Bogleheads

[Rick Ferri]

.
A simple way to construct a portfolio is through core holdings and extended holdings. The core holdings account for a majority of a portfolio’s risk and return characteristics. The extended holdings provide the finishing touches.

This post introduces the “Core Four” funds, and provides a brief framework for selecting extended holdings. Core funds are the cornerstones of a portfolio. They are the base from which the rest of a portfolio sits.

The “Core Four” are:

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)
Vanguard REIT Index Fund Investor Shares (VGSIX – fee 0.21%)
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX – fee 0.20%)

An example of a 60% stock and 40% bond portfolio with the Core Four is:

36% VTSMX
18% VFWIX
06% VGSIX
40% VBMFX

The above assumes 60% of the equity in VTSMX, 30% in VFWIX, and 10% in VGSIX. Is that optimal? No one knows or can know. And quite frankly, it does not make much difference is you can add a percent here or subtract a percent or two there. It will not make much difference. For example, to keep things simple by using factors of 5%:

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

As Andy Rooney would say, “Close enough”.

The inclusion of extension funds can expand a portfolio beyond the core markets. Extension funds can explore new markets that are not included in the Core Four, or introduce investment strategies into a portfolio that attempt to add “Alpha”. Remember that it is not necessary to add extension funds because the Core Four drive a majority of investment performance. Extending the portfolio may earn you a slightly higher return, or lower the risk, or both. However, nothing is guaranteed.

Extension funds can explore other market that that are not included in the Core Four. For example, Treasury Inflation Protected Securities (TIPS) are not in the Vanguard Total Bond Market Index fund. Adding a TIPS fund hedges a portfolio against an unexpected increase in the inflation rate.

Extension funds are also used to tilt a portfolio to one style or another. For example, the inclusion of a value fund will overweight the style of a portfolio to value stocks in hope that a value premium will be earned for the extra risk taken.

Finally, extension funds may replace a core fund if the strategy behind the extension has the potential for higher risk adjusted returns. For example, rather than using the Vanguard FTSE All-World ex-US Index Fund, I prefer to use a 40% fixed weight in the Vanguard Pacific Stock Index Fund (VPACX – fee 0.22%), 40% in the Vanguard European Stock Index Fund (VEURX - fee 0.22%), and 20% in the Vanguard Emerging Markets Stock Index Fund (VEIEX – fee 0.37%). The slice and dice strategy has returned slightly higher returns than an All-World ex-US without adding more risk.

In summary, the Core Four is your starting point from which to expand. IMO, it can also be an ending point because those four funds explain a vast majority of investor risk and return. For people who want to explore more, you can add markets that are not in the core funds, add strategies such as overweighting value stocks, and create your own strategies by slicing and dicing.

Going into 2008, remember Von Clausewitz' epigram, "The greatest enemy of a good plan is the dream of a perfect plan."

Happy New Year ~ Stay the Course!

Rick Ferri

[ramsfan]

[Mel Lindauer]

Hi Rick:

Great post! This will, no doubt, become a reference post that others can point newbies to. Thanks for all you do to help make this the best investing forum on the Internet.

Still reading your new The ETF Book.

Happy New Year to you and yours.

Best regards,

Mel

[Bruce]

Rick, good stuff, just curious, why not use

Vanguard Total International Stock Index Fund
VGTSX

for the international exposure??

happy new years,
Bruce
_________________
Bruce

"Simplicity is the master key to financial success."

[Jake46]

Rick,

Thank you for the post -- simple but elegant!

[RTR2006]

Thank you for posting this.

RTR

[Rick Ferri]

[livesoft]

Good stuff which I am migrating to. The 'core four' also have ETF share classes, VTI, VEU, VNQ and BND, right?

I'm wondering about slicing-and-dicing the fixed income portion between 4 funds: TIPS, short-term, intermediate-term and GNMA (tickers: VIPSX, VFSTX, VBIIX, and VFIIX).

Should one slice up fixed income or is total bond gonna do the job?

[RTR2006]

Originally I was going to ask how efficient it was to slice and dice your VFWIX into Euro/Pac/Emerging at only slightly different weights than VGTSX. Then you mentioned the issue of taxes in a subsequent post.

How can it be that VGTSX has tax obligations but its components (VEURX, VPACX and VEIEX), which you selected to replace VFWIX, do not?

RTR

[Adrian Nenu]

This is Scott Burns' Global Couch Potato portfolio with TIPS and REITs added.

I really dislike the use of the word "core" because it reminds me of Schwab's "core and explore" marketing. Each asset class is equally important, like the legs of a table. If they are not and held only in minimal quantities with little effect on portfolio diversification and return, why even bother using them?!



