The recession of 2007-2009 had a significant negative impact on your investments. Personal Investing: The Missing Manual gives you the tools and insight you need to evaluate and make investments designed to grow over the long term. Below, we feature an adapted excerpt from the book that will help you find the right asset allocation for your goals, timeframe and, not least, your investing personality.
Asset Allocation Made Easy
Smart investors use a simple approach to personal investing that delivers the goods: asset allocation. Using asset allocation, you divvy up your investment portfolio among different types of investments (called asset classes) based on the level of risk you’re willing to take. You typically invest in stocks for long-term higher returns, bonds to reduce your overall risk and to earn income, and cash for near-term expenses. The allocation you choose for your risk level, in turn, determines the returns you’re likely to achieve.
How to Choose an Asset Allocation Plan
Your tolerance for investment risk is unique, as is each of your long-term financial goals, so you have to choose an asset allocation plan that suits both the level of risk you want to take and your goals. The table below shows how different types of asset allocation work for people in different phases of their lives.
You’re probably wondering what to invest in to deliver these pairings of risk and return. Suppose you stick to the basic allocation choices of stocks, bonds, REITs (if you’re interested in diversifying into real estate), and cash. For a major goal like college education or retirement, figuring out the percentage of money you want to put into each of these asset classes is as easy as 1-2-3:
1. Put the money you’ll need within the next 5 years into safe short-term investments.
Create a cash reserve of low-risk low-return investments to cover your expenses for three to five years; that’s the time it typically takes stocks to recover from recessions and other temporary setbacks. For example, when you’re five years away from retirement or already retired, keep five years’ worth of living expenses in safe choices like savings accounts, money market accounts, certificates of deposit, and short-term bonds.
2. With a cash reserve set aside, choose the percentage of stocks based on your return-risk profile.
Put 10% of the remaining portfolio money in stocks, even if you want a low-risk portfolio. The typical low-risk asset allocation contains between 10% and 30% in stocks. A medium-risk allocation has between 30% and 60% in stocks. A long-term high-risk portfolio invests from 50% to 100% in stocks.
If you have very little money and your financial goal is near, you may not have much money to put in stocks or bonds. In that case, set up your cash reserve first, then apply your stock percentage to the money that’s left.
3. Choosing the percentage for bonds and REITs is easy.
It’s what’s left after you complete steps 1 and 2.
Your Guide to the “Lazy Portfolio”
Index funds provide instant diversification because they own many individual investments within categories like large and small companies, industries and sectors, bonds, and geographical regions. Because they follow indexes, their expenses and turnover are low. And allocating your money to different types of investments is the biggest factor in balancing the risk and return of your portfolio. Put those two ideas together, and you get the no-muss, no-fuss method for successful investing: the lazy portfolio.
Choose your asset allocation plan and then set up automatic purchases of index funds (mutual funds or exchange traded funds) for each asset class. That’s it! No need to peruse every inch of the Wall Street Journal or to hide in a cave when the markets turn ugly.
Building a Lazy Portfolio
If you contribute to your employer’s 401(k) or 403(b) plan, you’re already on your way to a lazy portfolio. All you have to do is set up your contributions according to the asset allocation percentages you chose (assuming that your employer’s plan offers funds for the asset classes you want).
Even outside of employer retirement plans or college savings plans, building a lazy portfolio is easy (it wouldn’t be a lazy portfolio otherwise!).
1. Open an account with a brokerage firm or index fund company.
ETFs that track market indexes you want are a great way to build a lazy portfolio. However, be sure to buy them through a discount brokerage so the brokerage commissions don’t eat up your regular contributions.
Vanguard is the top dog when it comes to low-cost index mutual funds (their index fund expense ratios are about 0.2%). They’re great if you have enough money to meet the minimum initial purchases, which can be $1,000 to $3,000 or more. You don’t pay commissions on purchases, just the expense ratio.
2. Set up an automatic deposit for your first asset class.
Take the amount you contribute toward your goal each month and multiply it by the percentage allocation for your first asset class. Set up an automatic deposit for that amount for the index fund that represents the asset class, such as the Vanguard 500 Index (VFINX) fund for large company stocks.
3. Repeat step 2 for each additional asset class.
That’s it! Easy, huh?
Stealing a Lazy Portfolio from an Expert
If you don’t want to design a lazy portfolio of your own, use one that financial experts have put together. Here are some of the best-known and laziest portfolios around:
* The Couch Potato Portfolio
Scott Burns, a financial writer for the Dallas Morning News, espouses a two-fund portfolio, split 50-50 between stocks and bonds, using the Vanguard 500 Index (VFINX) and the Vanguard Total Bond Market Index (VBMFX) funds.
* William Bernstein’s No-Brainer Portfolio
A retired neurologist, William Bernstein is a big fan of asset allocation and has written books on it. His no-brainer portfolio is a simple four-index portfolio with moderately high risk: 25% Vanguard 500 Index (VFINX), 25% Vanguard Small-Cap Index (NAESX), 25% Vanguard Total International Stock Index (VGTSX), and 25% Vanguard Total Bond Market Index (VBMFX).
* The Second-Grader Portfolio
This three-fund portfolio is another moderately high-risk portfolio, suitable for longer-term goals. That makes sense, because Allan Roth, a certified financial planner and CPA, developed it to explain investing to his young son. The portfolio includes 40% Vanguard Total Bond Market Index (VBMFX), 40% Vanguard Total Stock Market Index (VTSMX), and 20% Vanguard Total International Stock Index (VGTSX).
* Yale University Lazy Portfolio
David Swensen, author of Unconventional Success (Free Press, 2005), offers this five-fund portfolio as a simplistic replacement for the portfolio management strategy he uses for Yale University’s endowment fund. The portfolio includes 15% Vanguard Inflation-Protected Securities (VPISX), 20% Vanguard REIT Index, 15% Vanguard Short-Term Treasury Index (VFISX), 30% Vanguard Total Stock Market Index (VTSMX), and 20% Vanguard Total International Stock Index (VGTSX).