Asset Allocation Advice for Newbie.

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Topic Author
wijerg
Posts: 9
Joined: Mon Apr 23, 2012 4:57 pm

Asset Allocation Advice for Newbie.

Post by wijerg »

Hi,
I am 26 years and am looking to get into the world of investing.
I have read some of the articles about diversifying your portfolio and trying to mirror the overall stock market.
I am trying to set up an investment plan that will be open to a little bit of risk as I am young and have much more earning potential in the future.
I am single and have a simple lifestyle. I can save approximately 40k annually.

I already have enough money in the bank as an emergency fund.
I finished paying my college debt and credit card debt last year and I have no debt right now.
As of this year (2012) I am looking to save money at the above rate and invest monthly.

Here is my investment plan - please let me know what you think.

A few notes first -

* A lot of articles suggest that the healthcare industry will do well in the coming years as the baby boomers are retiring and will require more healthcare services.
This idea makes sense to me so I want to invest a little extra in the healthcare sector.
* I would like to invest a little extra in emerging markets as well so I'm buying a little of VEIEX to allocate towards that.
* I would like to research and invest in individual stocks as well so I'm setting up some money aside for that.

This is the asset allocation I have planned -

Vanguard Total Stock Market Index Fund Investor Shares VTSMX 35%
Vanguard Total International Stock Index Fund Investor Shares  VGTSX 20%
Vanguard Total Bond Market Index Fund Investor Shares   VBMFX 10%
Vanguard REIT Index Fund Investor Shares  VGSIX 10%
Vanguard Emerging Markets Stock Index Fund Investor Shares  VEIEX 5%
Vanguard Health Care Fund Investor Shares  VGHCX 10%
Individual stocks 10%


I have not considered investing in a 401k or roth because from what I understand you have to wait till 60 to withdraw from that.
My plan is to retire/semi retire in 20 years when I'll be 46.

I would really appreciate it if some of you more experienced guys would look at this plan and let me know if it sounds reasonable. I am open to risk but not too much.

I would also like advice on being more tax efficient since I don't have much understanding about that yet.

I am hoping for a return of about 8% over the next 20 years. Is that reasonable?

At this moment I have invested 5k in VTSMX and 3k in VGHCX. I intend on building my VTSMX account for now since it is my core holding and I am waiting for feedback from you guys about my plan.

Thanks in advance!
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hoppy08520
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Re: Asset Allocation Advice for Newbie.

Post by hoppy08520 »

wijerg wrote: * A lot of articles suggest that the healthcare industry will do well in the coming years as the baby boomers are retiring and will require more healthcare services.
This idea makes sense to me so I want to invest a little extra in the healthcare sector.
* I would like to invest a little extra in emerging markets as well so I'm buying a little of VEIEX to allocate towards that.
* I would like to research and invest in individual stocks as well so I'm setting up some money aside for that.
FWIW, these points are not in line with Boglehead investing philosophy.

Consider:
* You're not the only one who's noticed the demographics with health care and population in the US. Therefore, wouldn't you think that health-related stocks are already priced accordingly by the market?
* Same with emerging markets
* Sure, plenty of people buy individual stocks, but doing so lessens your diversification. More potential reward but more risk. You have to decide.
wijerg wrote: This is the asset allocation I have planned -
Vanguard Total Stock Market Index Fund Investor Shares VTSMX 35%
Vanguard Total International Stock Index Fund Investor Shares  VGTSX 20%
Vanguard Total Bond Market Index Fund Investor Shares   VBMFX 10%
Vanguard REIT Index Fund Investor Shares  VGSIX 10%
Vanguard Emerging Markets Stock Index Fund Investor Shares  VEIEX 5%
Vanguard Health Care Fund Investor Shares  VGHCX 10%
Individual stocks 10%
An interesting portfolio. You're basically making sector bets on REITs, health care and emerging markets to the tune of 25% of your portfolio. I'm surprised you haven't thrown in some small-cap value (another sector bet that's popular). Add in 10% for individual stocks. I feel like you're going pretty far out on a limb with this. I guess I'd ask, what special insight do you have that the brains at Vanguard (who based on their target date and LifeStrategy funds would suggest holding only the first 3 funds in your account) are missing? I feel like you're making a bit of a gamble. If your sector and stock bets pay off, then good for you. But you're also opening yourself up to risk that your crystal ball is cloudy.
wijerg wrote: I would also like advice on being more tax efficient since I don't have much understanding about that yet.
I have not considered investing in a 401k or roth because from what I understand you have to wait till 60 to withdraw from that.
My plan is to retire/semi retire in 20 years when I'll be 46.
Unless you plan on dying at age 70, you'll need money post-70 so you should probably still invest some in tax-advantaged accounts as well as taxable accounts. You can let those accounts sit there and compound from age 46-70. Plus, you're missing out on important tax breaks. And you might get an employer match with your 401k and you shouldn't turn that down.
wijerg wrote: I am open to risk but not too much.
You have a portfolio with 90% stocks and 10% bonds which is quite aggressive. But if you want to retire in 20 years you might need to be.
wijerg wrote: I am hoping for a return of about 8% over the next 20 years. Is that reasonable?
No crystal ball here, but from what I'm reading, people are less bullish about those kinds of returns in the future. The last ten years have been only +4% for S&P 500, and that's after recovering a lot from the 2008-2009 drop.

