 1/4 something else (bonds? the S&P 500? I don’t remember). It overweights international and underweights growth according to conventional wisdom (eg what I read on fool.com or in money magazine) for someone my age, but it isn’t too shabby.
Once you’re more comfortable with investing, then you can figure out the exact percentages that work better in your personal situation… maybe even play with one of those online calculators.
(Side note: I wonder if Google ads are recommending I invest in Gold because of this column or because I have the Colbert Report’s sendup of gold advertising on Fox open in another tab…)
December 30th, 2009 at 9:25 pm
Great post! I’m 33 and just started investing this past summer. So far it seems that ETFs are a great choice for those of us just starting out. They are easy to trade online and can offer great diversification. There are many different ETFs out there, and my wife and I have decided to split our allocation in three pieces. 42.5% in stocks; 42.5% in bonds and 15% in cash equivalents (online savings accounts and CDs). This allocation has worked out great so far. Also, for the nerdy of us numerous studies have indicated that passive index funds (i.e. most ETFs) have generally outperformed actively managed mutual funds. With that said, there are some active funds that look really appealing!
December 30th, 2009 at 9:35 pm
I’m generally with Lizabeeth; I usually recommend that people start with ETFs, at least for their “independent” investments (i.e. those not in a work sponsored plan).
If you plan to make IRA contributions one time per year to arrange your taxes right, transaction costs at a discount broker are modest and ETFs have rock-bottom expense ratios otherwise. Pick a broker that has free reinvestment of dividends as partial shares and you can pretty cheaply get reasonable lazy diversification with less money than mutual funds would require.
I like something with 3 investment categories: US Stocks (VTI), Non-US Stocks (VEU), and inflation-protected bonds (TIP). You can go more diverse when you have more assets.
If you can’t afford all three categories the first year, just buy one of them. By the second in year 2, and the third in year 3. As the amount you contribute grows, you can make purchases/sales in all three categories at the same time annually to balance your allocation, and fees are still kept in check.
December 30th, 2009 at 10:23 pm
There’s no reasoning given for any of the advice in this article at all.
Why 60/40? Why sometimes 80/20 or 40/60? Why *would* I want international investments? Why would I bother with this “asset allocation” stuff at all? What am I trying to accomplish by doing any of it?
Personally, my entire 401k is in a single index fund (FUSEX). I guess I could change that, but, eh, why bother? I don’t really see what it gets me. It’s all essentially play money for the next 30 years anyway. It’s hard for me to worry too much about money I can’t spend. You’ll tell me that’s a stupid viewpoint, probably. That’s fine. Why do you think more young people aren’t saving for retirement? Maybe cause it seems a bit like throwing money down a black hole where it disappears for decades? At least if you’re saving for a home down payment or something you actually get to buy a house before you’re old and gray.
That last paragraph turned into a bit of a tangent, but seriously, this post reads like “Heard of asset allocation? do 60/40 stocks/bonds. It’ll be great. Later.” It’s hard for me to care if you can’t tell me how this is supposed to help me.
December 31st, 2009 at 12:22 am
@23 Tyler
Given your age, you’re at the time where the most important thing is to save. I’ll agree with you there, because in the short term, a few percent here and there doesn’t add up to much when you consider the small balances we young professionals have.
The problem with “setting and forgetting” leads to problems. Most (near) retirees lost much of their account balances is because they were too heavily invested in stocks when the stock market crashed. This was due to ignorance, laziness, procrastination, and optimism. No one changed their allocation, because they didn’t know any better nor wanted to learn about it. Yes, this generation expected a pension, but they didn’t take the initiative.
(this becomes more general and less as a reply to Tyler’s post)
Everyone thinks stocks will go up, will gain in value, etc etc (sounds just like the housing market, huh?). Everyone is all about diversification to mitigate risk, but even with mitigation, you can still lose money. That is the first thing people must understand, I mean it’s called risk or a reason.
Diversification is to incorporate different types of investments that have different types of risk, and ideally, different industries. This way, if one industrial sector bombs, only that portion of the account balance takes a hit.
Those retirees who were informed and smart, or who had a financial adviser who did their job properly, would have had most of their assets in bonds which have a pre-determined rate of return (absolute or relative to inflation). These folks didn’t take a hit in the stock market crash. Imagine what if you had a few grand in a 5-year CD @ 6% interest compared to the pitiful 1%-2% rates you find today.
