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8 Simple Portfolios

I recently came across an interesting question on the Boglehead forum:

If you could only own one fund, what would you own?

That question got me thinking about one aspect of investing that doesn’t often get discussed: desire for simplicity. While some investors don’t mind managing a portfolio of ten different funds, other investors would never consider anything so complex.

Generally speaking, the more asset classes you include in your portfolio, the better diversification you’ll achieve, but it begins to require more work to manage the portfolio. Also, the additional diversification derived from adding each asset class is less than the diversification gained by adding the prior asset class.

I thought it would be fun (and perhaps helpful to investors reworking their portfolios) to put together a list of portfolios sorted by complexity. The following are my recommended one-fund portfolio, two-fund portfolio, and so on (followed by some additional thoughts). Please feel free to share your own suggestions. 🙂

For each fund, the first ticker is the open-end version of the fund, and the second ticker is the ETF version of the fund.

[Update: Some readers requested that I put together a similar list of portfolios using Fidelity funds rather than Vanguard. You can find that list here.]

One-Fund Portfolio

Two-Fund Portfolio

  • 70% Vanguard Total World Stock Index (VTWSX, VT)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Three-Fund Portfolio

  • 35% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 35% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Four-Fund Portfolio

  • 30% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 10% Vanguard REIT Index Fund (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Five-Fund Portfolio

  • 30% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 10% Vanguard REIT Index Fund (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Six-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Seven-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 20% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Eight-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 10% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
  • 10% Vanguard International Value (VTRIX, n/a)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

*Vanguard’s TIPS fund does not have an ETF version. As such, I’ve included iShares Barclays TIPS Bond Fund (TIP) as the comparable ETF.

Regarding Stock/Bond Allocations

In order to make comparisons easy, each of the above portfolios is built using a 70/30 stock/bond allocation. There’s no particular reason that a 70/30 split was chosen over any other stock/bond split.

Any of the above portfolios can be adjusted to fit your ideal stock/bond allocation. Simply increase (or decrease) the allocation to the bond fund(s) and decrease (or increase) the allocation to each stock fund in proportion to its original allocation.

Regarding U.S. vs. International Allocations

Each of the above portfolios is built using roughly a 50/50 split between U.S. and international stocks. Many investors and investment professionals would view this as too heavy an international allocation. You can see my reasoning here and decide for yourself whether to adjust the international allocations downward.

ETFs or Index Funds?

These portfolios could be implemented at Vanguard via traditional open-end index funds or at an online brokerage of your choice using ETFs. If you do opt to use ETFs, you have an additional motivation to keep things simple: Fewer funds means less commissions paid. (Unless you’re using a brokerage firm that offers commission-free trades, that is.)

Social Security Planning with a Desire to Spend More in Early Retirement

A reader writes in, asking:

I am considering taking Social Security soon. I have a pension and about $200k in mutual funds.

If I take Social Security now at 65, I get $1,400 per month. That would be $16,800 per year. If I wait three years that’s $50,400 I miss out on. I won’t break even until age 80.

But I need more now to live the life I want. I won’t care when I am 80. I won’t be traveling much, I won’t be driving all over the metro area, etc.

If you are not planning to spend an (inflation-adjusted) equal amount each year in retirement, I think the best approach to planning is simply to:

  1. Plot out a desired year-by-year spending level, then
  2. Work to figure out the strategy that is most likely to satisfy that spending plan.

In some cases it will turn out that a plan that includes a greater level of spending in early retirement is still most safely achieved by delaying Social Security, because doing so makes it less risky to spend at a higher rate from existing assets. After all, a high rate of spending is most likely to become a problem in “lived-longer-than-expected” scenarios, and those scenarios are precisely the situations in which delaying Social Security works out best.

On the other hand, there can be cases in which delaying Social Security is not a good match for a given spending plan. For instance, if the amount of safe, lifetime income you would receive by waiting until age 70 to claim Social Security (so, your pension plus 132% of your primary insurance amount) is greater than the amount you desire to spend per year, then there really isn’t a big benefit to holding off on claiming.

