The Two Fund Portfolio

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Senin
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The Two Fund Portfolio

Post by Senin » Mon Apr 23, 2012 3:27 am

I have heard about a lot of portfolios-- the Lazy Portfolio, the Three Fund Portfolio, etc.

How about the Two Fund Portfolio?

It consists of the Vanguard Total Stock Market (70%) and the Vanguard GNMA (30%). (Percentages can be adjustable).

In up stock market years the Total will soar and the GNMA will just be steady.
In down market years, the Total will suffer, but the GNMA will keep you afloat.

Even in market crashes, the VFIIX rarely has a bad year.

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Re: The Two Fund Portfolio

Post by Johm221122 » Mon Apr 23, 2012 4:07 am

Its not the end of the world but how many years is the US the best performing stock market?

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Re: The Two Fund Portfolio

Post by leo383 » Mon Apr 23, 2012 6:35 am

You could do worse than that, and I suspect most investors do.

My Two Fund suggestion would be Vanguard Total World and Vanguard Total Bond. 60/40, 50/50, 40/60, or age in bonds, pick one. Set it and forget it.

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Re: The Two Fund Portfolio

Post by nisiprius » Mon Apr 23, 2012 7:53 am

1) If you have more than one fund, I don't see the huge advantage to having two rather than three.

2) Simple portfolios usually use centrist, mainstream, choices. 100% GNMA isn't really.

3) I think it is at least controversial whether a 100% GNMA fund would be an obviously better choice than Vanguard Total Bond Market. I personally suspect that the GNMA fund became popular because it was available at a time when the Total Bond Fund didn't yet exist (1980 for GNMA, 1986 for Total Bond). The two have behaved very similarly. But most Bogleheads would say that Total Bond contains plenty of GNMAs and is a safer choice because it's more diversified. To go 100% GNMA is to express a distinct personal preference for a specific flavor of bond, and, furthermore, a flavor that at least some prominent authorities (Larry Swedroe) specifically recommend against. GNMAs have a special risk factor not present in most bonds. Vanguard says so right in their short description: "In addition to other bond market risks, the fund is subject to prepayment risk. When mortgage refinance activity is high, the yield on the fund is likely to decrease." Who knows if that's good or bad? People who like the fund say "has been just as safe and a little higher return." People who don't like it says "it has hidden risk that hasn't shown up." I really don't know, and I do feel any hidden risk in GNMAs is small--not lost-all-my-money risk, just thought-I-would-do-a-bit-better-but-actually-did-a-bit-worse risk. But I feel it does make the GNMA fund offbeat. Within the range of the sane, but offbeat.

4) Similarly, as of 2012 going 100% U. S. stocks is expressing a strong investing opinion, even if it doesn't really matter much. 100% U.S. may be fine, but it's offbeat.

5) If for some reason one feels that it's OK to deal with the management of more than one fund, but that three is to many, then it seems to me that the canonical Boglehead portfolio would be the one recommended by Malkiel and Ellis in The Elements of Investing: Vanguard Total World Stock Index for the stock portion and Vanguard Total Bond Index for the bond portion. I don't truly think that's any better than your proposal, but it's... less offbeat.

6) I think it's probably kidding yourself to go down the route of how a portfolio will perform during several different future scenarios. It's better than committing yourself to one ("I'm going 100% stocks because interest rates are sure to rise and bonds are sure to tank"), but you don't want to get to thinking that you've eliminated all risk or even reduced it much. Your comments that "VFIIX will keep you afloat" and "VFIIX has rarely had a bad year" apply equally well to just about any intermediate-term investment-grade bond fund. VFIIX doesn't have any special magic.

7) The real key is the stock/bond allocation, not the flavor of each. In your case, it's your choice of 70/30. Well, when stocks tank, bonds will only keep you 30% afloat. That's the key choice you're making here. If you look at the two funds you picked and asked "What happened between the end of 2007 and the end of Feb. 2009," the answer is that
--$7000 in VTSMX became 70% * $5141 = $3599
--$3000 in VFIIX became 30% * $10,978 = $3239.
--$10,000 total became $6,838 total, almost a 1/3 loss.

Yeah, VFIIX (total, with accumulated dividends) grew while VTSMX shrunk, but did VFIIX "keep you afloat?" I say it didn't, you just sunk three fathoms under instead of five.

