Based on the last lesson, and previous lessons that touch on diversification, we know that we need at least US Stocks and bonds in our portfolio. We’re going to use that as a starting point and then make our portfolio more and more confusing.
My personal approach is as minimal as possible while getting broad-market diversification across the entire world economy. I want my portfolio to do well even when the United States is going through a recession. It should also not suffer if a single country suddenly struggles.
So, let’s look at what a sample asset allocation would look like with 1 fund all the way up to 10 funds. My personal preference is 3-funds, but I’ll go over why some people recommend more or less.
The 1 Fund Portfolio
If you only have one fund to invest in, the largest and best option is a United States Index Fund. The two that are most often recommended are a Total Stock Market Fund, like $VTSAX which invests a little bit in just about every publicly traded company – 3,556 at the time I’m writing this. The percent in each company is based on the size of the company, so it invests much more in the largest companies.
The other potential fund is an S&P 500 fund like $VFIAX. Like we’ve talked about, it invests in only the largest 500 companies.
One way I find useful to compare funds is to look at their weighted distribution. This shows three types of companies based on size – small, medium and large companies. “Small-cap” means companies under about $2 billion. “Mid Cap” goes up to $10 billion and “Large Cap” is anything about that.
On the X-axis, there are three types of companies at each size: Value, blended and growth companies.
“Value” companies are usually ones that have solid, consistent revenue year after year. They aren’t growing at a massive pace, but they have dependable growth. Some examples of value companies are Disney, Walmart, and Johnson & Johnson.
“Growth” companies are ones that are trading at prices based on their future growth. Think Amazon, Tesla, Facebook.
“Blend” companies are somewhere in the middle.
S&P 500 indexes learn more towards the large-cap companies – which makes sense. A total index fund like $VTSAX will skew about 10% more towards small and medium cap companies. Historically these have performed about the same, so either is a good choice. $VTSAX is the more diversified choice since it invests in more companies.
One fund portfolio allocation:
| Sector | Amount |
| US Equities | 100% |
| Fund | Amount |
| $VTSAX or $VFIAX | 100% |
Pros:
- Super easy to do! Just one fund!
- Great when you’re getting started investing. You could invest in just this one fund until you have 1 year’s salary saved up and not even bat an eye.
- Historically the best performing 1-fund portfolio you could get based on the risk-reward.
- You can continue to invest any more money into this fund and keep it growing.
- Best suited for people with at least 10-20 more working years ahead of them.
Cons:
- The highest risk, but also the highest reward
- In years where the US underperforms, you’ll have a bad time.
- If you have a lot invested, it’ll have large swings
The 2 Fund Portfolio
This is where you’d bring in bonds. There are a bunch of different types of bond funds you can invest in – US bonds vs International, short, mid and long term treasury bonds, private company bonds, local bonds and more. To start, stick with a fund that invests in ALL of them like $VBTLX, Vanguard Total Bond Market Index Fund Admiral Shares.
Ok, so how much do you allocate towards bonds and how much towards US Stocks?
Let’s look at the returns again for a portfolio of stocks and bonds:
| Asset Allocation %(Stock/Bond) | Worst Year | Best Year | Avg |
| 0/100 | -8.1% | 32.6% | 5.3% |
| 10/90 | ~-9.1% | ~31.3% | ~6% |
| 20/80 | -10.1% | 29.8% | 6.6% |
| 30/70 | -14.2% | 28.4% | 7.1% |
| 40/60 | -18.4% | 27.9% | 7.7% |
| 50/50 | -22.5% | 32.3% | 8.2% |
| 60/40 | -26.6% | 36.7% | 8.6% |
| 70/30 | -30.7% | 41.4% | 9.1% |
| 80/20 | -34.9% | 45.4% | 9.4% |
| 90/10 | ~-39% | ~49.8% | ~9.7% |
| 100/0 | -43.1% | 54.2% | 10.1% |
I’d split these into three categories:
70% – 100% stocks are great for long term investing. The longer your time horizon and the higher your risk tolerance, the higher the percentage you should put in stocks.