For Example…

Let’s make up some numbers for illustration’s sake. Let’s say you want to spend:

  • $50,000 per year from ages 65-69,
  • $45,000 per year from ages 70-74, and
  • $40,000 per year from age 75 onward.

If your Social Security benefit would be $16,800 per year if claimed at age 65, that means it would be:

  • $18,000 per year if claimed at age 66,
  • $19,440 per year if claimed at age 67,
  • $20,880 per year if claimed at age 68,
  • $22,320 per year if claimed at age 69, and
  • $23,760 per year if claimed at age 70.

If your primary goal is simply to ensure the desired standard of living at each stage — as opposed to desiring to a) leave behind a bunch of money or b) preserve the possibility of a much higher standard of living at the risk of ending up with a lower standard of living — then my approach would be to delay Social Security until you have a floor of income that will satisfy the lowest-spending stage of your spending plan (i.e., $40,000 per year in this case).

For example, if the pension is $20,000 per year, and your Social Security at age 70 would be $23,760 per year, that’s a total of $43,760, which is a greater level of ensured lifetime income than you really need.

Instead of waiting until 70, it would probably make sense to claim around age 67.5, at which point your Social Security would be roughly $20,000 per year and your total lifetime-guaranteed income would be roughly $40,000 per year.

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Sunk Costs and Mutual Fund Sales Loads

A reader writes in, asking:

“I am currently at Edward Jones and of course was sold A-class mutual funds in 2009. I would like to move to Vanguard but had the high pressure sell today from the Edward Jones advisor that I already paid the commission for the funds and it would be dumb to move now. Is there any truth to it or does it not matter based on the other fees involved?”

The advisor is giving you a nonsense argument. At this point, the commission is what’s referred to in economics as a “sunk cost” because you have already paid the cost and there is no way to recover it. From a decision making perspective, sunk costs should be ignored.

For example, if you’re 45 minutes into a movie and you find yourself hating it, the fact that you paid $10 for your ticket is irrelevant when trying to choose between A) leaving or B) sitting through the rest of the movie. There is no financial difference between options A and B — neither option gets you your $10 back. (That is, your $10 is a sunk cost.) So the only thing that matters at this point is what you want to do with the next hour of your time: sit in the movie or be somewhere else?

The sales load on a mutual fund is like the ticket price for a crummy movie. Once you’ve paid it, it becomes irrelevant for future decision making purposes.

If it makes sense to continue holding A-shares of a given fund, it is only because you have some reason to think that the fund manager’s performance will more than offset the fund’s higher forward-looking cost (that is, the amount by which its expense ratio exceeds the expense ratio on a low-cost index fund in the same fund category).* The decision should not be affected either way by the commission that has already been paid.

*If we’re talking about a taxable brokerage account (as opposed to a tax-sheltered retirement account), there are additional factors to consider such as:

  • The tax-efficiency of the fund relative to an index fund (in most cases, actively managed funds have higher ongoing tax costs than index funds), and
  • Whether you would have to pay any taxes due to selling the actively managed fund.

…but the already-paid commission should still not be a factor.

Annuitizing as a Backup Plan

As I’ve mentioned before, if I were retiring today, my strategy would be to lock in a sufficient level of safe, inflation-adjusted income to satisfy our basic spending needs. This would be done first by delaying Social Security until age 70 (with a few years of free spousal benefits in the meantime) and, if that doesn’t provide enough income, by buying inflation-adjusted lifetime annuities to cover the balance.

One key point to understand about that plan, however, is that it is largely influenced by the fact that my wife and I have no kids and care very little about how much money we leave behind when we die.

For those with a stronger bequest motive (i.e., desire to leave behind a pile of money) and a sufficiently large portfolio, it sometimes makes sense for annuitization to be “plan B” rather than “plan A.” That is:

  • Begin retirement with a typical withdrawal strategy from a typical stock/bond retirement portfolio.
  • Keep an eye on how your portfolio value compares to the amount needed to purchase an annuity that would pay the desired level of income for the rest of your life.
  • Then, if things go poorly and your portfolio falls to the point where it can just barely fund the purchase of such an annuity, you can buy the annuity at that point in order to prevent things from getting any worse.

