______ % of my portfolio will be in fixed income investments and the remaining _____ % (1- fixed income %) will be in equity investments. The total should be 100%.
- For simplicity, throughout the rest of this post, we will assume that the asset split you choose is 30% fixed income and 70% equity.
So, you know that 30% of your investments should be placed in fixed-income vehicles. However, which ones should you choose to make up this 30%?
- No matter what the time horizon is for when your specific cash needs will occur, academic research has shown that short-term fixed income investment instruments have 1) less interest rate risk, and 2) higher returns.
- Because of these two factors, short-term (1-3 maturities) fixed income investments are considered superior to long-term ones.
- Fund Management
- As with equity investments, the fixed income security markets are extremely efficient, and therefore, active management is a loser’s game.
- Because of this, we will only want to seek out indexed/passively managed fixed income instruments for our investments.
- In my opinion, there are really four different options available to you as an individual investor for the fixed income portion of your portfolio:
- Cash / cash equivalents
- This category would include extremely liquid investment account types.
- Examples include money market accounts, savings accounts, and checking accounts.
See following link to read my previous posting on these types of accounts – My Money Blog – Cash Equivalent Savings Accounts.
- Short-Term Indexed Bond Funds
- Offered by Vanguard and Fidelity. Vanguard fund I use is the Short-Term Bond Index, Ticker symbol – VBISX. Vanguard Bond Index Funds
- Feature low cost, passive management and expense ratios.
- Inflation Protected Bond Funds
- Also offered by Vanguard and Fidelity. Vanguard fund I use is the Inflation-Protected Securities fund, Ticker symbol – VIPSX.
- This type of investment instrument provides a hedge against changes in inflation.
- The interest rate associated with the bond fund changes with fluctuations in inflation.
- US Treasury Securities
- Can be used in place of Short Term Indexed Bond Funds. Personally, I prefer to use indexed bond funds due to the fact that they are offerred by Vanguard, and it therefore, keeps all of my investments in one place.
- Bought directly from the US government/treasury.
- Backed by the full faith and credit of the US goverment, and are therefore, very safe investments.
- Still have interest rate risk associated with them, however.
- Select the cash % allocation of your total portfolio, according to the first row of the table.
- Assume that you will allocate 5% of your total portfolio to inflation protected securities.
- Subtract the cash % and 5% inflation protected securities allocations from the overall fixed income allocation you calculated (in previous posts) to obtain the % of your portfolio that will be made up with a short term index bond fund.
For the 30% fixed income / 70% equity asset allocation example above (assuming the investor is below 60+ years old) –
- 5% of your overall portfolio would cash
- 5% would be inflation protected securities
- 20% (30%-5%-5%) would be index short term bond funds.
Note: The data is this table is taken from pgs. 350-351 of Malkiel’s famous book,
A Random Walk Down Wall Street. If you haven’t read it, click on the link to the left to pick up a cheap used copy from Amazon.com.
In Part 4 of this series, I take everyone through how to figure out your specific mix of index funds for the equity portion of your portfolio.
Keep on learning!
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