A reader asked me to expand on the thought process behind my asset allocation choices. I don’t have a highly scientific answer, but here’s how I would explain it to a friend over drinks. Prepare yourself for some rambling…
I know that I could run simulations and backtest return data to figure out exactly which mix of assets have produced the best risk/return characteristics historically. I’ve also looked at various model portfolios based on such analyses. However, perfection can only be seen in retrospect and it is constantly changing. I just try to take away the big nuggets.
The overall goal is to hold asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out.
Stocks Breakdown (Benchmark Ticker)
- 38% US Total Market (VTI)
- 7% US Small-Cap Value (VBR)
- 38% International Total Market (VXUS)
- 7% Emerging Markets (VWO)
- 10% US Real Estate (VNQ)
To put it briefly, I am taking the total markets and increasing the portion of one additional asset class which I think has the highest diversification benefits. For example, Small Value is a subset of Total US market, and Emerging Markets is a subset of the Total International market.
38% US Total Market. Instead of “stocks” or “equities”, I prefer to call it “owning businesses”. It’s not just a ticker blip going up and down. I am buying a diversified mix of real businesses that are a critical part of a huge economy. A single company or even a handful of big companies might go bankrupt, but as a whole they are not going anywhere.
The Vanguard Total Stock Market ETF (VTI) holds 3,600 stocks to represent the entire US publicly-listed market from Apple ($770,000 million) to Bridgford Foods Corp. ($100 million). It is market-cap weighted, which means that the amount of each stock held is directly proportional to the total market value of the company. See my VTI review for details.
7% US Small-Cap Value. Historically, small-cap value stocks have produced a higher risk-adjusted return than the entire market. You could also argue that small companies a more representative of the private business market. Therefore, I choose to hold a little more of this asset class via the Vanguard Small-Cap Value ETF (VBR).
You probably haven’t heard of 99% of the stocks in the Small Value index, which is kind of the point. Someone who invests in individual small cap stocks must be wary of that company going bankrupt (or effectively bankrupt). But by owning 828 of these stocks at the same time, I don’t have to worry about VBR ever going to zero (although it can be relatively volatile). Will VBR outperform VTI by a huge margin? Maybe, maybe not, but it probably won’t lag the overall market greatly either.
VTI can be roughly broken down into 85% Large-Cap companies, 10% Mid-Cap companies, and 5% Small-Cap companies. My blend of 85% VTI and 15% VBR is still roughly 72% Large-Cap and 19% Small-Cap. I have “tilted” the amounts, but it’s still predominantly composed of huge businesses like ExxonMobil, Google, and Johnson & Johnson.
International Total Market. The United States is not the only place where businesses create value. Many brands that you deal with every day are listed in foreign countries – Nestle, Shell, Samsung, Toyota, GlaxoSmithKline, Anheuser-Busch InBev. (Bud Light is a foreign company!) The Vanguard Total International Stock ETF (VXUS) holds over 6,000 stocks from around the world according to market-cap weight. See my VXUS review for details.
I also keep to close to the world market-cap split with 50/50 US/non-US. If you want to go 70/30 or 60/40, that’s perfectly fine with me. Again it’s more important that you stick with it than any specific ratio.
Emerging Markets. Within the foreign markets, I choose to put extra money towards Emerging Markets – countries that currently include China, Taiwan, India, Brazil, South Africa, Mexico, Russia, Thailand, and Malaysia. Again, this asset class is more volatile but also has higher historical returns. The Vanguard FTSE Emerging Markets ETF (VWO) allows me to track this asset class in an efficient and low-cost manner. If there were better options for International Small Value stocks, I would have been open to that.
VXUS is 43% Developed Europe, 30% Developed Pacific, 19% Emerging Markets, and 7% Canada. My blend of 85% VXUS and 15% VWO is 37% Developed Europe, 26% Developed Asia, 31% Emerging Markets, and 6% Canada. Again, it’s not a huge tilt.
(Exit option: If something happened to me and my wife wanted to simultaneously simplify the portfolio, reduce the overall risk level, and generate cash, she could simply sell off my US Small Value and Emerging Markets positions that make up ~10% of the entire portfolio. The resulting portfolio would still be diversified.)
Real Estate. The Vanguard REIT ETF (VNQ) holds publicly-traded real estate investment trusts (REITs) which hold things like office buildings, hotels, apartment complexes, nursing homes, self-storage units, and shopping malls. I choose not to be active in residential real estate other than owning my own home, so I like the diversification and income that this asset class provides.
I am sticking with domestic REITs for both simplicity and lower costs. REITS only make up about 7% of my overall portfolio. I might include foreign REITS if it was a larger holding, but I’m going to bother splitting up 7%.