The upside of such a strategy is that it gives you the chance to experience a higher level of income (and/or leave behind a larger sum to your heirs) if your portfolio performs well. In addition, like laddering annuity purchases, it leaves more to your heirs if you die early.

How About an Example?

Claire is 65 years old. Her husband is deceased, and she has two adult children to whom she would like to leave something when she dies. She wants to be absolutely sure that her income does not fall below $35,000 per year.

Based on her earnings record, Claire expects Social Security to provide $18,000 of income. She has no pension. In other words, Claire wants her portfolio to satisfy at least $17,000 of spending per year.

As I write this, the highest quote for an inflation-adjusted lifetime annuity for a single 65-year-old female is 4.25%. In other words, it would take exactly $400,000 for Claire to be able to lock in $17,000 of annual inflation-adjusted income with an annuity (thereby giving her the $35,000 total she desires).

If Claire’s portfolio is, say, $600,000, she has no need to annuitize anything right this minute. (And in fact there’s a good chance she’ll never have to annuitize anything at all.) She can invest in a typical stock/bond retirement portfolio and use a typical withdrawal rate strategy. If Claire’s portfolio performs poorly and declines to the point at which she barely has enough to lock in her desired level of spending, she can annuitize at that time.

Important Caveats

This strategy requires that you keep a close eye on things. Not only do you have to watch your portfolio, you also have to regularly get new quotes for annuities. Otherwise, if interest rates decline and you fail to notice, you could find yourself in a situation in which your portfolio is no longer sufficient to safely provide the desired level of income.

In addition, if implementing such a plan, it’s important to go ahead and annuitize when there would still be some liquid investments left over to serve as a source of cash for satisfying unpredictable expenses (i.e., an “emergency fund”).

Finally, it’s worth noting that the psychological difficulty in implementing such a backup plan, should it become necessary, is likely to be immense. If you’re the type who finds annuitizing to be an undesirable idea even when you’d have a decent-sized portfolio left over, it’s going to feel even less desirable when:

  1. The necessary annuity will consume most of your net worth, and
  2. Buying such an annuity will require selling out of your portfolio immediately after a market decline.

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Can I Retire Cover

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Laddering Annuity Purchases

A reader writes in, asking:

“I saw on the Bogleheads somebody mentioned the idea of laddering annuity purchases. Given the irrevocable nature of buying an annuity, buying annuities in chunks rather than all at once seems appealing. What would be the pros and cons of doing so?”

What Are You Doing With the Money in the Meantime?

The primary determinant in how this strategy plays out is how your money performs in the meantime (that is, while you wait before deploying it into an annuity at a later date). For example, is the money invested in I Bonds where it will precisely keep up with inflation? Or is the money invested in a typical retirement portfolio, of which unpredictable investments like stocks make up a significant portion?

Naturally, if your money earns very good returns while you wait to annuitize it, you’ll be better off waiting. And if your money earns very poor returns (e.g., due to a stock bear market), you probably would have been better off annuitizing right away rather than doing it over time.

For the time being, let’s assume that you keep the money in something that keeps up with, but does not outpace, inflation.

When Laddering Annuity Purchases is Helpful

When talking about inflation-adjusted lifetime annuities, the advantages to laddering the annuity purchases — rather than annuitizing a larger lump sum immediately — are twofold:

  1. You benefit if interest rates increase over the period during which you’re building your ladder, and
  2. Your heirs get more money if you die before the annuity ladder is completed.

For example, if you have $300,000 that you plan to annuitize over a 5-year period ($60,000 per year) starting at age 70, you will benefit from any interest rate increases that occur between ages 70 and 74, because you’ll be buying annuities at those higher rates.

Or, if you die at age 72, only $180,000 of the $300,000 amount will have been annuitized by that point, thereby leaving a significantly larger sum of money to your heirs.

What’s the Downside?

If you do not die prior to the point at which your annuity ladder is completed, you need rates to increase in order to win your bet.

