(originally posted here∞)

After the last few threads about where to invest, and based on what I'd already planned to do, I put together what I think would be a decent mix of Vanguard funds to have my mom invest in. I'd like comments on what I put together and suggestions for what can be changed.
She will not be putting the majority of her money into this, at least not now. It's main purpose is to get some money out of sight so that she can let it grow for 20 years until she hits 70 and theoretically retires, or at least slows down. The money will be in a regular taxable account.

Also, since she can open a Roth IRA, and it's a good vehicle for inheritance money, I'm going to have her open one with Vanguard. Since she turns 50 in November, I assume she can make "catchup" payments as soon as she opens it. The focus of the IRA will be to let it grow, with no plans to draw from it unless something bad happens during retirement where she will need the money. What would be a good fund strategy for that account? Since she can only buy one fund every 2 years (approx) and avoid the fees they charge, it doesn't need to be a long list ;)


With that said, here's what I came up with. The site says they charge for every fund below $10k, so 4% = $10k (at least as currently planned for her to invest). Again, this is not all of her money that will be going into this.

Parenthesis are for the breakdown of the fund they are in, not separate purchases.

• Total International Stock Index Fund - 10% (European Stock Index Fund - 7.344%)
  (Pacific Stock Index Fund - 3.108%)
  (Emerging Markets Stock Index Fund - 1.548%)
  
• Emerging Markets Stock Index Fund - 4%
• Total Stock Market Index Fund - 20%
• Large-Cap Index Fund - 16%
• Extended Market Index Fund - 5%
• Small-Cap Index Fund - 6%
• Equity Income Fund - 6%
• Energy Fund - 4%
• Total Bond Market Index Fund - 9%
• Target Retirement 2025 Fund - 20% (Total Stock Market Index Fund - 9.42%)
  (Total Bond Market Index Fund - 8.22%)
  (European Stock Index Fund - 1.66%)
  (Pacific Stock Index Fund - 0.7%)

Thanks,

Scott

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Biggest question: are you going to be doing all the work, or does she understand all of the financial concepts herself? I ask because there are a couple major issues here.

(a) What if something happens to you? Would she know how to rebalance? Would she know which funds to withdraw from first? Would she even know all of the account #s?

(b) You're at over 80% equities, which is very aggressive for someone her age. That's probably fine if you're sure she won't need the money for another 20 years, but I have a feeling it reflects your risk tolerance more than it does hers. If her portfolio lost half its value, would she have the gumption to stay the course?

Major question #2: is any of the money in a tax-deffered account right now? If not then by all means start an IRA,* but that's going to be a miniscule piece of the whole for quite some time, so you'll need to find tax-efficient vehicles.

*A standard IRA is probably more appropriate than a Roth. Being in her early 50s she is probably near her peak earning power. Roth-style accrual starts out at a big disadvantage if she's in a higher tax bracket now than she will be during retirement, and 20 years of tax-free growth probably isn't enough time to make up the difference.

As to the portfolio itself, there's a ton of overlap. The whole point of a fund like TR2025 is that you don't have to spend effort drafting and maintaining an asset allocation plan -- "lifestyle" funds in general are designed to be adequate as one's only holding.

Similarly, within a given universe like domestic stocks, some people like to "slice & dice" while others just hold Total Stock Market. Pursing both strategies at the same time doesn't make sense to me since it means you take on the complexity of S&D without the [potential] upsides. You also lose potential access to Admiral shares.

Assuming pessimistic answers to my questions, my suggestion is to just use TR2025 for everything. The only time I see that being suboptimal is if her accounts are split about evenly between taxable and retirement, in which case there's no good place to put a balanced/lifestyle fund: its bonds would be best if tax-deferred, while its stock indexes would do just fine in taxable. In a case like that, I'd still keep in simple:
TSM 40%
Tax-managed Intl 20%
TIPS 40% -- in IRA

If she doesn't have enough room in her IRAs to fit the bonds, then you have to crunch numbers to see whether munis would be appropriate for the remainder. I-bonds would also work for tax deferral.

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So it's for her heirs? If so, talk to an estate professional, but my guess is she'll get better mileage by funding their Roths than by starting her own. There's no avoiding the up-front tax bite either way.

So use TR2035 or TR2045 :confused:

Right now, it's not making much difference at all. TR2025's ratio will change about 25% in the next two decades, but it's only 20% of this portfolio, which you're describing as a small piece of the whole puzzle...all you're doing is adding complexity and tax-inefficiency.

Good idea, but that's not what you wrote. TR2025 has all of TSM. LC index + SC index = the whole TSM duplicated yet again. Then you have VEXMX thrown in sort of randomly. (Intl and bonds show the same general confusion to a lesser degree.) Let me go ahead and X-Ray∞ the whole thing:

23 28 17
07 07 07
04 04 03
64% US stock / 18% Intl stock / 18% bonds.