Bonds Breakdown
- 50% High-quality, Intermediate-Term Bonds
- 50% US Treasury Inflation-Protected Bonds
I keep roughly 30% of my portfolio in bonds. This is meant to be the stable ballast of my portfolio, but it should also generate some level of interest income. Bonds are debt, so I only lend money to the places that I think will pay me back most reliably:
- US government, which can both tax residents and print the world’s reserve currency. This includes US Treasuries, FDIC-insured bank accounts, and US Savings bonds. Treasury Inflation-Protected bonds also offer an interest rate that adjusts with inflation.
- Local municipalities, which can tax residents. If you don’t pay your property taxes, they take your house. “Muni bonds” currently offer the best tax-effective yield for my situation. I hold them through low-cost, actively-managed funds like Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX). See, I’m not only about index funds!
I exclude investment-grade corporate bonds because I don’t see enough benefit in taking on extra risk in this manner. I’d rather get 3% dividend yield through stock ownership (which includes unlimited upside potential) than get paid 3% interest (with no upside potential). Corporate bonds don’t have the company interests aligned with you – they want to appear stable and pay as little interest as possible. I’m not overly trusting of bond rating agencies in general.
I also exclude international bonds because what’s the point of diversifying to get a significantly lower interest rate? Vanguard US Total US Bond Market ETF (BND) has a current SEC yield of 2.43%. Vanguard Total International Bond ETF (BNDX) has a current SEC yield of 0.74%. Blech!
Recap. At a basic level, I own baskets of US businesses, international businesses, real estate, and high-quality debt. I plan to eventually spend the dividends from the businesses, rent from the real estate, and interest from the loans. I expect the stock dividends and rent to increase faster than inflation. I expect that the bond interest will at least keep up with inflation. This mix makes sense to me and I believe I can hold it through the ups and downs. It is not perfect but it is good enough.
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Thanks for sharing, Jonathan. My portfolio is very similar to yours.
I own REITs, but a smaller percentage, because I’m not interested in being a landlord and want to share in the returns of real estate. Some people say there’s enough REIT exposure in VTI and VXUS, but I also prefer an additional allocation.
I don’t own any VWO, as I’m happy with the emerging markets portion in VXUS.
I try to pick mostly active managers with bonds and I am having mixed success with that. I believe bond managers can add value, but it is of course difficult to find those who will add value going forward.
About 20% of my bond allocation is international, just a personal preference.
Thanks for your comment. I have done a bit more digging and added the following paragraph to my original post:
In terms of active bond managers, I enjoy reading the writing of Jeffrey Gundlach but in my portfolio I still tend to go with low-cost active bond funds. I feel that low costs are forever, but bond kings can go in and out of style.
Am I missing something, or does the muni-bond index fund seem really expensive? A 1.9% yield, but an expense ratio of .19%. If a stock fund charged 10% of its yield you’d be outraged!
This isn’t a knock on this fund–but rather bond funds in general.
It’s true, bond yields are quite low right now. I link to the investor shares ($3,000 minimum) but I actually own the VWIUX Admiral shares ($50k minimum) which has an expense ratio of 0.09%. Unfortunately, since it is an active fund Vanguard doesn’t offer an ETF version at the Admiral share cost level. And remember, that 1.9%/2% yield is exempt from federal income taxes which can be up to 40% depending on your bracket.
Thanks for pointing out the Admiral one! I’m hesitant to get into munis because they aren’t as liquid as treasuries. The admiral one seems like a worthwhile trade off between liquidity and yield though. I’ll definitely be exploring it some more
Excellent, excellent post. Thanks for still helping out us newbies.
I hope you found it useful 🙂
Great post as usual I am a big fan of the blog And the kicker is I completely disagree. My retirement money is in Target 2045 funds now. I have started looking at rental property and have 1 now. I wonder if all this asset allocation gives us false sense of control when we don’t actually have any. I feel I am more in control with real estate (though this is top of market likely) than any tinkering with the stock/bond allocation.
I view being a landlord as more of a job that can have a high per-hour rate. For those that enjoy it, it can be a great way to build wealth. I don’t knock it, but I don’t want to do it either.
Control is an illusion 🙂 Yes, you may have more control over some things, but you also can’t control if you get a squatter tenant who stops paying rent and knows how to use your local tenant laws to their advantage and squeezing out several more months of free rent. My stocks also can’t sue me for mold in the house. My friend’s condo is vacant again for another month right now because the person backed out at the last minute.
The best part about real estate is that you can’t just make a couple mouse clicks and sell. Real estate lends itself to longer holding periods and thus long-term wealth generation.
Thanks for the writeup! Quick question: How can you put monthly contributions on autopilot and maintain a balanced portfolio?
The only truly hands-off autopilot methods currently are either setting up automatic transfers into a fund that maintains a balance for you (such as the Target Date ones), or paying a fee for one of the many robo-advisors do do this on your behalf.