We’re going to look at a few sample portfolios in lesson 4, Popular Asset Allocations. One common theme in them is a portfolio of 90% stocks, 10% bonds when you’re growing your investments. When I was working and investing, I kept my bond allocation between 15% and 25% most of the time.
Most investment advice you’ll see online mentions lowering your stocks significantly in retirement. Depending on how long your time horizon is, this may be detrimental though! Think about this:
Let’s say you want to spend $80,000 a year in retirement. To do that, you’d need to save up and invest somewhere between $2,000,000 and $2,666,666 to use a withdrawal rate of 4% or 3% respectively. The closer to the $2 million mark you are, the more aggressive you’ll need to invest – leaning towards the 100% stock side
If we take a look at this amazing graphic by Big Ern over at EarlyRetirementNow, it showcases this.
This graphic looks at how likely a portfolio of different stock/bond ratios is likely to survive for a given number of years with a given withdrawal rate. The withdrawal rate is a ratio of how much of your portfolio you live off each year in retirement. A 4% withdrawal rate means you’re cashing out 4% of your total investment portfolio each year. A 3% withdrawal rate means you’re cashing out 3%. I go over the withdrawal rate in the Interactive Guide to Early Retirement and Financial Independence if you want to learn more.
There’s a lot to take in from this graphic. For one, you don’t hit a 100% success rate for any scenario until you lower your withdrawal rate to 3.75% – and even for that, it’s only for a 30-year retirement. If you’re retiring early, you may have to account for many more years.
There’s a lot of talk about the “4% rule” – building up enough assets so you have 25x your spending and then you’ll be set for life. Unfortunately, there’s no allocation where that’s 100% true. With 75% to 100% stocks, you can get close though! With an 85%+ chance of success it’s close.
For me, I’ve retired with a 60-year timeframe and about a 4% withdrawal rate. If I look at the 60-year options here, there’s a HUGE difference between 50% stocks and 75% stocks. Choosing a 75% stock portfolio increases my odds of success by 20%! That’s huge!
Take a look at this chart and try to come up with your ideal placement on it. For me, that’s about 70-80% stocks with the rest in bonds. When I was working it was closer to 90% stocks.
We’ll use 80% stocks with the rest in bonds as a baseline for the rest of this lesson. That puts our sample portfolio somewhere around here:
| Sector | Amount |
| US Equities | 60% – 90% |
| General Bond Fund | 10% – 40% |
| Fund | Amount |
| $VTSAX Vanguard Total US Market or$VFIAX Vanguard S&P 500 | 60% – 90% |
| $VBTLX – Vanguard Total Bond Index | 10% – 40% |
Ok, let’s review the key points.
#1, if you really wanted to, you could invest 100% in a single US Equity fund. It wouldn’t be that diversified, and you’d see huge swings in your portfolio year over year, but it’s still better than not investing at all. Lucky for us that live in the United States, we can invest in $VTSAX and be invested in thousands of US companies.
#2, a bond allocation of between 10% and 30% can significantly lower your risk without a massive change to your potential returns. Most portfolios that we’ll talk about in the last lesson in this course have at least 10% in bonds.
#3, don’t go too conservative on your asset allocation! Many target-date funds put 70% of more into bonds – way more than most people would want. Take a look at the chart from Early Retirement Now again. Based on how long you have to live and how much you plan to withdraw, what would your asset allocation be when you retired?
Bonds are one of the least interesting parts of investing. They don’t shoot up like stocks, and no one gets rich off of them. What they do enable is more peace of mind. The ability to sleep at night knowing that your portfolio’s riskiest parts are offset by something safer.
It’s hard to know what your risk tolerance is until you’ve seen your portfolio fall out from under you. In 2008 I saw my portfolio drop by more than 50% – and that was with some of it invested in bonds. Luckily I was investing with a financial advisor at the time and he encouraged me not just to leave my investments in the market, but to rebalance to stocks, and even invest more. Because of that advice, I was able to prosper from the economic recovery in the following years.
Find that spot that enables you to continue investing without leaving the market. That’s where you’ll make the most money long-term.