Meanwhile, here's TR2035:

25 29 20
06 06 06
03 03 02
62% US stock / 15% Intl stock / 21% bonds.

So 9 extra funds later, all you have is an insignificant tilt toward small/midcap, a small tilt toward Emerging, and a small gamble on Energy. Your asset classes are correlated enough that I don't think there'd be a rebalancing bonus, but even if there were, the implementation looks difficult. If Large Growth has a big year, do you rebalance away from VLACX, VTSMX, or VTTVX? If Small tanks, do you buy more NAESX or VEXMX? I'm having a hard time deciphering it all.

No such thing. In taxable accounts it's always important to use tax-efficient securities & strategies, especially given her bracket; otherwise taxes will eat her lunch. That means TSM, I/EE or tax-exempt bonds, tax-managed versions of inefficient asset classes like SC and Intl. It also means rebalancing goes out the window, especially in your portfolio since your correlations are high.

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Yes. My point wasn't that you should hold TR2035 in a taxable account (you shouldn't -- forget future gains, the bond income alone will kill you). It's that your asset allocation lacked focus. You managed to add 10 funds and convince yourself they were giving you advantageous weights in various directions, when actually you ended up right where you started.

That's not to suggest your porfolio wouldn't meet your goals. It probably would. But it indicates you need to think a bit more about what your goals are, what they imply for your AA, then draft a plan that makes the most sense for all involved.

Another tidbit: since this is going to be a bulk purchase, you should consider using VIPERs instead of traditional mutual funds. Then rebalance using her SEP, Roth(s), and individual bonds.

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It's not a matter of "too many," it's a matter of picking a target allocation and then finding the fund combo that makes the most sense.

Why 2 smallcap funds? Why 3 largecap funds? And then TSM on top of it all? I honestly can't figure out what you're trying to do.

Good plan. An idea, though -- what state does she live in? Vanguard (and others) have muni bond funds that would make things much easier than maintaining your own ladder.

FYI, the recent bills to eliminate the "death tax" would also eliminate the step-up. So there's a potential for people who need to sell inherited assets to pay more tax (!). The only certainty is that everyone will need to do more paperwork.

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You asked for it :p

I don't think you've grasped the point...maybe pictures will speak louder than words....

In general, the possible advantages from adding more funds are:
(1) diversify (into new sectors, new countries, or even new types of securities∞)
(2) slice & dice uncorrelated asset classes ("rebalancing bonus")
(3) overweight asset classes (e.g. value tilt)

That's in order of your likelihood of getting a "free lunch" -- better returns and less risk. Diversifying almost always gets you both. (2) gets you less volatility and slightly improves returns over most (but not all) data sets. (3) is almost never a free lunch; people overweight things like value stocks or emerging markets because they want to take on more risk in hopes of potential outperformance.

Your choices so far have rarely provided any of the above. Here's what I mean by uncorrelated, BTW:


Green is large, blue is small, red is REIT. Largecap & smallcap are different enough that everyone should own both. But despite large's huge rally in the late 90s, the fluctuations in the curves are fairly similar. It would be worthwhile to rebalance between them only if you could do so without many fees, e.g. in an IRA or using new money to Dollar Cost Average.

Commercial real estate, OTOH, is very uncorrelated -- not even the ubiquitous zigzags bear much resemblance. (In fact, emerging markets∞ track U.S. stocks better than U.S. REITs. That's because they are dominated by huge growthy companies, like any other total market index.) So REITs make great diversifiers, combining equity characteristics with high current income -- their dividends typically track 10yr Treasuries. Unfortunately that makes them unsuitable for taxable accounts like yours, but I hope I've illustrated the point.

Meanwhile, back to your porfolio....



The line in the middle is the S&P 500. Yet VMCAX (which targets the S&P 500) diverges from it more than VTGIX (Russell 1000). VLACX (MSCI 750) hasn't been around very long, but look, it tracks the S&P even more closely...



Keep in mind we're zoomed in here, so these already-small differences are actually magnified vs. the first graph. Conclusion: these funds are completely and totally redundant.

To help yourself rationalize away from fund-itis in practical terms, some history is in order. Vanguard introduced VTGIX only because they felt the Russell 1000 was more objective picture of the large-cap universe than the S&P, which is manually screened by a committee.

Similarly, VLACX arrived as part of a larger falling out with Dow Jones (who runs the Wilshire indexes) -- Vanguard felt they had too much arbitrary turnover, so they switched over to MSCI completely. VLACX is intended as a direct replacement for VFINX, a fact made obvious when its subindexes VIVAX & VIGRX switched abruptly from the S&P/Barra 500 value & growth to the MSCI equivalents in 2003. In fact, MSCI's new index reconstitution rules (e.g. to allow limited style drift) make VLACX, VIMSX, & friends almost as tax-efficient as their explicitly tax-managed equivalents, so there's also less difference between the standard and tax-managed families than ever.