And, guess what? Vanguard Target Retirement 2020, with a very roughly similar bond allocation, became $6308. I don't want to analyze whether that's better or worse than your portfolio or why, the point is that the green line is a good pictorial illustration of what it means to have a 30% bond allocation, and how far it goes in "keeping you afloat" when stocks are having a bad time.
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Re: The Two Fund Portfolio

Post by CA lifter » Mon Apr 23, 2012 8:44 am

I often wonder how people can even have a 2- or 3-fund portfolio - even if you only have a couple asset classes, by the time you factor in his/hers 401(k) choices, you end up a bit blended anyhow.

But if I had to choose two:

Total World and Intermediate-term treasury for me.

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Re: The Two Fund Portfolio

Post by 555 » Mon Apr 23, 2012 8:52 am

If you were going to retire in, say, 2042 then a more sensible Two Fund Portfolio would be 60% Vanguard Target Retirement Fund 2040 and 40% Vanguard Target Retirement Fund 2045.

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Re: The Two Fund Portfolio

Post by BYUvol » Mon Apr 23, 2012 11:34 am

555 wrote:If you were going to retire in, say, 2042 then a more sensible Two Fund Portfolio would be 60% Vanguard Target Retirement Fund 2040 and 40% Vanguard Target Retirement Fund 2045.

I personally don't think that approach makes sense. Look at the glide-paths of each fund, the only difference is that the 2040 fund will start into the TIPS and Cash at a slightly earlier time. The difference in allocation will never be more than a couple percent.

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Re: The Two Fund Portfolio

Post by 555 » Mon Apr 23, 2012 12:17 pm

BYUvol wrote:
555 wrote:If you were going to retire in, say, 2042 then a more sensible Two Fund Portfolio would be 60% Vanguard Target Retirement Fund 2040 and 40% Vanguard Target Retirement Fund 2045.
I personally don't think that approach makes sense. Look at the glide-paths of each fund, the only difference is that the 2040 fund will start into the TIPS and Cash at a slightly earlier time. The difference in allocation will never be more than a couple percent.
It's relative. I just said it was a more sensible Two Fund Portfolio. :wink:

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Re: The Two Fund Portfolio

Post by Senin » Mon Apr 23, 2012 3:54 pm

nisiprius, your chart made my point exactly. When the stock market tanked, and the Target Retirement 2020 did too, the GNMA kept chugging along.

The point is that you hope the market does well, hence the Total Stock Market, but if it does take a nose dive, at least your preserve something with GNMA. Without GNMA you just have a total disaster, as per 2002-2003 and 2008-2009.

I don't know what your figures mean in Point #7.

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Re: The Two Fund Portfolio

Post by yobria » Mon Apr 23, 2012 4:00 pm

I like the idea of a two fund portfolio - but those are the wrong funds, since you're leaving so much juicy diversification on the table. I'd do Total Global, and Total (US) Bond.

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Re: The Two Fund Portfolio

Post by nisiprius » Mon Apr 23, 2012 4:05 pm

Senin wrote:nisiprius, your chart made my point exactly. When the stock market tanked, and the Target Retirement 2020 did too, the GNMA kept chugging along.

The point is that you hope the market does well, hence the Total Stock Market, but if it does take a nose dive, at least your preserve something with GNMA. Without GNMA you just have a total disaster, as per 2002-2003 and 2008-2009.

I don't know what your figures mean in Point #7.
My figures mean that if you define what happens without an intermediate-term investment-grade bond fund as "total disaster", then what happens with 70% stocks, 30% bonds is still "70% disaster." The fact that you have a package of securities in which some member of the package does well under most scenarios does not mean that the package is magically protected from all harm. The point of the numbers is that 70% stocks, 30% bonds lost about 1/3 of its value in 2008-2009, whether you got it by mixing a 70/30 two-fund portfolio or letting Vanguard do it for you in a one-fund portfolio.

If you're saying you actually want to use this portfolio, is it sane, sure, why not, go for it. It's not what I'd use myself but hey. If you are saying you think it is distinctly better than using Total Bond for the 30% allocation, I don't see it, and I'd like to hear your explanation. And I honestly don't understand what the advantage is of using only two funds, rather than adding a third to get some international stock exposure.
yobria wrote:...I'd do Total Global...
Vanguard calls it "Total World," VTWSX.
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Re: The Two Fund Portfolio

Post by abuss368 » Mon Apr 23, 2012 4:12 pm

I would think you could do a lot worse than the two fund portfolio.