Overall, I'd suggest a more conventional 3-Fund portfolio when you start out. In the beginning, your contributions are more significant than asset allocation. And I would really think long and hard about putting all your investments in taxable accounts. You could be making a big mistake that you can't recover from, since you can only put in a certain amount of money in tax-advantaged accounts per year ($5K in Roth IRA, $16,000 (?) in 401k, but I believe there are some exceptions to these). So many conversations on this board are about how to maximize tax-advantaged space -- you want to have that space, even if you think you can retire early. Keep reading and learning and try to stay away from extremes (which isn't to say your proposed portfolio is extreme -- it's not that radical). If you want to do some "play money" in stocks, most people here suggest no more than 5%.

Be sure to report back in 20 years on how you're doing :-) It's great how you can save so much so early. Good luck.
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hoppy08520
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Re: Asset Allocation Advice for Newbie.

Post by hoppy08520 »

BTW, I admire your boldness and thought that you put into this. I might sound a bit contrarian but I figure that's what you're looking for by posting here. Boglehead-investing may seem a bit dull and it may look like we're not trying hard enough or risking enough or being bold. I may be repeating myself, but your portfolio may in fact beat the more conventional advice that most people here follow. But I think most people here are content with just "settling" for the benchmarks because we're not confident anyone, including ourselves, really knows how to beat them even if they tried. That's probably the toughest part of being a Boglehead -- you're basically admitting defeat that you won't even try to "beat the market". But the prize is, the "defeat" of matching the benchmarks (less small expenses) is actually a bigger nest egg than probably 90% of the people who try to beat the market, only to slide down the mountainside.
pkcrafter
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Re: Asset Allocation Advice for Newbie.

Post by pkcrafter »

wijerg wrote:
I am trying to set up an investment plan that will be open to a little bit of risk
This does not compute with an AA of 90/10.

Healthcare is a sector and we don't recommend overweighting them. Boomers and healthcare will do well? Don't you think every professional investor out there already knows this?

Don't waste 10% of your portfolio on individual stocks.
I have not considered investing in a 401k or roth because,,,
Huge mistake.


Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
coldplay221
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Re: Asset Allocation Advice for Newbie.

Post by coldplay221 »

wijerg wrote:Hi,
I would also like advice on being more tax efficient since I don't have much understanding about that yet.

I am hoping for a return of about 8% over the next 20 years. Is that reasonable?

At this moment I have invested 5k in VTSMX and 3k in VGHCX. I intend on building my VTSMX account for now since it is my core holding and I am waiting for feedback from you guys about my plan.

Thanks in advance!
Hello wijerg, welcome to the forum.

From your post, I suspect you haven't yet read a book in the recommended reading section. I would read one of them first. One of my favorites is "rational investing in irrational times".
Assuming your tax rate is 25%, that would assume a ~12% return in a tax-deferred account. That is better than the 8% (which is definitely a stretch :| )you might get on a taxable account for the same AA!
Topic Author
wijerg
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Joined: Mon Apr 23, 2012 4:57 pm

Re: Asset Allocation Advice for Newbie.

Post by wijerg »

Thanks guys for the responses.

