The more risk you can handle, the less bonds you need. When you are young, your prime earning years lie ahead, and it will be decades before you need to access the money. So, higher stock allocations may be suitable since big drops in stock prices will not hurt as long as you do not flee the market. John Bogle advises that "as we age, we usually have 1 more wealth to protect, 2 less time to recoup severe losses, 3 greater need for income, and 4 perhaps an increased nervousness as markets jump around.
All four of these factors suggest more bonds as we age. A key reason for devising an asset allocation strategy is to help an investor reduce the risk inherent in volatile equity asset classes that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets. These balanced portfolios help reduce volatility and down-side risk, thus better enabling an investor to maintain a long term investment program stay the course without panic selling during bear markets.
With a strategic asset allocation - as explained in this article - an investor selects a base target allocation to a selection of different asset classes for the long run. It may be changed due to life events, but it should not be changed due to market conditions. The main asset classes are equities stock , fixed-income bonds and cash. The goal is to select an asset allocation that lets you sleep at night, and avoid the destructive urge to sell out in a panic the next time the market plummets; then having to agonize over when its a "good time' to get back in.
This leads to selling low and buying high, the exact opposite of prudent investing. Because the three main asset classes - equities, fixed-income, and cash equivalents - have different levels of risk and return, each will behave differently over time. As such the allocation to these asset classes is periodically rebalanced back to the target allocation to keep the target risk-return characteristics. Alternatively, a tactical asset allocation shifts allocations according to economic or valuation factors.
Vanguard has historically used tactical asset allocation for a limited number of its balanced funds. A dynamic asset allocation calls for allocations to shift in accordance with changing future liabilities. Owning stocks is necessary to get the expected return needed to accumulate funds for retirement.
Stocks provide us with a share of the profits generated by publicly owned companies in the economy. But in exchange for the hope of high return, stocks are extremely volatile and risky. Over time, stock prices roughly follow the trend of the economy, which is to grow. But prices can stagnate or decline for decade-long periods. This is why having an allocation to bonds is a necessary element of asset allocation. Bonds are a promise to pay back a loan of money on a pre-set schedule.
Bonds do not produce the same expected high returns that stocks do, but they are much less volatile. The way to get reasonable growth without stomach-churning drops is to hold a mix of stocks and bonds. In short, during the next 20 or 30 years, there will be a single, best allocation that in retrospect we will have wished we have owned.
The only problem is that we haven't a clue what that portfolio will be. So, the safest course is to own as many asset classes as you can; that way you can be sure of avoiding the catastrophe of holding a portfolio concentrated in the worst ones.
This period was marked by falling stock prices. The second table reflects the longer-term rewards investors hope to receive, assuming that the historical pattern of bond returns providing a premium return over inflation, and stock returns providing a premium over bond returns will be realized. The tables show why asset allocation is important.
It determines an investor's future return, as well as the bear market burden of periodic losses that he or she will have to carry successfully to realize the returns. Although an investor's exact asset allocation should depend on the goals for the money, some rules of thumb exist to guide decisions. The most important asset allocation decision is the split between risky and non-risky assets. Benjamin Graham 's timeless advice was:  [note 3].
There is an implication here that the standard division should be an equal one, or , between the two major investment mediums. Bogle also suggests that, during the retirement distribution phase, investors include as a bond-like component of wealth and asset allocation the value of any future pension and Social Security payment expected to be received. Investors choosing to use less conservative guidelines should understand why they feel they have the need, ability, and willingness to take on the greater inherent risk as explained in the next section.
All age-based guidelines are predicated on the assumption that an individual's circumstances mirror the general population's. Individuals with different retirement ages earlier or later , asset levels those who have saved enough to fund their retirement fully with TIPS , or needs for the money e. Risk is the uncertainty variation of an investment's return. To know whether an asset allocation is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?
This is very hard to accurately assess before you have already gone through a bear market. Author Larry Swedroe has written a multi-part guide for selecting your asset allocation; how much to invest in stocks versus bonds. In general, Swedroe suggests choosing the lowest equity allocation from among ability , willingness , and need to take risk and adjusting goals as needed.
In the case where the ability is greater than the need to take risk, it is possible to choose an equity allocation in the range between these two factors, based on your willingness to take risk. Over time an individual's asset allocation may change from it's original position as a result of the difference in returns from the various asset classes. Rebalancing is the act of bringing the asset allocation in line with current investment policy.
A typical recommendation is that an investor should review the portfolio asset allocation once a year, and if necessary, rebalance as specified in the investment policy. Rebalancing is often the most difficult part because it is counterintuitive, it requires one to sell a portion of an investment that went up, and buy more of what went down. Strategic asset allocation strategies range from simple to complex. Lazy portfolios are designed to perform well in most market conditions.
Most contain a small number of low-cost funds that are easy to rebalance. They are "lazy" in that the investor can maintain the same asset allocation for an extended period of time, suitable for most pre-retirement investors. An asset-allocation fund or a balanced fund is a mutual fund that holds multiple asset classes. Typically these funds hold a stock component; a bond component, and in some instances, a cash component. Many balanced funds maintain a fixed asset allocation ; some pursue a variable allocation policy, changing asset weightings according to market conditions.
Target date funds are balanced funds that gradually change asset class weightings in harmony with an investor's supposed changing need for a lower risk profile over time. Even if you are going to use a single LifeStrategy fund , you need to decide which of them to use, based on the percentage of stocks each one holds.