On the other side, bonds are not entirely risk free. You can lose money if the interest earned does not keep up with inflation. For example, getting a 5-year CD @ 1% would be bad if our economy recovered and inflation occurred. If the inflation rate is 4% and your money is earning at 1%, then you’re missing out.
I personally own 100% stocks in my 401k, if it goes down in value, I don’t care. I’ve got 50+ years until retirement, and for now, I want more shares. I’d actually prefer the price to drop, so I am able to purchase more shares. I am not being optimistic in thinking the price will rise in the long term, but betting on it. I’m conscientiously making a gamble that the future value will be higher in the long term than the short term. I’m not thinking it will, just hoping.
Also, I’m entirely fine with losing value in my 401K. For the next few years, I will probably stick with 100% stocks, and slowly diversify with different index funds. But, I’m not OK with losing my entire balance, which is why I do not pick just 1 stock and put everything in there. If I had all my money in 1 stock, and they went bankrupt, then ALL of my retirement money would be gone. *cough* ENRON *cough*
I think Dylan’s post is perfect for beginner investors, because it makes them question common “wisdom” and makes them determine their risk tolerance. Like he said, 60/40 stocks/bonds is just a starting point, and there are too many variables for a perfect answer for everyone. There will be high risk takers (me and you both) and there will be those who put most of their money into bonds/savings (those who can’t stand or afford to lose much value to their accounts).
How much you are willing to lose should be reflected in the diversification of your account. Even within asset classes there are different groups to choose form. You can go safe with “blue chip stocks” from stable companies like Walmart and Coke, or go with Foreign Markets if you are a real risk taker.
The only real problem I have with the post is this paragraph.
“Next steps
Once you have more money invested for longer periods of time, asset allocation decisions become more significant. Just keep in mind that increased stock market exposure doesn’t always mean a greater chance of achieving your financial goals. The added risk of additional stock may work against you, and in some cases can decrease you chances of achieving your financial goals. I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.”
A chance is a chance. There are no guarantee and the risk of losing your money is very real. When you have a greater chance of higher returns, you also have a greater chance of losing what you already have. Given the basic nature of the rest of the post, you jumped form return to financial goals, which you should probably be elaborated more on.
A person with $10 million in the bank doesn’t need stocks ensure a comfortable retirement by our frugal standards (I would be able to make do with 1/5 of it or even less) with all the money in bonds earning 1% a year. That’s 100k to spend a year and lead a VERY comfortable life. But, the millionaire might want $100 million in the bank before he retires, at that point, they would depend upon stocks.
Look at Warren Buffet, he’s worth ~$62 BILLION. I’d be drooling to get that money into a Bank of America 0.40% interest checking account @ BoA, but it ain’t good enough for him.
December 31st, 2009 at 1:04 am
“… starter allocation using VBINX with $3,000.” I am just curious, why VBINX? Why not VSCGX or VSMGX? If I don’t have 3k, can I use VGSTX?
I want to memorize this: “When your balance is small, what you contribute matters more than what you contribute to.”
Thanks for the post!
December 31st, 2009 at 3:52 am
Stock market investing is another form of gambling.
John DeFlumeri Jr
December 31st, 2009 at 9:40 am
“Stock market investing is another form of gambling.”
And what do you propose people put their 401(k) and IRA money in that will come out ahead of inflation by the time they retire? I’m seriously curious.
December 31st, 2009 at 9:59 am
“Stock market investing is another form of gambling.”
I just came back from Vegas last month. At the same time I was losing 100% of my $50 “investment” playing craps, my stocks were slowly bringing in dividends, modest gains and impressive returns.
Granted, no one knows the direction the market will take us, but with a fair level of certainty we can be sure the market will continue to churn upwards in years to come. There has never been an extended period of time (decades) where the market declined.
Here’s the bottom line: Anyone who refers to the stock market as gambling didn’t leave their money in long enough. As the “oracle” Warren Buffett said, “my timeline is forever.”