You guys are right that my portfolio may be a little too risky.
Like I said I am willing to take on a little risk at this stage of my life but am confused at what percentage of my portfolio I should invest in high risk investments.

To make it short, I want to invest the majority of my portfolio in the 3-Fund style(what you bogleheads recommend) and the rest in to a few high risk investments. I was under the impression that 75%-25% would be good enough. If it isn't, then what percentage would you recommend? Should it be 95%-5%?

And yeah I should probably invest some of it into a tax deductible account as well. Are there any good threads/articles that you can recommend about the variety of the accounts and the pros and cons of them? I really don't have much knowledge about taxes and how to minimize them.

I will make a few risky investments and see if they pay off. If not I can still work till 60 and go the traditional way :)
Let me know what you think...

Thanks a lot for your advice.
Topic Author
wijerg
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Joined: Mon Apr 23, 2012 4:57 pm

Re: Asset Allocation Advice for Newbie.

Post by wijerg »

coldplay221 wrote -
From your post, I suspect you haven't yet read a book in the recommended reading section. I would read one of them first. One of my favorites is "rational investing in irrational times".
Assuming your tax rate is 25%, that would assume a ~12% return in a tax-deferred account. That is better than the 8% (which is definitely a stretch )you might get on a taxable account for the same AA!
No I haven't.
I will do that!
Thanks
Topic Author
wijerg
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Re: Asset Allocation Advice for Newbie.

Post by wijerg »

BTW, I plan on investing 10% on REITs because from what I know the Total Stock Index has very little invested in it. So I look at that as more of a diversification than a risk.
Is that a wrong assumption?
pkcrafter
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Re: Asset Allocation Advice for Newbie.

Post by pkcrafter »

The additional information helps, so here are additional comments in blue....

The most important thing you can do now is focus on education. Some links:


Getting started: http://www.bogleheads.org/wiki/Getting_Started

401k Plan: http://www.bogleheads.org/wiki/401%28k%29

Roth: http://www.bogleheads.org/wiki/Roth_IRA
wijerg wrote:Hi,
I am 26 years and am looking to get into the world of investing.
I have read some of the articles about diversifying your portfolio and trying to mirror the overall stock market.
I am trying to set up an investment plan that will be open to a little bit of risk as I am young and have much more earning potential in the future.
I am single and have a simple lifestyle. I can save approximately 40k annually.<--This is excellent and when just starting it has a much bigger impact on your portfolio that the returns you get.

I already have enough money in the bank as an emergency fund.<--6 months minimum?

I finished paying my college debt and credit card debt last year and I have no debt right now.<--Again, excellent.

As of this year (2012) I am looking to save money at the above rate and invest monthly.

Here is my investment plan - please let me know what you think.

A few notes first -

* A lot of articles suggest that the healthcare industry will do well in the coming years as the baby boomers are retiring and will require more healthcare services.
This idea makes sense to me so I want to invest a little extra in the healthcare sector.<--I and most other posters here would not recommend this.

* I would like to invest a little extra in emerging markets as well so I'm buying a little of VEIEX to allocate towards that.--Try to keep things a little simpler for now. Saving rate far outweighs any small added return you might get from this.

* I would like to research and invest in individual stocks as well so I'm setting up some money aside for that.<--Don't waste time or money on this. You will be much farther ahead putting the time into educating yourself on fundamentals and behavioral mistakes so you can avoid them.

This is the asset allocation I have planned -

Here's an alternative suggestion... I'm suggesting a 60/40 portfolio because your savings rate is so high and you have not studied asset allocation Here are two links on risk and AA to get you started. If you feel comfortable with a higher equity allocation after after looking at the links and reading a book, then you could go as high as 75% equity.

http://www.bogleheads.org/wiki/Risk_and ... troduction

http://investingroadmap.wordpress.com/2011/02/25/205/

Vanguard Total Stock Market Index Fund Investor Shares VTSMX 34%
Vanguard Total International Stock Index Fund Investor Shares  VGTSX 20%
Vanguard REIT Index Fund Investor Shares VGSIX 6%
Vanguard Total Bond Market Index Fund Investor Shares   VBMFX 40%
REIT should be between 10 and 15% of equity. REIT and total bond should be in tax-advantaged accounts.