Adrian
anenu@tampabay.rr.com

[Trebor]

Very nice!

I would consider Tips to be a "core" holding since it is not covered at all in your top four. Likewise, I would move Reits to "extended" since they are already part of the total market index. All in all this is great stuff. It is just the way I like to think about it.

Trebor

[Rick Ferri]

[bob u.]

Let's see. Do I second, third, fourth, fifth, or what?

Ah, hell. It's essentially where I've ended up (TIPS in the mix) with non-annuitized portfolio thanks to Rick. Bob U.

[il_gancio]

Hi Rick,
I am long-time lurker whose AA is largely influenced from having read your All About Asset Allocation book. From your "Building Your Portfolio" chapter, I understood your suggestions for Early Savers and Mid-Life Accumulators to have a 10% of your total portfolio allocated to REITs. In your post here, you describe it as 10% of your stock allocation. I realize that you may be rounding numbers for simplification, but I have enough experience that I am interested in your more precise suggestion.

So for a 70% stock, 30% bond portfolio, do you recommend 10% allocation to REIT or 7% (10% of 70% stock)?

Thanks so much for your great books and contributions to this forum!!!

-Il Gancio

[foodnerd]

Rick, my question to you (and to the forum) is that won't the cost difference between All World Index versus the Total International index also make some of the difference in tax deferred accounts (.4 for All World vs .27 for Total Int). Will the tax credit make up that difference in the taxable account?

FN

[bolt]

[removed at request of poster]

[Paulo]

With regards to international diversification of fixed income allocations, a very nice resource is at Everbank which is available online. This is a US based bank, with FDIC insured accounts. I use there foreign currency combination 3 month CDs.
There is a Commodity exporting index CD that is a combination of Australian $, New Zealand $, Canadian $, and South African Rand and yields 5.40 %.
Hard to beat that. There is also a Prudent Central Bank "index" CD comprised of Brittish pound, Euros, Australian $ and New Zealand $. There are several others: World energy, non-Opec oil countries, and others. Go to the everbank website and navigate to the "World Currency Index CD"s. The CD's roll over every term unless you request otherwise. They provide excellent service with advanced e-mail and snail mail notification. Great way to hedge the dollar and diversify fixed-income in my opinion.

[DaveTH]

[DA]

[RTR2006]

Thanks for the clarification...I'll take this to heart as I do some re-balancing early in the new year.

Kind regards,

RTR

Happy New Year to all!!

[Munir]

Would you recommend the same percentages for a retiree in the distribution phase? If not, what percentages would you suggest?

A couple of people have asked if a TIPS fund can replace REITS since TSM already has REITS. What do you think?

Munir

[Amishman]

So much for the simplicity of the "Core Four"

[Taylor Larimore]

Hi Rick:

Few investors have more experience and knowledge about portfolio construction than you do. Your simple and elegant "Core Four" portfolio is one of the very best I have seen. It has the virtues of:

Very low cost
Very diversified
Very tax-efficient
Very simple to understand, rebalance and maintain

It is not often we see simple portfolios from the investment industry. They want us to believe that investing is too complicated for investors to do themselves.

Thank you and Happy New Year!
Taylor

[DRiP Guy]

[Murray Boyd]

I like it. Just say no to tinkering!

However, I do think every portfolio should add up to 100%.

[Munir]

What is being called "tinkering" I would describe as adjusting Rick's recommendations to one's individual situation such as age, retiree, distribution phase etc..I doubt if Rick means his recommendations to be cast in stone in the exact percentages he lists. After all, he does call it "core" and allows extenders.

Munir

[stan1]

[Rick Ferri]

Ooops! Your are right, Stan!

30% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

Does not add up to 100%



So, let's go with:

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

BTW, with the edit feature of this forum I took the liberty to change my original post to the above allocation.

Rick Ferri

[BigD53]

Thank you Rick. I like the simplicity of your core four (with extensions) portfolio. It reminds me of my Vanguard Target Retirement Income fund.

VTINX
Allocation To Underlying Funds as of 11/30/2007

Vanguard Total Bond Market Index Fund 45.1%
Vanguard Total Stock Market Index Fund 24.4%
Vanguard Inflation-Protected Securities Fund 19.9%
Vanguard Prime Money Market Fund 4.5%
Vanguard European Stock Index Fund 3.4%
Vanguard Pacific Stock Index Fund 1.5%
Vanguard Emerging Markets Stock Index Fund 1.2%

After I retire, I would like to trim my portfolio to include this one simple fund. I want to enjoy my retirement and not worry about my investments. I intend to keep 25% to 30% in equities at all times. The Vanguard Target Retirement Income fund fit my needs very nicely.