That said, you can use tools like the nifty spreadsheet Jonathan shared to make the process (which doesn’t need to be done very often) quite straightforward: https://www.mymoneyblog.com/simple-portfolio-rebalancing-spreadsheet-tool.html
We have some auto-contribution set up int the 401k, but most of our investments are manual. I don’t automatically re-invest interest and dividends but instead use the cash accumulated + other savings and buy things at least quarterly in the asset classes need to go back to the target allocation. I use this spreadsheet:
https://www.mymoneyblog.com/simple-portfolio-rebalancing-spreadsheet-tool.html
I wouldn’t aim for perfection, you can always rebalance annually or whenever if things get too out of whack.
Great stuff. I’ve been following you for a few years and I appreciate all your posts.
Question for ya. Why do you hold so much in bonds being that you’re so young? Is it because you want an early retirement and therefore some downside protection? Bonds do provide diversification but over the long term can dilute returns, especially when we take into consideration time and compound interest.
My personal opinion is a little bonds/cash is always good. You could say you have 100% stocks + a 6 month emergency fund but that could also be called 90% stocks 10% cash, etc. On the flip side, a little stocks is always good. I think Harry Markowitz said you should always be somewhere between 25% stocks/75% bonds and 75% stocks/25% bonds. I don’t necessarily agree to those exact numbers but that’s the general idea.
Yes, I have a relatively high bond allocation because I expect to start living off my portfolio in a few years. I want it to have enough ballast that even a 50% drop in stocks won’t affect my day-to-day living. If my retirement was 30 years away, I’d probably be closer to 85% or 90% stocks.
Makes sense. Thanks for the quick reply. Follow up question to your fund selection as they’re mostly index founds. Not sure what the exact proportion is nowadays but they usually say 90% of the time, index funds will outperform managed funds. Have you looked into the small percentage of managed funds that might outperform index funds over the long term, net of expenses? Curious to know what they might be.
Hi MMB,
Thanks for sharing your portfolio with us. I was wondering, isn’t there some overlap between the VTI/VBR/VNQ and VXUS/VWO? How do you account for that?
I agree with you that perfection is the enemy of the good. While I have been guilty of it too, relying too much on the past, or relying too much on backtested models could produce perfection that is illusory at best ( since the future will not fit into the same mold as the past)
Yes, there is overlap and I just account for it by looking inside. VBR is 2.5% of VTI. VWO is 19% of VXUS. VNQ is 3% of VTI.
For example, VTI can be roughly broken down into 85% Large-Cap companies, 10% Mid-Cap companies, and 5% Small-Cap companies. My domestic stock blend of 85% VTI and 15% VBR is still roughly 72% Large-Cap and 19% Small-Cap after taking into account all the stuff inside both ETFs. I don’t think there’s anything inherently wrong with overlap as long as you acknowledge and adjust for it.
Thanks for the share! I had a few questions to further dive into your VTI and VBR holdings.
What was your logic behind going with VBR instead of VB or VBK? Also, I understand that VTI and and VBR give you a pretty nice exposure to large and small cap companies. However, how come you didn’t seek to increase your holdings in mid cap companies? Is a median amount of mid cap companies provided in your VTI holdings enough to give you diversification between large/mid/small cap?
Thank you!
Mostly, I wanted a little “spice” to my core US Total holdings and it seems like Small Value stocks would be the “strongest” spice. High volatility, high historical returns. I didn’t want to make things more complicated than that. It is quite possible that a more heavily sliced-and-diced portfolio may perform better in the future.
Thanks for the info. Regarding international small cap stocks, I use VSS for that to get some international small cap exposure.
VSS is a good alternative that I did consider instead of VWO. I do wish there was a international value fund. However, I can’t really predict which will have the higher performance over the next 10, 20 years.
Jonathan, based upon the number of comments that you received on your article in such a short period of time, you must have quite a following. Congratulations!
Your timely replies to our comments are also appreciated.
Jon, Speaking of bonds – I was laughed at when I bought savings EE savings bonds years ago through the payroll deduction because they only paid 4%. Now every month a $500 bond matures that I paid $250 for 30 years prior. The banker cashes them for a little over $1000. It’s a nice bump to my retirement income.
Johnathan..
Would you mind doing an intro into investing into REITS? Id like to start but not sure where to start. Thank you.
I also have Vanguard Total Market and Vanguard Small Cap Value as my only domestic stock positions. I’ve never figured out a rational way to calculate what % of each I should have. Just curious how/why you decided on 85-15%? If Small Cap is 5% of Total, then Small Cap Value is 2.5%, so you multiplied that by 6? The total Small Cap Value portion of your domestic stock portfolio is 17% (.025x.85 + .15), which is a tilt multiple of 6.85 (.17/.025)?