I have not considered investing in a 401k or roth because from what I understand you have to wait till 60 to withdraw from that.

Does your company have a 401k plan? If so, find out if there is any matching and please post the funds available with names, tickers and expense ratios. If there are too many, then just post the ones with lower expenses.


My plan is to retire/semi retire in 20 years when I'll be 46.

I would really appreciate it if some of you more experienced guys would look at this plan and let me know if it sounds reasonable. I am open to risk but not too much.

I would also like advice on being more tax efficient since I don't have much understanding about that yet.<--Yes, this is very important and you only want to use tax-efficient funds in your taxable accounts.

http://www.bogleheads.org/wiki/Principl ... _Placement

I am hoping for a return of about 8% over the next 20 years. Is that reasonable?

Returns in the past decade have not been that high, but long term returns have been.


At this moment I have invested 5k in VTSMX and 3k in VGHCX. I intend on building my VTSMX account for now since it is my core holding and I am waiting for feedback from you guys about my plan.

I wouldn't use VGHCX and it's not tax-efficient, so even if you did you should not put it in a taxable account.

Thanks in advance!


Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
Topic Author
wijerg
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Joined: Mon Apr 23, 2012 4:57 pm

Re: Asset Allocation Advice for Newbie.

Post by wijerg »

Hi,
I read through the articles you posted.

Yes I have 6 months of expenses in my savings account.

About tax efficiency -
from what I understand you should be allocating the funds which produce more capital gains and less dividends into taxable accounts and the funds that generate more dividends into tax advantageous accounts am I right?

My current employer does not do 401k so I am thinking of opening a roth ira.
I think that for a single guy to be eligible for a roth account, your income must be less than 120k. I am fine with that now but in my field there is a possibility that my income may be higher than that sometime in the future(6 years?). So am I supposed to suspend my contributions to roth if that happens? Is there any penalty if I miss out on paying my roth in a given year?

Since I can only contribute 5k (12%) annually into a roth account, I will still have to contribute 35k(88%) to a taxable account.
I am thinking of going with 70/30 for now and reallocating sometime in my thirties. I would like to take on a little extra risk.

So this is what I am thinking -

Roth ira -

Vanguard REIT Index Fund Investor Shares VGSIX 6%
Vanguard Total Bond Market Index Fund Investor Shares VBMFX 6%

Taxable account -

Vanguard Total Stock Market Index Fund Investor Shares VTSMX 40%
Vanguard Total International Stock Index Fund Investor Shares VGTSX 24%
Vanguard Total Bond Market Index Fund Investor Shares VBMFX 24%
Total 100%

From what I've learned, VTSMX and VGTSX are very tax efficient so I will have all of them in my taxable account.
Since the total bond index isn't that good in a taxable account, is there any way that I can break the bond section down to more tax efficient and tax inefficient funds?

As for VGHCX, they have a redemption fee of one percent so I will have to stick with it for this year and transfer it next year.
I will start with filling the total stock fund.

I will keep studying about the stock market and maybe in the future I'll use a little bit of my portfolio (5%?) to play with some high risk investments.

Thanks a lot for your advice...
I really appreciate it.
Topic Author
wijerg
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Re: Asset Allocation Advice for Newbie.

Post by wijerg »

One more thing...

I have my emergency fund of 11k currently sitting in a money market account earning a whopping 0.05%.
I have heard of high yield savings accounts such as ING Direct that can give much higher interests.
Does anyone have any experience with this? Are these accounts as liquid as regular savings accounts?
Default User BR
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Re: Asset Allocation Advice for Newbie.

Post by Default User BR »

wijerg wrote:One more thing...

I have my emergency fund of 11k currently sitting in a money market account earning a whopping 0.05%.
I have heard of high yield savings accounts such as ING Direct that can give much higher interests.
Does anyone have any experience with this? Are these accounts as liquid as regular savings accounts?
There are normal higher-interest-rate accounts that are paying around .8% or so. I use American Bank, and this is just a checking account. It's as liquid as it gets. https://www.ambk.com/

There are also higher-rate accounts that require a number of activities each month, and typical restrict the balance that will get the good rate.


Brian
fixitnowlt11
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Re: Asset Allocation Advice for Newbie.