If rates go down, laddering annuity purchases clearly works out poorly (relative to annuitizing all at once at the beginning of the period) because the payout on each of your successive annuity purchases will be based on a lower interest rate than the original annuity purchase.

In fact, even if rates stay the same you lose out by holding off on annuitizing. That’s because, the sooner you purchase the annuity, the more mortality credits you get to collect. (Mortality credits are the portion of the annuity payout that comes from the unused portion of annuity premiums from annuitants who died early, thereby relieving the insurance company of the obligation to make annuity payments to them.)

Granted, at young ages, these mortality credits are small, because few people are dying. (For example, out of a thousand people who have survived to age 60, the vast majority –more than 99% according to the Social Security Administration — will survive to age 61 as well.) But they’re still greater than zero.

In Short…

The decision to ladder the purchases of inflation-adjusted lifetime annuities will tend to be preferable to purchasing them all at once in scenarios in which:

  • interest rates go up while you wait,
  • you die prior to the ladder being completed, or
  • your money outpaces inflation while you wait to annuitize it.

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Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

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Using Historical Returns to Predict the Future

Historical financial data can be a useful tool. It can confirm common sense ideas such as the concept that stocks should usually earn more than bonds, and that bonds should usually earn more than cash.

And it can be used to find flaws in plans — as William Bengen did in his famous 1994 study, which found that you’re setting yourself up for trouble if you spend from your retirement portfolio at a rate equal to its historical average return.

But it’s easy to get into trouble by using specific historical figures as a tool for predicting the future.

Which Figures Should We Use?

According to my 2012 edition of the Ibbotson SBBI Classic Yearbook, the annualized after-inflation return for U.S. stocks from 1926-2011 was roughly 6.6%.* And the inflation-adjusted return for U.S. Treasury bills over the same period was roughly 0.6%.

So, if we’re trying to pick a number to use for average stock returns for the future, should we use the 6.6% real return figure? Or should we expect the more stable figure to be the 6% equity risk premium (that is, the difference between stock returns and Treasury bill returns)?

If it’s the risk premium that we expect to be more stable, given how low interest rates are right now, that would give us an expected real return for stocks of just 4.1%.**

And according to a paper from the Credit Suisse Research Institute***, from 1900-2012, the global equity risk premium was just 4.1%. So going forward, should we be projecting based on the historical equity risk premium in the U.S.? Or should we be using a global average? Using that 4.1% figure would give us expected inflation-adjusted stock returns of just 2.2%.

The World Changes

In statistics, you learn about a given population by studying a sample of the population. And the larger your sample size, the more confident you can be in your conclusions about the underlying population.

With investing, the only way we can increase our sample size is to wait. For instance, if we’re concerned about annual U.S. stock returns, we have no choice but to collect that data at the glacial pace of one data point per year.

And a decent case can be made that the underlying population from which we’re drawing our sample is in fact changing over time, thereby reducing the usefulness of our older data points.

For example, in the 1930s, most U.S. households did not own stocks, placing a trade took several minutes and required talking to an actual person, trades were much more expensive, there were hardly any mutual funds (and no index funds or ETFs), nobody had up-to-the-second news, and the regulatory environment was entirely different.

So, if the purpose of our statistical analysis is to draw conclusions about what we can expect in the future, should we really be including results from the 1930s in our analysis? What about the 1940s? It’s not really clear where to draw the line.

Should We Ignore History?

My point here isn’t that history is useless. Rather, my point is that any time you encounter projections or conclusions based on historical figures, you would be well served to maintain your skepticism. In many cases you will find that there are alternative ways to interpret and apply the historical data that would lead to different conclusions.

*”Stocks” meaning the S&P 500 and the S&P 90 prior to the creation of the S&P 500.

**Calculated as 0.1% Treasury bill yield, plus 6% risk premium, minus 2% inflation (based on the market’s apparent expectation of roughly 2%, calculated as the spread between yields on short-term TIPS and nominal Treasuries).

***The study in question has since been taken offline. The 2014 version, however, can be found here.

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