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Friday, 9 May 2008

How to Build a Simple, Low-Stress Portfolio

By Andrew Gunter

It has been about a year since subprime contagion swept the nation, and what a year it's been. We've seen a gold rally, fast and deep interest-rate cuts, and oil prices that remain stubbornly near all-time highs. The uncertainty has taken its toll on stock markets: From May 2007 through April 2008, the S&P 500 lost about 4.7%. Much of the pain came in this year's first quarter, the index's worst in more than five years.

This return of heightened volatility in both stock and bond markets has prompted a lot of worried questions from our readers regarding what kind of overhaul might be appropriate for their portfolios. But making big adjustments to your portfolio based on short-term market news is rarely a good idea. Instead, investors attempting to get their sea legs amid all the volatility should focus on building simple portfolios that can withstand market ebbs and flows.

Two Assumptions
I made a few assumptions as I went about suggesting simple portfolios. The first is that investors have fairly long time horizons of 10 years or more and are comfortable weathering the periodic ups and downs of equity investing. The portfolios therefore have fairly aggressive asset allocations: 50% to 60% in U.S. equities, 30% to 40% in international equities, and 10% to 20% in bonds.

The second assumption I made is that investors are holding these portfolios in tax-deferred accounts such as IRAs or 401(k)s (for the sake of picking bond funds, etc.).

Option One: The Simplest Portfolios Around
The simplest way to a good-looking portfolio is to invest in an aptly titled target-date fund. These funds are hassle-free. Once you buy one, the fund company directs assets to underlying funds that it also manages across various asset classes (think large caps, small caps, international stocks, bonds, etc.), in weightings appropriate to your time horizon. As different asset classes post hot or cold streaks, the managers rebalance these funds. Also, the managers gradually adjust asset allocation over time to become more conservative as the retirement year approaches. These funds even work for investors who are nearing retirement or are already in it; they can opt for a fund with a target year of 2005 or 2010. Such funds already have tilted assets more heavily toward bonds and cash equivalents.

Fund companies small and large offer target-date offerings, and some of them are better than others. We recommend seeking one with the following characteristics: Low fees (including expenses from underlying funds), ample diversification, and a dose of equities even in funds whose retirement year is has passed. Click here to learn more about target-date funds, including our favorites.

Option Two: Join the Bogleheads
Index providers continue to slice up markets into ever-narrower pieces, but some of the best indexes remain the broadest ones. As for the best index funds, they are the ones that offer ultralow fees and, of course, by their very nature, eschew active management. These funds' low fees are part of the strong case for using them versus actively managed funds, and low fees have helped index funds beat the majority of actively managed rivals over long time periods.

An easy way to build an all-index portfolio is to buy just three or four funds: One that invests in the whole U.S. bond market, another one that invests in the whole U.S. stock market, and a third that invests in international stocks. (Vanguard will soon roll out a global stock index fund--combining U.S. and foreign stocks--that will further simplify equity exposure for index fans.) A few large fund families offer extremely low-cost index funds, with Fidelity and Vanguard continuously competing for "cheapest index fund" rights. For the sake of single-fund-family investing, here's how I'd build an all-index portfolio of Vanguard funds. (Investors could easily build a similar portfolio of all Fidelity funds, but with the caveat that Fidelity Spartan International Index (NASDAQ:FSIIX - News) doesn't include emerging-markets stocks).

--55%: Vanguard Total Stock Market (NASDAQ:VTSMX - News), expenses of 0.15%. This fund owns more than 3,500 U.S. stocks--the whole market from blue chips to micro-caps.
--35%: Vanguard Total International Stock (NASDAQ:VGTSX - News), expenses of 0.27%. That expense ratio includes underlying funds, because this is a fund of three funds: Vanguard European Stock Index (NASDAQ:VEURX - News), Vanguard Pacific Stock Index (NASDAQ:VPACX - News), and Vanguard Emerging Markets Stock Index (NASDAQ:VEIEX - News).
--10%: Vanguard Total Bond Market Index (NASDAQ:VBMFX - News), expenses of 0.19%. There are good reasons this investment-grade bond fund is home to more than $60 billion in assets. Low expenses combined with sturdy index-portfolio management, which comes with its own set of traps in the bond sector.

Two notes here: Although we recommend dollar-cost averaging--buying in little by little over time--investors who want to build a portfolio all at once should consider Vanguard's exchange-traded funds for the domestic index, Total Stock Market Index ETF (AMEX:VTI - News), and the bond index, Total Bond Market Index (AMEX:BND - News). They're less expensive.

Option Three: Index Funds Complemented By Specialty Funds
All-index portfolios can be highly effective, but if you'd like a chance to juice returns a bit, building a portfolio to do that is still simple. Use index funds as core holdings for the majority of assets, but then pick a few actively managed funds for the fringes of your portfolio. Here's an example of how to do that within the 55%/35%/10% broad asset-class weightings

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