Post by fixitnowlt11 »

I have a money market checking account at Discover. Check out their rates:

https://www.discover.com/online-banking/
kikie
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Re: Asset Allocation Advice for Newbie.

Post by kikie »

you could wall off 10% and call it "mad money" ; but it's rather pointless to ask "is this a good bet or is this".

I think you need to develop your question a bit more.

Why not read the basics like William Bernstein's book and until you know what your doing, keep 1/2 the money out of the stock market. You have as much time to lose your money as gain, in the upside down system we have post 2008 or post 1997 I guess.
Those who know do not speak; those who speak do not know.
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Kevin M
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Re: Asset Allocation Advice for Newbie.

Post by Kevin M »

wijerg, you have made good progress since your first post. You are on the right track. Here are a few additional comments.

You can withdraw contributions from a Roth IRA at any time, tax and penalty free. It's only the earnings that you must wait to withdraw penalty-free until age 59 1/2. So if you contribute $5,000 for 2012 (you have just missed the deadline for 2011 contributions), and it earns $300 in one year, you could withdraw $5,000 in one year penalty and tax free. EDIT: Also, once your income exceeds the limit for a direct Roth IRA contribution, you can do a "backdoor" Roth IRA contribution unless the tax law changes before then. No need to worry about this now.

If you do get access to a 401k, you should contribute to it. If you retire early, you can roll it over to an IRA, and set up a plan to do penalty-free early withdrawals under IRS regulation 72t. Don't worry about this now--just know that it is an option for the future.

Since you have limited tax-advantaged space, the most common advice would be to skip the REIT fund for now, and just fill the IRA with a bond fund. I like REITs, so I won't discourage you too much from using them, but most probably would.

In your taxable account, you may be better off using a Vanguard tax-exempt bond fund. If there is one for your state, and you are in a high-tax state, consider using it. Otherwise use one or more of the national muni funds. There are short-term, limited-term, intermediate-term, long-term, and high-yield; these are in order of increasing risk and expected return. You should do the math to see whether a tax-exempt bond fund or taxable bond fund gives you a better after-tax yield for a comparable level of risk; look at the SEC yields of the bond funds. The intermediate-term or even long-term muni fund is comparable in risk to TBM; long-term muni funds are not really very long term--they are more like a little bit longer intermediate-term bond funds.

To compare taxable with tax-exempt rates, you can either convert the taxable yield (e.g., Total Bond) to equivalent after-tax yield, or convert the tax-exempt yields to before-tax yields. To do the former, multiply the SEC yield of taxable fund by (1 - mtr), where mtr = marginal tax rate. To do the latter, divide the SEC yield of tax-exempt fund by (1 - mtr). If using a state-specific fund, include your marginal state tax rate in mtr (this won't be exactly correct if you itemize and deduct state taxes, but it will be close enough for a rough calculation).

Also consider CDs instead of a bond fund, especially in the IRA. See this post for some of my thoughts on why: http://www.bogleheads.org/forum/viewtop ... 10&t=92997. The specific CD mentioned in that post no longer is a good deal, so just read the "why I'm doing this" part, and click through to my blog if you want to see updates on specific CDs to use.

For a taxable account, you want to do the same calculation to compare after-tax yields of CDs with tax-exempt bond funds, but also consider that CDs have no credit risk and virtually no interest-rate risk, so you may want to consider accepting a somewhat lower after-tax yield in exchange for the lower risk.

For my thoughts on alternatives for short-term savings, see this post: http://www.bogleheads.org/forum/viewtop ... 4#p1346764. You can do much better than 0.05%, and even much better than 1%.

Finally, for the best replies, edit your original post using the "Asking Portfolio Questions" format; see link below. You may already have provided all the information we need, but check to make sure.

Again, you are learning quickly. Keep coming back with questions, and keep reading.

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)
Topic Author
wijerg
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Re: Asset Allocation Advice for Newbie.

Post by wijerg »

I've been travelling so I wasn't able to check this forum over the last few days.

So this is what I've planned after the advice I've received on this forum.


Emergency funds = 6 months of expenses available in high yield savings account at 0.8%.

