Index Mutual Funds, Current Asset Allocation, and Investment Strategy

Note: This post will serve as a running list of topics and updates related to mutual funds, asset allocation, dollar value vs. dollar cost averaging, and retirement investing accounts. The advice here should not serve to replace the advice of a financial professional, but rather is to give you some ideas to talk about further with your financial counsel.

Asset Allocation –

As a result of reading the books listed in the Financial Book Review post of my blog, I came up with the following target asset allocation percentages, based on my long-range view of investing and being young/able to tolerate high levels of risk.

% Equity = 75%
% Cash/fixed income securities = 25%
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Total Portfolio = 100%

For the equity portion of my portfolio, my target split is shown below:

% US Domestic Equity = 71% (71% x 0.75 equity = 53% of total portfolio)
% International Equity = 29% (29% x 0.75 equity = 22% of total portfolio)
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Total Equity Portion of Portfolio = 100%

To further break this down in to subcategories so we can select INDEX mutual funds to give us exposure to these areas, the books recommended the following %’s.

Detailed Allocation Calculations
1. % Cash (money market target 5%)
2. % Non-Inflation Protected Short Term and Intermediate Bond Funds (avoid long term bond funds) (target 15%)
3. % TIPS Bonds (Inflation protected bonds -target 5%)
4. % International Equity (Target 11%)
5. % International Emerging Markets (Target 11%)
6. % Domestic Large Cap (Target 8%)
7. % Domestic Small Cap (Target 8%)
8. % Domestic Small Cap Value (Target 14%)
9. % Domestic Large Cap Value (Target 13%)
10.% REIT (Real Estate Investment Trust – target 10%)
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Total Net Worth = 100%

Recommended Vanguard Index Funds for These Categories – All of these have very low fees, and since they are index mutual funds, you will have higher returns than 70% of investing professionals with active management. You can open an account with Vanguard very easily at http://www.vanguard.com/. There are generally no commissions/fees for buying Vanguard funds through your Vanguard account. All funds require $1000-$3000 of initial principal to buy a particular fund.

1. Cash – place in Dollarsavingsdirect.com high yield savings account – see blog post titled, Favorite Online Savings Accounts.
2. Vanguard Total Bond Market Index (MUTF:VBMFX) and Vanguard Short Term Bond Index (MUTF:VBISX)
3. Vanguard Inflation-Protected Secs (MUTF:VIPSX) – Note: this is an actively managed fund.
4. Vanguard Total Intl Stock Index (MUTF:VGTSX)
5. Vanguard Emerging Mkts Stock Idx (MUTF:VEIEX)
6. Vanguard Total Stock Mkt Idx (MUTF:VTSMX)
7. Vanguard Small Cap Index (MUTF:NAESX)
8. Vanguard Small Cap Value Index (MUTF:VISVX)
9. Vanguard Value Index (MUTF:VIVAX)
10.Vanguard REIT Index (MUTF:VGSIX)

Investing New Money when it Comes In –

So, I’ve bought the funds listed above, now what do I when I get my paycheck each month and have new money to invest? There are essentially two ways to do this exercise.  This is where dollar-value averaging and/or rebalancing comes in to play!

Portfolio Rebalancing


Portfolio is the process of maintaining the recommended allocation target %’s listed previous in order to maximize return and minimize risk. The rule I follow for when to rebalance is called the 5% rule. For example, the target allocation % for the REIT part of your portfolio is 10%. Following the 5% rule, you would rebalance the portfolio either by selling shares or contributing more money depending on whether the current % of the total portfolio was 15% or 5%, respectively.

As a general rule, I try to avoid selling shares of mutual funds (even in tax-sheltered accounts) frequently in order to perform rebalancing. Instead, when new money comes in, I buy additional shares in other funds if as needed to maintain my targets.

However, a full rebalancing of your portfolio should be 1X to 2X per year, unless your allocations targets are already aligned from keeping it up throughout the year with monthly investments.

Dollar Value Averaging


Another method of maintaining your portfolio/deciding how much money to invest and when is called dollar value average. This is similar to it’s cousin, Dollar Cost Averaging, but I believe it is slightly more effective.

In Dollar Cost Averaging, the idea is that a constant amount of money is invested each month in to your account, and therefore, will buy MORE shares when the market is down and LESS shares when the market is up.

However, in Dollar Value Averaging, the idea is to meet portfolio value goals that you pre-define at regular intervals throughout the year. For example, say you just bought the S&P 500 index mutual fund with Vanguard in your Roth IRA for $3000 in 2009. In 2010, you plan to contribute $200 per month to the fund for all 12 months. Therefore, you would then lay out value targets throughout the year as follows.

End of Month
Jan     $3200
Feb    $3400
Mar   $3600
Apr   $3800
May  $4000
etc

At the end of the month, you assess the current value of the portfolio and compare it to the targets above. For example, if at the end of Jan, the fund is worth $2900, you would then contribute $300 instead of $200 in order to force yourself to buy more shares when the market goes down. Continuing with this example, so we invested $300 at the end of January. Then, at the end of Feb, the market has gone up a lot and we find that the value of fund is currently $3500. Since it is over our target, we would then invest nothing in the stock fund, and instead place the investment money in a cash or fixed income security. Make sense?

In my opinion, I believe that Dollar Value Averaging works best with a one mutual fund portfolio. Since I own a lot of mutual funds, I tend to steer clear of using it because it would be hard to apply to my situation.
Keep learning!

Student