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Asset Allocation Comes First. Then Fund Selection

I received this question via email a couple days ago:

“What do you think of Vanguard’s Small-Cap Growth Index Fund? Looking on Vanguard’s site, it looks like it has had very good long-term performance (5 and 10 years), and Morningstar gives it 4 stars.

I know it’s an aggressive fund, but I’m a young investor, so I think that might be OK. What do you think?”

I liked this question because it’s a perfect example of a common investing mistake: Building a portfolio backwards by starting with investment selection.

A better way to build your portfolio is to first decide what asset allocation you want to use, then select which investments you’ll use to meet that allocation. After all, a fund can be a great fund, but have absolutely no place in your portfolio.

For example, I think Vanguard’s Inflation-Protected Securities Fund is excellent. It’s a low-maintenance, low-cost way to invest in TIPS. But I don’t use it because I don’t want an allocation to TIPS in my portfolio (because I’m not very exposed to inflation risk).

Choosing Your Asset Allocation

As we’ve discussed before, when choosing your asset allocation, the most important questions are:

  1. What portion of your portfolio do you want in stocks (as opposed to bonds or cash)?
  2. What portion of your stocks do you want to be invested in the U.S. (as opposed to internationally)?

After you have answers to those questions, you can move on to selecting investments to meet that allocation.

Or, if you want to, you can further customize your allocation in any of several ways–adding an allocation to REITs, tilting your stock holdings toward small-cap and/or value stocks, including an allocation to TIPS, etc. But you don’t have to.

Selecting Investments

After you’ve decided what allocation you want to use, it’s time to go ahead and pick funds to meet that allocation. My approach to investment selection involves just two rules:

  1. In each asset class (U.S. stocks, international stocks, bonds, etc.), select the lowest-cost option available.
  2. Use as few funds as possible.

When selecting investments, it’s important to remember to view your portfolio as a whole rather than viewing each account as a separate portfolio. By doing so, you can simplify your holdings dramatically (because you won’t need to hold multiple funds in each account), and you may be able to reduce your costs as well.

No Need to Complicate Things

There’s little point in researching a fund unless you’ve already decided that the asset class represented by the fund is one that you want to include in your portfolio. And once you have decided which asset classes you want in your portfolio (and how you want to allocate between them), the portfolio almost builds itself–just keep costs low and keep things simple.

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  1. Thanks so much for this post! I’m often bothered by questions such as the one you received, but I could never quite put my finger on why. Now that you’ve written about it, it seems obvious: it’s most certainly putting the cart before the horse. This insight will help me tremendously when similar questions come up in the future.

    Granted, there’s always a chance the person asking this questions has already determined their target allocation and has appropriately moved on to fund selection. If that was the case, though, the question would probably be framed differently. And at that point, deciding which fund to use is usually pretty obvious.

  2. Great article! I know I am guilty of starting with an investment selection myself.

  3. Mike excellent post, right on the money. I can’t tell you how many prospective clients that I see with a collection of investments and no overall plan for them. As I call it, financial clutter is very common these days. So many folks have several old 401(k)s, IRAs, a brokerage account, etc. These end up being forgotten and neglected. In most cases stepping back, doing a financial plan including an overall asset allocation as you suggest is the best way for these folks to maximize what they have and any future investments they might make.

  4. I agree, it is definitely important to have an idea of your overall allocation before worrying about individual positions. With this thought in mind, it is also important to identify some things about yourself before choosing an allocation. How will you react to fluctuations in the value of the account? What is your time horizon for needing the funds from the account? What are your expectations for return in the account? The answers to these types of questions may make the proper allocation choice more clear.

  5. Mike I really like your post. More emphasis needs to be put on educating people on the subject of asset allocation. The vast majority of portfolio returns in determined by asset allocation, NOT individual investments within the portfolio. I would like to add this: I believe the most important factor in choosing your asset allocation is valuation. This is more important than any other factor including age. Thanks again.