As for non tax managed performing better, that's hardly a guarantee. First of all, taxes themselves are a much bigger factor. In addition, the tracking error that comes from tax-loss harvesting, swapping futures, etc. is random, not necessarily negative. Look at the middle graph circa 2000, for instance. Meanwhile, funds like DFA's who explicitly seek out tracking error in hopes of slightly improved returns, via block trading and the like, have underperformed to date. That's not a criticism of DFA, who provide an excellent all-around passive strategy, but it shows that nothing is certain, especially effects like index tracking which are inherently random.

In sum, the various indexes reflect internal improvements, not fundamental differences. If you want to see a technical breakdown, check out my wiki page∞. (Posted it a few times now, don't want to spam...) Using that data, it's easy to sort out the smallcaps:

VEXMX = VTSMX minus VFINX
NAESX = VTSMX minus VLACX minus the tiniest 1% MSCI doesn't consider investable but Wilshire does
VTMSX = IJR.

VTMSX is the clear choice in this category -- NAESX's lower index turnover isn't enough to compensate for tax management and stricter redemption rules, and going by the anti-DJ rationale above there's a good chance VTMSX will switch to MSCI soon anyway. If you want a tax-managed index fund that's more targeted, you'll have to look toward DFA, Bridgeway, or perhaps a Barclays ETF.

Your Intl strategy makes sense to me: own the total market while overweighting Emerging a bit.

As alluded to above, I'm not sure as about the domestics. Here's the X-Ray of your most recent picks:
18 22 15
06 07 08
08 08 06

So you want to overweight small by about 2X, make a small gamble on Energy, and stay style (value vs. growth) neutral. Sounds fine.* Here's a very simple way:
VTSAX Total Stock Admiral 60%
VTMSX Tax Managed Small 20%
VGENX Energy 4%

Voila!
17 24 14
06 07 09
08 09 06

*I'm tempted to advise against a smallcap tilt right now since they're coming off a huge runup, but don't listen to me...at worst, just DCA into it. Write down an asset allocation plan, sign it in blood, and stick to it. Straying from the course is the main way people lose money.

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Looks fine.

If possible I would choose another method for tax-deffering your bonds -- traditional IRA, munis, I-bonds, you know the drill. General rule for tax-inefficient assets: put lower performing assets (e.g. bonds) in tax-deffered accounts and higher performing assets (e.g. stocks) in tax-free accounts. The math is pretty intuitive: Roths start off with lower $$ figures* and make it up by compounding growth. It sounds like she has lots of room in existing IRAs, so it would be nice to save the Roth for inefficient stocks like REITs or small/value or international smallcap or whatever.

Then again, the Roth contribution limits are so low in comparison with her total portfolio that adding fancy new asset classes probably won't make much difference regardless. I say this to remind everyone that despite what it looks like during Internet debates, the objective isn't to make a 100% optimal portfolio or to outpace your neighbor by 0.3%. Pick an AA plan that fits your goals, write it down, and get on with your life.

BTW waiting 20+ years to start gifting money may cost your generation tens of thousands of dollars in taxes, but you probably knew that.

*I won't call it "less money" because 25%+ of the money in 401ks/IRAs isn't really yours.

Yeah...good luck with that. :)

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There's no doubt that energy will cost a lot more in 20 years than today (even in real dollars). It's impossible to know whether governments will continue to subsidize the industry as consumer demand rises (profit++) or governments will impose controls while cost of drilling & refining skyrockets (profit--). And that's just the easy scenarios: if we run into a serious crisis I could see industry getting outright nationalized, or at the other extreme, becoming obsolete as someone else (a government, a private startup, a breakoff member of the industry) develops the Next Big Thing. Nobody knows...meanwhile, the hopes & fears of all the professional analysts who think they know is priced into the market by definition.

Same arguments can be made for VG's other big sector fund (heathcare). Lots of "index diehards" buy both anyway.

Me, I'm a natural contrarian, i.e. more likely to make a bet on distressed markets like Japan; when a sector sees a 100%+ runup like we have in the last couple years, I'm inclined to stay away. Of course, even if it is an irrational price bubble, staying completely out of the market loses you a lot of profit on the way up -- exiting tech in '97 because of Greenspan's famous statement would've lost you more money in opportunity cost than the actual losses suffered by people who bought in early '01. Thankfully, there's plenty of energy stocks in TSM, so you can have your cake & eat it too.

Sorry for the non-answer, but that's life.

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Everyone is free to their own opinion of what the future holds, but the issue of what happens to $25k in real money is not trivial.

I'm not going to argue the merit of chasing hot sectors in Scott's thread, but I know that if that $25k were my money I wouldn't want someone calling its fate "no issue."

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