Debt: None

Tax Filing Status: Single

Tax Rate: 28% Federal 6?% State of Residence

Age: 26

Desired Asset allocation:80/20 (stocks/bonds)

Intl allocation: 37.5% of stocks


Current portfolio : Still small but able to save 40k annually for the next few years

Taxable

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) 50%
Vanguard Total International Stock Index Fund Investor Shares (VGTSX) 30%
Vanguard Long-Term Tax-Exempt Fund (VWLTX) 8%

Roth IRA
Vanguard Total Bond Market Index Fund Investor Shares VBMFX 12%

Total of All Accounts Together (not each account individually) equals 100%


Notes:

I am going with 80/20 allocation because at this stage I am willing to take a little extra risk and also for tax efficiency because I can only contribute 5k annually to my Roth account. I will reallocate more towards Bond funds as I grow older or if I find an employer who does 401k.

My only concern with this is that since the VBMFX already will invest in the same bonds that the VWLTX invests in, I may be contributing a bigger portion of my bond section to municipal bond shares. Is this a big issue or will this be a good set up for me right now?

I think all of the above funds are also available as Admiral Shares and I will convert them once I have enough money.

Thanks a lot for your advice,
I've already learned a lot from visiting this forum.
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Kevin M
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Re: Asset Allocation Advice for Newbie.

Post by Kevin M »

Looks pretty good.

Did you investigate reward checking accounts for at least part of your emergency savings? How about Ally 5-year CDs and I Bonds?

Did you consider CDs instead of TBM for your Roth?

VBMFX does not normally invest in the same bonds that VWLTX invests in. What makes you think that is the case? Other than the fact that I would use something like PenFed 7-year CDs instead of VBMFX in the Roth, I would not worry about this.

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)
Topic Author
wijerg
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Re: Asset Allocation Advice for Newbie.

Post by wijerg »

Hi,

I haven't considered a reward checking account for my savings. I will look into that.
I don't want to use a 5 year fixed deposit because there can be times where I may have to withdraw about $1000-$2000 from my savings account and replace with my pay check. Same for I bonds. But yeah I could probably put a certain part of my savings into one of those to get a better interest. I will think about that.

I have not considered Cds for the Roth because the interest rates are pretty low in the ones I checked(Approximately 2%). The TBM has returned more than that over the years (6.78% since inception). Although I know that past returns are no guarantee for future returns, I think the chances are slim that the return will go below 2%.

My assumption for VBMFX comes from the fact that it invests in the Total bond market so it will contain a certain allocation towards long term municipal bonds as well.
If that's not the case then that's great.

I didn't know about the PenFed 7 year CDs, they seem good but why would you pick that over TBM?

You seem to advocate CDs over Bonds. I've been thinking that bonds would be a better choice since the historical returns have been higher and most articles and forum posts I've read adivce you to split you asstes between stocks and bonds.

I've read the article you mentioned about CDs in your previous post but I'm still not clear on it.

Kevin M wrote -
What I am Doing and Why

I am transferring funds currently held in IRA money market accounts (paying almost no interest) at Vanguard and Fidelity into INOVA IRA Step Up 6-year CDs. My reasons are:
•The interest rate on the CD is much higher than a comparable bond fund.Every Bond fund I look at has at least 4% return since inception. I can't find any rate like that from CDs. Am I doing something wrong here?
•There is no risk of decline in value of the CD if interest rates rise (unlike a bond fund).True. But like I said I am willing to take that risk during these years.
•If rates rise enough, I can use the one-time step up option to increase my rate, and if rates rise more, I can do an early withdrawal, pay the EWP and reinvest at a higher rate.But can't you do the same with bonds and move the money into a CD if interest rates rise?
•If an early withdrawal is disallowed, I still am likely to come out ahead of a comparable bond fund over the next six years.How?
•I still have plenty of my fixed-income allocation in bond funds and deposit accounts for rebalancing and spending (I'm retired).
•I already have CDs at Ally Bank and PenFed that will approach the federal insurance limits if held to term (but I probably would go for the INOVA CD anyway).
I will look into I-bonds since that seems like a good deal.
Thanks a lot for your help on this.
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Kevin M
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Re: Asset Allocation Advice for Newbie.

Post by Kevin M »

wijerg, let me try to clear up some of your misunderstandings about bonds and CDs.