This is a conservative rule, and leads to smaller percentages of stocks than Vanguard chooses for its Target Retirement series. The second decision is what percentage of your stock allocation should be U. This is a much less critical decision because U. As of , Vanguard provides a tool that recommends a balanced portfolio similar to the kind discussed here Vanguard recommends a four fund portfolio , with percentages based on your responses to a short online questionnaire. The tool is entitled Get a recommendation to fit your goals ; you can navigate to it by way of Vanguard.
See Asset allocation for more details. Since your portfolio may be split between multiple locations one or more tax-advantaged retirement accounts, and one or more taxable accounts you should look at Principles of tax-efficient fund placement to determine which funds belong in each account.
In general, the international fund should go into a taxable account, the bond fund should go into a tax-advantaged account, and the domestic equity fund should fill in the remaining space. You may need to hold the same or equivalent funds in multiple accounts to have ideal asset allocation and asset location.
For Bogleheads , the answer for "what mutual funds" to use in a three-fund portfolio is "low-cost funds that represent entire markets. If you ask different people to choose funds for a three-fund portfolio, you will get different fund choices. The differences are usually of no fundamental importance, and are usually the result of a making choices between nearly identical, almost interchangeable funds, and b simplifying further by using combination package funds.
Watch out for high expense ratios, particularly in the bond funds. Taylor Larimore's ' "Lazy Portfolio " in fact, consists of these three funds based on the investor's desired asset allocation. One could, of course, use ETFs rather than mutual funds. Vanguard fans would suggest that Vanguard has the best and most complete lineup of such funds, and that the most convenient place to hold Vanguard mutual funds is directly at Vanguard.
Thus, the Bogleheads forum and Wiki tends to be Vanguard-oriented. But investing according to the Boglehead philosophy certainly does not require you to invest at Vanguard or use Vanguard products. Here are some suggestions on how to do it with other funds.
Refer to the associated wiki article for additional information. TIAA mutual fund retail participants can use: [note 10]. The relative percentage of domestic and international stocks is a subject of intense discussion in the forum.
One sensible option is to hold domestic and international stocks in the same proportions as they represent in the total world economy. This option is recommended by Burton Malkiel and Charles Ellis, both of whom have longstanding ties to Vanguard, in their book The Elements of Investing. Such a two-fund portfolio would use these funds:. By adding an international stock fund, one could create a three-fund portfolio with two funds.
One Marketwatch article  quotes various non -Boglehead commentators as saying such things as "You can make it really simple, be well-diversified, and do better than two-thirds of investors" and "That three-pronged approach is going to beat the vast majority of the individual stock and bond portfolios that most people have at brokerage firms Dogu describes this approach and comments "With only these three funds Vanguard Total Stock Market Index fund, Vanguard Total International Stock Market Index fund, and the Vanguard Total Bond Market fund , investors can create a low cost, broadly diversified portfolio that is very easy to manage and rebalance Some investors may be uncomfortable with holding only three funds and will question whether they are truly diversified.
With these three holdings the answer on diversification is a resounding 'YES'. In a article, "The only funds you need in your portfolio now" , Walter Updegreave commented: "Of course, some advisers will suggest that you're missing out unless you spread your money among all manner of exotic investments which they're more than happy to sell you. But the more complicated your portfolio is, the more expensive and more prone to blow-ups it's likely to be -- which also increases the odds that it will generate subpar returns," and suggested a "three-fund diversified portfolio: simply invest in the following three funds or their ETF equivalents : a total U.
S bond market fund. Some would argue that a three-fund portfolio is good enough and that there is no real proof that more complicated portfolios are any better. Others would argue that the evidence for superiority of slice and dice , " small value tilting ," and inclusion of classes like REITs is too strong to ignore.
As of when this is being written, bond interest rates are near historic lows and there is a good deal of buzz to the effect that the "thirty-year bull market in bonds has ended" and that investing strategies that have worked for decades should be changed to reflect new realities. Should the three-fund portfolio be modified? No definitive answer can be given to this controversial question, but we can sketch out some of the prevalent and conflicting opinions on the matter.
There are single, all-in-one, "funds of funds" that are intended to be used as an investor's whole portfolio. Vanguard funds in this category include the Target Retirement funds, the LifeStrategy funds; perhaps the actively-managed Wellington and Wellesley funds would qualify, too. On the one hand, a three-fund portfolio involves a do-it-yourself aspect that makes it more complicated than using an all-in-one fund.
For example, because different assets grow at different rates, any investor who chooses a do-it-yourself approach needs to " rebalance " occasionally — perhaps annually — in order to maintain the desired percentage mix. On the other hand, three-fund portfolios are simpler than the genres called "Coffeehouse portfolios" William Schultheis's term , "couch potato" portfolios, or " lazy portfolios ," which are intended to be easy for do-it-yourselfers but are nevertheless slice-and-dice portfolios using six or more funds.
Some see advantages in holding a do-it-yourself four-fund portfolio rather than a LifeStrategy fund or Target Retirement fund, even if the same four funds are used. The advantages are small but meaningful to some, and include:.
Lazy portfolios are specific portfolio suggestions, designed to perform well in most market conditions. Most contain a small number of low-cost funds that are easy to rebalance.
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A three-fund portfolio is a portfolio which uses only basic asset classes — usually a domestic stock "total market" index fund, an international stock. Asset allocation is both the process of dividing an investment portfolio among different asset categories, and the resulting division over. A personal introduction to investment guru Taylor Larimore, The Bogleheads' Guide to the Three-Fund Portfolios, shows how a simple.