[Murray Boyd]

And it took an ENTP to do it!

I think when someone is worried about if they should invest 1.5% of their portfolio in Emerging Market Small Value or Emerging Market REIT, that's tinkering.

[ramsfan]

[bottlecap]

Thank you very much, Rick. It is a good and timely ('tis the New Year, after all) post. Thanks to those involved in the discussion about the FTSE ETF v. the Total Int'l as well.

JT

[SmallHi]

I am all for simplicity. When I see 12 to 15 asset class portfolios, I just scratch my head...

That being said, I think it is a huge mistake to ignore the Fama/French 5 Factor model (Equity, Size, Price, Credit and Term risk) when developing an asset allocation. One should at least consider a multifactor investing as the CORE part of their portfolio.

First of all...multifactor investing isn't really all that complicated. If you've taken the time to register on this forum or read a decent books, I'm sure you can figure it out.

Secondly, in many periods, your equity tilt is as important, or more important than your equity to fixed income ratio.

Thirdly, if you can cut through all the noise, there are a number of high quality, low cost smaller and more value oriented options now available for the retail investor, and Dimensional has made "tiltiing" just as easy, and almost as tax efficient as TSM investing with the advent of their Core strategies.

Fourth, a multifactor tilted portfolio's expected returns can be easily estimated based on risk exposure and estimate of risk premiums (with the aid of 80 years worth of historical data).

Fifth, an investor with multifactor intensions is more able to customize their asset allocation to account for their unique personal situation (concerns about volatility, tracking error, human capital risk, concerns about portfolio losses and the timing of those losses)

Sixth, investors who choose to tilt are able to achieve necessary diversification without incorporating sector-like specific portfolios (REITS) with industry specific risk.

Seventh, multifactor investors are able to spread their equity risks across market dimensions. Size and Value exposure does increase timing and volatility risks, but can serve to offset long periods where beta risk does not produce a return premium. Every few decades, beta has gone 10 to 15 years without producing a return premium. Bettiing all of your risky "growth" $ on beta is unnecessarily concentrated. Furthermore, it is well documented that Beta only explains approximately 65% of equity portfolio returns, while size and value factors increase that number to almost 95%. If we understand how markets work and where returns come from, it is not prudent to ignore those options as part of your CORE allocation.

Eighth, looking at "beta" exposure as the CORE of a portfoliio, and size/value tilts as an EXTENSION will likely result in an investor timing in and out of value and small dimensions as popularity waxes and wanes. This will promote performance chasing behavior in the vast majority of investors, likely causing them to underperform the allocation they've chose

Nineth, its been pretty well documented that investors are better off taking their risks on the equity side of the portfolio (the payoffs are larger and more persistent for a given level of risk), and ratcheting down the fixed income risk (call risk, credit risk, and significantly longer term bonds add uneeded and unrewarded risk, complexity, and agency issues). A TSM/TBM portfolio is completely agnostic to this.

Finally, you'll be less likely to chase higher cost active management strategies whose recent returns appear to be "positive alpha", but in reality are just multifactor (value or small tilted) strategies.

Bottom line, not everyone should tilt away from the market, but everyone probably should consider multifactor investing. There is no reason to expect a positive global equity risk premium, as Rick has apparently done with his original post, without also expecting positive expected returns to size and price dimensions of the worldwide equity markets.

SH

[1210sda]

If you don't like 60/40, then try this

VTSMX 35%
VFWIX 15%
VGSIX 10%
Tot Equities 60%

Therefore,
VTSMX is 35%/60% or 58.33% of equities (round off to 60%)
VFWIX is 15%/60% or 25.00% of equities
VGSIX is 10%/60% or 16.67% of equities. (round off to 15%)

Choose the percent you want for equities and multiply by the above
percents (60%, 25%, & 15%). For example a desired 80% allocation to equities would work out to 48% VTSMX; 20% VFWIX & 12% VGSIX. The remaining 20% to reach 100% would go to VBMFX

Hope this works for you

1210

[Rick Ferri]

SmallHi

As you say, there are many ways to 'tilt' away from a portfolio of market risk, and I am not against any of those ways if an investor fully understands what that means. That does not change the fact that pure market risk is where every investor should begin. That is the way Fama/French envisioned their three-factor model to work, i.e. start with market risk and add value and size risk to it if you want too.

IMO, a portfolio of market risks is where many investors should end. I agree that value and size risks are not too difficult to comprehend for experienced investors, but three-factor investing is an advanced strategy. Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions! As such, many investors would be better off not doing a three-factor portfolio.

