Overview: Determine your asset allocation: your stock to bond ratio. Stocks carry more risk but also more reward. Once you’ve decided on an allocation, stick with it. Don’t plan on changing your allocation but once a decade or so. Keep your allocation consistent across your entire portfolio. A simple spreadsheet or a free service like Personal Capital can easily show you where to add or remove funds to keep your allocation within the target upon which you’ve decided.
Your asset allocation is the breakdown of how your money is invested. It’s generally stocks and bonds, but also includes alternatives like real estate and precious metals.
Stocks carry more risk than bonds, so investors are compensated for this higher risk with higher returns. Bonds tend to balance out the risks of your equity position (stocks) and have lower returns. Again, this is all personal, but you’ll need to select a stock and bond mix that gives you both the returns you want while also allowing you to sleep at night. A common rule of thumb is “Age in Bonds”. As you age, you increase your bond holdings and gradually get more conservative. People recommend this so you don’t get hurt as badly by a sequence of returns risk (having a large down/bear market just prior to or right after retirement). Following the age-in-bonds method, if you are 20, have an 80/20 stock to bond split, and if you are 60, have a 40/60 split. This is fairly conservative, but probably something you should consider as it’s what John Bogle (founder of Vanguard) advises. Another good rule of thumb is to never have more than 75% or less than 25% bonds.
Target Date Funds
A simple approach to all of this is to simply pick a target date fund. These are “funds of funds” that a broker like Vanguard or Fidelity manages for you. They get more conservative as you age. A 2050 fund will have more stocks in it than a 2020 fund, for example. They tend to have low expense ratios, but not as low as buying individual funds on your own, described below. Lot’s of “pro’s” might scoff at Target Date Funds, but they help people stay the course, are professionally chosen, affordable, and keep people within the bounds of normal investing lanes. When investors have 30 or 40 funds, some being very obscure, they could be helped by the simplicity of Target Date funds.
You don’t have to pick a target fund based on your own retirement date. Maybe you will retire around 2050 but prefer the mix of funds offered in the 2030 fund. When you find the stock to bond allocation you are happy with, buy the fund that matches that allocation.
Buying Individual Funds
To lower fees even farther than the Target Date funds, you can buy individual funds. In this way, you can make up your own stock to bond ratio and control that ratio very precisely.
Once you’ve chosen your stock to bond split, say 60/40, an easy way to determine the rest of the breakdown of your allocation is by visualization. The Finance Buff offers this helpful chart. Of your 60% stocks, break them further down into US vs International, Large vs Value, etc. Your bond allocation helps reduce risk in your portfolio. For this reason, I’d avoid things like risky junk bonds. Take your portfolio risks in stocks, not bonds. Bonds can pay nominal interest, which is not indexed to inflation, or real interest, which is indexed to inflation. VBTLX pays nominal interest and a TIPS fund provides real interest, and are both good options.
Asset Location
For asset location, keep tax efficiency in mind. Most bond funds pay dividends which get taxed at your marginal income tax rate. Those should usually be placed in tax sheltered accounts like a 401(k) or IRA. In very low interest rate times, bonds could be placed in a taxable account, simply because their taxable gains will be very low. Some bond funds have federally tax free dividends, like municipal bonds (munis) which are good for taxable accounts. Quality stock index funds are naturally tax-efficient. They have low turnover, qualified dividends (dividends taxed at capital gains rates instead of your income tax rate), and long-term capital gain rates (LTCG) which is either 0%, 15%, or 20% based on your tax bracket.
Also, with allocation and location, it makes the most sense to have one asset allocation across your entire portfolio. If you have a 401(k), an IRA, and a taxable account, treat all of those as one account when it comes to allocating your fund percentages.
For Example
Suppose you have $100k in retirement savings, with $40k in your 401(k), $40k in your Roth IRA, and $20k in your spouse’s Roth IRA. You’d like to invest in a high quality US stock index fund (VTSAX), a high quality international stock index fund (VTIAX), and a high quality US bond fund (VBTLX) and have decided in a 50/20/30 split.
Take your total retirement savings ($100k) and multiply by .5, .2, and .3 to see how much money makes up your asset allocation. Start by “filling the 401(k) bucket” first, then fill the two Roth accounts. The 50/20/30 means you want $50K in the US stock fund, so all $40k of your 401(k) should be used to purchase a stock fund. Many 401(k)s are notorious for having poor quality funds at high ERs, but most will have a stock index fund like the S&P 500. Use all $40k to buy that fund.
You still need to buy $10k of US stock, so use the first $10k of your $40k IRA to buy the additional $10k of US stock. Your target said you’d like $30k in bonds (30% of $100k) so use the remaining $30k in your IRA to buy a high quality US bond index fund. Finally, your plan called for $20k in international stock. You can use the $20k in your spouse’s IRA to buy the last $20k needed to finish out your asset allocation.
There are more in-depth examples and explanations of this here.
A final note on gold in your asset allocation. Centuries ago, an ounce would buy a man’s suit. Today? An ounce will buy a man’s suit. Gold is for hedging inflation, not investing. If I had 20-30 million in investments, I might consider a monster box of gold worth over $1,000,000 in 2023. I don’t, however, think it’s a good investment for investors who aren’t yet in the two-comma club in assets.