  6. Bob Hester says

    I have recently purchased and read three of your books – great job in making the case for index fund investing. I have basically invested in large-cap, dividend paying stocks for many years. I have donely fairly well using that approach but as I near retirement, I want to simplify my investment portfolio. Maybe I missed it on your website or in your books, but I don’t know if you have addressed: 1) how do you readjust a portfolio of stocks to index funds? All at once, over a period of months, etc? 2) how do you withdraw money from your indexed portfolio once you reach retirement but also maintain your asset allocation? In my case, I do have a military pension so I don’t need to take distributions yet – but that day is coming as it ultimately is for everybody – not a question of “if”, but “when”. Thanks again for “expanding” my thinking about how to invest in the future (as I can’t do anything about the past). I never thought about or even knew about being an “oblivious investor” but I find this approach most intriguing and a very possible “fit” for my situation in the days ahead. Best Regards, Bob

  7. Hi Bob.

    I’m happy to hear you enjoyed the books. 🙂

    As to switching one’s portfolio from individual stocks to index funds, it depends whether we’re talking about a taxable account, tax-advantaged accounts, or a combination of both.

    If the investments are in a tax-advantaged account such as an IRA, I’d just go ahead and do it all at once–pick the allocation you want, sell everything, and move it into low-cost index funds that will meet the desired allocation.

    If the investments are in a taxable account, the answer depends on whether or not you have large unrealized capital gains. If selling everything would result in a large capital gain and you have no capital losses that could be used to offset the gain, then it may make sense to hold on to certain investments, and build the rest of your portfolio around them.

    As to withdrawing money during retirement, my suggestion is generally just to incorporate it into the process of rebalancing your portfolio.

    For example, if you rebalance once per year, and you plan to withdraw 4% per year, the first step of rebalancing would just be to sell enough of the most overweighted fund(s) to meet your 4% withdrawal. Then, rebalance what’s left in the portfolio to meet your desired allocation.

    If you have follow-up questions, please feel free to ask.

  8. Bob Hester says

    Mike, thank you for the reply.

    Like many investors, I fall into both categories. On the taxable side, I have large captial gains in several oil stocks/royalty trusts/mlps in which I have invested for decades (not just years). I think I will let those ‘be’ for right now and continue to use those dividends to supplement current income – BUT, have a view to slowly selling individual positions at appropriate times as I switch to index funds in the taxable position.

    I tend to be a conservative investor ‘by nature.’ For my IRA, which currently consists of large-cap dividend paying stocks and bond funds, should that be primarily BND as it generates more income? Then, in my taxable account, should that contain VTI / VEU / VWO as they generate less income? When I finish the switch to index funds, I’m thinking about 45% BND; 40% VTI; 15 % divided between VEU / VWO. Also, for the taxable position, do you see any need for ‘munis’ or is that just making things too complicated?

    Like many people, I am ‘all over the place’ with funds / stocks/ mlps. I want to simplify the portfolio so my wife would have less to worry about should something happen to me. However, I am finding the “emotion” that goes into investing and making a large switch in my investing philosophy to be more difficult to deal with than initially expected. I have made investing mistakes in the past – can’t really afford to do that now as I would have less time to recover. Thanks again, Bob

  9. Bob:

    Yes, it makes sense to tax-shelter your bond holdings before tax-sheltering your stock holdings. (Though just to be clear, it’s not that they generate more income, it’s that the income they generate is fully taxable at ordinary income tax rates, whereas dividends and capital gains from stocks are taxed at lower rates.)

    As to international holdings, since Vanguard updated their “Total International” fund last year, I generally find that to be satisfactory rather than having to use multiple international funds.

    As to munis, they might make sense–it depends on what tax bracket you’re in and whether your tax-advantaged space is large enough (relative to your taxable space) to achieve the bond allocation you’re looking for.

    Also, one thing I can’t suggest strongly enough: Posting your portfolio and proposed changes in the “Help with Personal Investments” section at the Bogleheads Forum. That way, in addition to my thoughts, you’ll likely get the input of several other people who know at least as much as I do.

    (Just to be clear: I’m not trying to discourage you from asking questions here. I’m happy to answer them of course. It’s just also valuable to get others’ opinions as well.)

  10. Bob Hester says

    Thank you Mike – I appreciate your time in answering my questions. I will certainly take a look at the Bogleheads Forum. I’m just starting to learn how many great resources are available in which to seek help with questions in regards to investing / asset allocation. I know your forum here at the Oblivious Investor will be at the top of my list.
    Best Regards,

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