Again, I have no issue with experienced and disciplined investors doing a three-factor portfolio. But I cannot recommend that everyone do it. To assume that everyone is sophisticated is just no reality. And it takes a deep understanding of the strategy to stick with it during long periods of under-performance.

Rick Ferri

[Robert T]

.
Rick,

Thanks for the post – very useful. I agree that the total market is often a useful endpoint for many investors and for some a useful starting point from which to tilt (reasons often cited for tilting include to diversify human capital risk with higher international allocations and to achieve higher needed expected return with a greater small and value tilt).

As new investment products are continuously becoming available, as witnessed by the rapid rise in ETFs, I find a more constant framework is to have targets for exposure to the four core risks, the four core markets, and caps for the four core costs (as listed below – at least this has been helpful for me). Fund selection may change overtime as new, cheaper, more tax efficient, better structured etc. products become available (as with the recent Vanguard FTSE All-world ex-US Index fund) but the targets in the areas listed below should remain more constant thus forming a firmer bedrock/foundation for portfolio decisions. Fund selection within this framework is then to minimize costs per unit of desired (and consistent) risk exposure across the four core markets.

The ‘Core Four’ risks which drive portfolio returns

Market (stocks vs bonds)
Size (small cap vs large cap stocks)
Value (value vs growth stocks)
Term (longer term versus short term fixed income)

The ‘Core Four’ markets, which when combined, reduce the volatility of portfolio returns

US Equities
Non-US Developed Market Equities
Emerging Market Equities
US Treasuries

The ‘Core Four’ costs which when reduced (or minimized) can enhance portfolio returns

Expense ratios
Taxes
Trade costs
Advisor fees (and wrap account fees)

And perhaps to add importantly:- The ‘Core Four’ emotions which if not kept in check can devastate returns:

Tracking error regret (with the market and ‘hot’ sectors or asset classes)
Myopic loss aversion
Overconfidence
Impatience

An IPS can help keep emotions in check (it has been personally helpful, at least so far:).

Just a few additional thoughts.

Happy New Year!

Robert
.

[SmallHi]

[Rick Ferri]

Rober T

Thank you for that fine post.


SmallHi,

I agree with what you are saying, although I think you are overstating the importance of using the three factor model in portfolio management. Using it is just not that critical. Developing a plan and staying consistent is the most critical factor of any investment plan.

FF research shows that CAPM explains 70% of diversified portfolio's return. CAPM is based on a function of beta, or market risk. The three factor model explains 95% of a diversified portfolio's return, with beta being the dominant of the three factors!.

Any way you slice the data, it comes back to the basic fact that market risk (beta) is the dominant factor driving portfolio returns. And I believe Fama and French would agree.

That being said, if people want to diversify beyond market risk (or beta), that is fine with me as long as they fully understand the risk. Investing in any strategy without understanding risks eventually leads to breakdown.

Rick Ferri

[Michael Weiss]

[Rick Ferri]

[cfs]

Just when I had all the answers they changed the questions on me ...

I like this!!!

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX
_________________
cfs est nomen ejus

[stepjone]

Rick:

Great Post!

Just one question: Does this "Core Four" allocation apply to those in thier younger years as well.....say 25-35 yrs of age? I am so new at the investing that I thought I would ask.

Stephen

[CountryBoy]

Rick, I bought your ETF Book and am continuing to study it. I am wondering if it could be more efficient for some people to buy some of the Core funds in ETFs.

For example if one knows that they are a DH and are going to put money in 'for the long haul' and not trade ETTs then couldn't it be more efficient to buy say VTSMX in the ETF equivalent?

Thanks.

Countryboy

[Sunny Sarkar]

[Sunny Sarkar]

[sgr000]

[Taylor Larimore]

Hi Bogleheads:

"Recency" has made value and small-cap stocks popular (and maybe rightly so). However, it is helpful to go back and look at SCV domestic stock performance reported by Morningstar for various periods ending 6-30-00:

Style.......1 Yr.....3 Yr......5Yr....10 Yr....15 Yr.
LCG......27.19...27.04...24.98..17.85....17.15
LCB........8.93...17.29...20.35..15.60....15.23
LCV.......-5.21.....8.74...15.16..13.36....13.45

MCG.....57.24...31.09...24.81..18.14....16.82
MCB.....11.87...12.36...16.09..14.12....14.23
MCV......-2.56.....7.23...13.20..12.77....12.64

SCG......55.14...24.42...20.86..17.12....15.64
SCB......17.77...10.08...15.30..13.03....12.02
SCV........3.29.....3.55...12.58..11.80....11.34

Best wishes and Happy New Year!
Taylor

[kiki]

[DaveTH]

[SmallHi]

Taylor,