Looking at historical bond returns is a waste of time. This is pure math. If a bond fund was yielding 5% in the past, then it has gained in value both from the higher yields and the declining interest rates. It is impossible for TBM currently yielding about 2% to provide total returns anywhere close to the past returns you are looking at, unless rates decline further, in which case you will gain a maximum of about 10% if rates decline to 0%, but then the party is over.

To understand this, you must understand the relationship between bond prices and interest rates; this is best captured by the duration of the bond fund, which you can easily look up. The duration of TBM is about 5 years. This means that if interest rates increase by 1%, the value will drop by about 5%, and vice versa. This is why I say the maximum gain from price appreciation now is about 10%; an interest rate drop of 2% would result in a gain of about 5 x 2% = 10%. That is your maximum upside, since it is unlikely that TBM rate will drop below 0%

By contrast, your downside is much greater, since rates could easily increase by more than 2%. If rates were to increase by 3% back to a more normal level of 5%, the value of the fund would decrease by about 5 x 3% = 15%. At a 5% yield it would take three years to just break even (0% total return over 3 years).

So your perception that the odds of TBM earning less than 2% annualized are not supported by the math. The expected return over the next five years is about 2% if rates do not change. This is what the SEC yield tells us. The only way to earn more than 2% annualized is for rates to drop further, but then that temporary gain will be eroded by the even lower yield. If rates increase at all, it is virtually certain that you will earn less than 2% annualized over the next five years.

On the plus side, the distribution yield of TBM currently is about 2.7%, but that is a fleeting number. The SEC yield of about 2% tells us that over about the next five years, if interest rates do not change, the distribution yield and the value of the fund will drop so that the total return over the five year duration will be about 2%.

Now look at the CD. The PenFed CD yields 2.5%, which already is higher than TBM SEC yield, so if interest rates don't change at all over the next 5-7 years, you come out ahead with the CD. Unlike the bond fund, if interest rates increase, the value of the CD does not fall. If interest rates were to increase to 5%, you simply do an early withdrawal, forfeit your interest for up to one year, then reinvest at the higher rate. After three years you will be up by more than 15% on the CD, while you will just be getting back to even in TBM.

I am not predicting anything about interest rates. I am simply illustrating that a bond fund has much more potential downside than upside at current low rates, while the downside of a CD is limited to the early withdrawal penalty (EWP).

Nevertheless, for people who like to keep things simple, TBM is fine. In the very long run, you will be OK, but if rates increase, those who invest in CDs now will always be ahead; the bond fund investors will never catch up. About the only way the bond fund wins over the next 5-7 years is if interest rates remain steady for the next few years, then drop by 1% or more. This will give the bond fund a pop in value of 5% or more shortly before the CD matures and must be reinvested at the lower rate.

Regarding the articles and posts you've read, one of my pet peeves is the persistent use of the term "bonds" rather than the more general "fixed income". Your comment demonstrates the reason this concerns me. It leads people to neglect to consider alternatives that provide safety that is similar to or better than bonds, and that have a better risk/return profile in the current low-rate environment. Not the worst mistake one could make, but still a mistake IMO (assuming one has the choice, as in an IRA).

Regarding savings, as I pointed out in a post I linked to earlier, Ally CDs would be for money you are unlikely to spend in six months or more, and I Bonds for money you definitely will not spend for one year from initial purchase. The reward checking account, on which you currently can get up to about 4% on $10,000 or 3% on $20,000 would be for the ongoing expenses and shorter-term unexpected expenses. None of this is huge in dollar terms, and even less after taxes, and for many people it is not worth the hassle. To me it is worth it.

Regarding the "total bond market" nomenclature, this really is somewhat misleading. TBM does not invest in municipal bonds, nor high yield bonds, nor international bonds. From the product summary:
This fund is designed to provide broad exposure to U.S. investment grade bonds. Reflecting this goal, the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues).
Note that it does not mention municipal bonds.

I hope this is useful,

Kevin
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wijerg
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Re: Asset Allocation Advice for Newbie.

Post by wijerg »

Hi,
Sorry for the delay in response.

I guess you are right about the interest rates and my expectations about bond market returns.

However I do intend to hold on to these funds for at least 20 years. So in the long run it may not be a bad idea.