December 31st, 2009 at 3:14 pm
This post comes at a time right when I am considering changing the funds my 401k is invested in. I struggle with deciding on a right mix of stocks and bonds. I also want to have a little exposure to international stocks and I’ve read the benefits of investing in small, mid, and large cap stocks as well as value and growth stocks. When I try incorporating all these assets into my 401k I would end up with probably 8 different funds. Instead I’m choosing a few asset classes and sticking to them. I won’t have exposure to everything but I will have a good mix. I’ve also decided that since I am so young (27) I won’t worry so much about having exposure to bonds quite yet. As I age I will gradually move some of my funds towards fixed income securities.
December 31st, 2009 at 3:56 pm
“And what do you propose people put their 401(k) and IRA money in that will come out ahead of inflation by the time they retire? I’m seriously curious.”
There are a few options, of course you may not like them, but I will list them below. Along with the options, the benefit is listed alongside. Please let me know if you have questions.
1. The mattress. This location is ideal for anyone who likes the smell of green during the hours of slumber. Additionally, if your bills are crisp, the firm nature of money inside the mattress may prevent back problems when you reach the ripe age of 65.
2. In a jar in the backyard. This option is great for individuals who believe the IRS implants a homing device in your money. If you dig deep enough into the earth, the minerals in the soil will confuse the IRS’ sophisticated machinery for locating your hard-earned, inflation-unadjusted cash.
3. Underneath the floorboards. Assuming you’re lucky to have invested in a hacksaw to obtain access, this would be your third best option. Recent research studies show mice and other rodents are not attracted to money because the US dollar has fallen so sharply over the past year.
There you have it: Your options. I’m big on number one; my back has given me trouble since I brought home all my money in a large, heavy garbage bag from the bank last week and the mattress is fairly comfortable. However, ultimately, the choice is yours where you would like to hide your loot.
December 31st, 2009 at 5:02 pm
I like how you tackle asset allocation. I think asset allocation is one of the hardest parts of investing to get your arms around. 60 40 may be to conservative for many people under 50. The important thing is asset allocation first.
December 31st, 2009 at 6:12 pm
@31 Pey
He said he wants to stay ahead of inflation. The money under the mattress loses value over time due to inflation. Each dollar is still worth a dollar, but it buys less.
@32 Daddy Paul
Asset allocation is secondary. What most important is how much you are willing to risk for a chance to get more in return. However much returns stocks can offer is useless unless you can stomach losses, like this current market. How many people exited at the worse point? How long will it take to recover their losses, especially with the gains made after ward.
First is to determine how much you’re willing to risk, then figure out how to minimize chance of losses while maximizing returns.
December 31st, 2009 at 6:22 pm
“The money under the mattress loses value over time due to inflation. Each dollar is still worth a dollar, but it buys less.”
Not so, Steven. The sentimental value accumulated from years of lying on your money is quite substantial. You should try it sometime; the benefits are quite clear to us money-in-the-mattress hoarders. In time, you’ll see.
Also, it might do you good to look up the definition of “sarcasm” in the dictionary and do your best at noticing when others are using it.
December 31st, 2009 at 6:54 pm
Just think, Pey, how much more your back would hurt if you’d invested in gold!
January 3rd, 2010 at 1:20 am
I’d like to recommend “What Works On Wall Street” by James O’Shaughnessy. The author is a numbers freak and does an exhaustive study of what worked over the last 70 years….the end result for average investors such as myself is to stick with a standard asset allocation based on index funds and STICK WITH IT. If you think you can time it, you’re screwed.
Also check out “Winning the Loser’s Game” by Charles Ellis…not an easy book to read but it explains that you cannot win against the Big Boys, so just try to not lose (as opposed to trying to win).
January 5th, 2010 at 2:49 pm
@23 Steven:
[quote]
The only real problem I have with the post is this paragraph.
“… I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.”
[/quote]
Dylan is right, although it is not straight forward to understand. A “favorable outcome” means lots of average yield with a minimum of risk. That is usually a contradiction, but by mixing asset classes you can get a better yield per % of volatility.
You can make diagrams of those two values, too. Plot volatility on the horizontal axis and average yield on the vertical axis. Then make dots for every asset allocation that you want to check. Most people should choose the dot that is on the top left, furthest away from the diagonal. If you can take more risk you should take a dot with stronger emphasis on yield even if have to take a bit more volatility.
The thing is that by mixing asset classes that have a low correlation you end up with dots that are more in the left upper part of the diagram.