Age-based models for determining the bond/stock ratio in an investment portfolio are a popular strategy for managing risk and optimizing returns over time. The principle is to allocate a higher percentage of your portfolio to bonds as you age, reducing exposure to the more volatile stock market. This model aims to decrease portfolio volatility as you near retirement, protecting your nest egg from market downturns. Historically, bonds have been less volatile than stocks, providing a safer investment as you age.
However, this approach simplifies the patterns of human capital dynamics and overlooks the volatility of your human capital and its dependency on other assets, such as rental income and stock plan compensation, varying risk tolerance, financial goals, and market conditions.
Evaluate the stability and volatility of your human capital, including job security, income variability, and other financial commitments. Incorporate other income sources and assets into your investment strategy. For example, if you have stable rental income, you might afford a higher allocation to stocks. By integrating these elements, you can create a more robust and personalized investment strategy that better matches your unique financial situation and goals.
A common rule of thumb is to subtract your age from 100 (or 110) to determine the percentage of your portfolio that should be in stocks. For example, if you are 30 years old, 70% of your portfolio should be in stocks and 30% in bonds. This approach aims to balance growth potential with risk management, as bonds typically offer more stability and lower returns compared to stocks.
Assuming an 80/20 stock/bond split, the next step is to determine the allocation between US and international (ex-US) stocks. Vanguard recommends a 60/40 split, but anything in the range of 20-40% international is acceptable.
The stock/bond allocation depends not only on your retirement horizon but also on how close you are to your capital accumulation target and your personal temperament. If a market crash tempts you to sell stocks, it may indicate a need to shift more towards bonds. Understanding your risk tolerance is fundamental. The most important aspect is having a plan that you will adhere to, regardless of market fluctuations.
However, focusing solely on bonds and stocks overlooks the potential benefits of diversifying into other asset classes. Including a variety of asset classes can improve portfolio performance and reduce risk through diversification.
So, consider whether to invest in additional asset classes. real estate investment trusts (REITs) behave like a third asset class,76 so let’s include a small investment in REITs for diversification. Since REITs are stocks, they will be part of our stock allocation. We’ll allocate 5% of our total portfolio to REITs.
Our model portfolio looks like this: 75% stocks, 20% bonds, 5% REITs.
Applying the 60/40 US/ex-US split, we get:
If your choice of funds is limited, such as in a 401(k) or HSA, and does not include a total U.S. stock market fund, you can replicate the total U.S. market using the Institutional Index Fund (which tracks the S&P 500) and the Extended Market Index Fund (which tracks the remainder of the U.S. market, S&P Completion Index). To replicate the total market, these funds are typically held in an 80/20 ratio. However, Vanguard recommends a 70/30 ratio. This results in:
This allocation aims to closely mirror the performance of the total U.S. stock market by combining the large-cap exposure of the S&P 500 with the mid-cap and small-cap exposure of the Extended Market Index.
For international investments, the split is between developed and emerging markets. Vanguard Total International Stock ETF (VXUS) is essentially a combination of Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets ETF (VWO), as they all track FTSE indices. However, consider the expense ratios: VXUS has an expense ratio of 0.07%, VEA is at 0.05%, and VWO is at 0.08%. In the VXUS blend of VEA and VWO, VEA is the larger component. You can replicate VXUS by purchasing approximately $3 of VEA for every $1 of VWO, reflecting the market capitalization ratio of developed to emerging markets. While insignificant, this split allows rebalancing between these classes.
There are no shortcuts in investing. Avoid get-rich-quick schemes and be wary of anyone claiming they can beat the market or achieve higher returns with lower risk.
For an 80/20 stock/bond ratio, the allocations would be:
Total:
To either of the above, add a money-market fund for cash reserves (such as Vanguard Federal Money Market Fund (VMFXX)), if you don’t have a savings account that earns a high interest rate. This represents a highly simplified, institutional-grade, low-cost structure. Historically, such passive index strategies have a high probability of outperforming actively managed portfolios. If you meet the investment minimum, prefer Vanguard’s Admiral Shares to the Investor Shares. They contain the same holdings, but have a lower expense ratio.
Debt (such as a mortgage) is a negative bond. If you hold any debt, you probably don’t need bonds in your portfolio. Making a debt payment has a rate of return equal to the interest rate of the loan, just like a bond.
Paying down debt increases your net worth the same as buying a bond does, the only difference is that in the former case, your net worth is negative. But paying down debt still increases your net worth (which is your ultimate goal).