As for CDs, I could invest in a few CDs for now and switch to Bonds in future if bond returns increase. But isn't that also trying to time the market which is generally discouraged by boglehead philosophy?

One more thing, I am a citizen of a foreign country and the banks of my country offer CD accounts called NRFC(Non-Resident Foreign Currency) accounts where I can deposit money in US Dollars. The interest for a 5 year CD is about 3.25%, which is better than the best rates I was able to find here in US.
My question is, can I invest my Roth account in a foreign bank?

Thanks a lot for Kevin and everyone else for your help.

I have a much better understanding of things now. I will continue to read articles and visit this forum and try to learn as much as I can.

Thanks.
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Kevin M
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Re: Asset Allocation Advice for Newbie.

Post by Kevin M »

wijerg wrote: As for CDs, I could invest in a few CDs for now and switch to Bonds in future if bond returns increase. But isn't that also trying to time the market which is generally discouraged by boglehead philosophy?
Good question. I don't worry much about how things might be labeled, but let's explore it a bit.

I think market timing refers more to trying to predict what will happen in the future, and moving in and out of investments based on these predictions. Buying stocks when you think they are undervalued and selling when you think they are overvalued would be an example.

Note that I am not predicting anything about interest rates. I am simply looking at the risk/reward trade-off, which is something any rational investor does. We own stocks because of higher expected returns, and in doing so we accept more risk. With fixed income (cash, CDs, bonds) we take less risk and accept lower expected returns. When I compare a good CD to a comparable bond fund (treasury bond fund), I see significantly higher expected return for the CD, about the same credit risk (as long as it's federally insured), and much less interest-rate risk. To get a similar return on a bond fund as a good CD, I must take credit risk, and I still have the higher interest-rate risk. So although I continue to own bond funds, my preference is for CDs.

If the economics changes in the future so that the expected returns for bond funds are high enough to justify the additional risk (given my unique risk tolerance), I may start moving from CDs to bond funds. However, a common phrase is "take your risk in equities--bonds are for safety", or something like that, and it occurs to me that anyone who invests in anything other than short-term treasuries or federally insured deposits is not really following that dictum. Extending maturity adds interest-rate risk, and investing in anything other than government guaranteed bonds adds credit risk. So if I were a purist (which I'm not), maybe I should just stick with CDs.

Personally I take some risk on the fixed income side. Not only do I own bond funds, I own bond funds with different levels of credit risk and term risk. I consider CDs among the super-safe portion of my fixed income. Owning CDs lowers the overall risk of the fixed income portion of my portfolio. This is not something new for me; I've owned CDs for a long time, but I have moved a lot more into CDs as interest rates have declined and bonds have become riskier. Remember, it takes longer to recover from a 1% increase in rates when you're starting at a yield of 2% than if you're starting at a yield of 5%.

I compare it more to rebalancing than to market timing. If stocks increase enough in value my portfolio becomes riskier, so I move some from stocks to bonds to restore my portfolio risk to my target level. As interest rates decline, bond funds become riskier, so I move more from bond funds to CDs.
One more thing, I am a citizen of a foreign country and the banks of my country offer CD accounts called NRFC(Non-Resident Foreign Currency) accounts where I can deposit money in US Dollars. The interest for a 5 year CD is about 3.25%, which is better than the best rates I was able to find here in US.
My question is, can I invest my Roth account in a foreign bank?
Another good question. That's a great rate. For nationally available CDs in the US, the best rate is about 2.25%. I don't know the answer for sure, but it seems to me that one question is whether or not a bank in your country offers Roth IRA accounts. You can't open an IRA account unless the financial institution offers them. For example, until recently Ally Bank did not offer IRA accounts, so no matter how good their CD rates were, one could not own a CD in an IRA account at Ally Bank. I kind of doubt a bank in another country would offer IRA accounts, but I don't really know.

A quick web search turned up this article, which says you cannot roll over a Roth IRA to a bank in another country, but you may be able to roll over a traditional IRA to a bank in another country. I don't know if this is reliable, or if it applies only to rollovers as opposed to new contributions.

Kevin
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sanfran2012
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Re: Asset Allocation Advice for Newbie.

Post by sanfran2012 »

videos explaining boglehead philosophy

http://www.bogleheads.org/wiki/Video:Bo ... philosophy
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