While I am not familiar with the Vanguard All World Fund, I understand the fund has the market capitalization of International holdings (i.e. 50% or more).

The Total Stock would probably be just as fine.

As for the bonds, GNMA's are probably ok too, but if I was selecting a two fund, I would go with the Total Bond Market index fund for the additional diversification. GNMA are a narrow part of the bond market with additional risks that Vanguard discloses (i.e. prepayment risks).
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Re: The Two Fund Portfolio

Post by Lbill » Mon Apr 23, 2012 6:21 pm

One problem with the two fund portfolio proposed is the diversification benefit. For example the returns of 60% VTSMX, 40% VFIIX have a .98 correlation with the returns of VTSMX alone. 40% VTSMX, 60% VFIIX correlates .92. In order to get any diversification benefit from VFIIX, you have to increase it's allocation to at least 70%-75% of the portfolio, and that dilutes your portfolio returns a lot. In order to get a diversification benefit from bonds and not cripple your total returns you have to increase the duration of your bond holdings; e.g., by holding long-term Treasurys (VUSTX). Holding 60% VTSMX, 40% VUSTX will get you the diversification benefit of 30% VTSMX, 70% VFIIX and produces an annual return that is 12% higher (based on fund returns from 2002-2012). The average volatility of this portfolio is only 60% of the volatility of the stock market - quite acceptable.
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Re: The Two Fund Portfolio

Post by momar » Mon Apr 23, 2012 6:35 pm

Senin wrote:nisiprius, your chart made my point exactly. When the stock market tanked, and the Target Retirement 2020 did too, the GNMA kept chugging along.

The point is that you hope the market does well, hence the Total Stock Market, but if it does take a nose dive, at least your preserve something with GNMA. Without GNMA you just have a total disaster, as per 2002-2003 and 2008-2009.

I don't know what your figures mean in Point #7.
If you consider that TR 2020 tanked, but that a 70/30 mix of TSM/GNMA would be fine, you missed his point. The TR 2020 is meant as a proxy for your proposed mix.
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Re: The Two Fund Portfolio

Post by Senin » Mon Apr 23, 2012 11:09 pm

Then the proxy tanked!

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Re: The Two Fund Portfolio

Post by Senin » Mon Apr 23, 2012 11:25 pm

Vanguard Total Intl Stock Index Inv can have some disasterous years.

2002- Down 15%
2008- Down 44%
2011- Down 14%

I am not sure if I really want this fund.

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Re: The Two Fund Portfolio

Post by Johm221122 » Tue Apr 24, 2012 1:37 am

Senin wrote:Vanguard Total Intl Stock Index Inv can have some disasterous years.

2002- Down 15%
2008- Down 44%
2011- Down 14%

I am not sure if I really want this fund.
I think you need to check total stock market down years, you may not want that either!
Then again they made rebalance and good years so all is well :D

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Re: The Two Fund Portfolio

Post by stemikger » Tue Apr 24, 2012 1:53 am

I like the two fund portfolio.

Ultimately, when I leave the work force, I will put my entire portfolio 75% in one of Vanguard's Target Retirement Fund and 25% in the Vanguard Balanced Index Fund. I will never have to rebalance, and I will feel safe with 75% at a conservative 30% in equities (with the Target Retirement Income Fund), but still feel like I'm getting a boost with 60% equities with 25% of my portfolio. It will help me psychologically knowing when the market is doing really good I will still feel like I'm benefiting from it and also on the down days I will feel like it is only 25% of my portfolio. Kind of like the best of both worlds.

On a side note, Scott Burns who created The Couch Potato Portfolio recommends 50% in The Total Stock Market and 50% in the Total Bond market and rebalance once a year. This is the AA you would keep for life.
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Re: The Two Fund Portfolio

Post by Aptenodytes » Tue Apr 24, 2012 3:39 am

stemikger wrote:I like the two fund portfolio.

Ultimately, when I leave the work force, I will put my entire portfolio 75% in one of Vanguard's Target Retirement Fund and 25% in the Vanguard Balanced Index Fund.
But in that case you like the four-fund portfolio. The Target Retirement Fund invests in Total Stock, Total Bond, Total International, and TIPS (along with a small bit of cash). The Balanced appears to invest in something approximating Total Stock and Total Bond (I haven't looked at it in depth).

And you will still need to rebalance, unless the Target Retirement and Vanguard Balanced yield identical returns, which isn't likely (and which you don't expect, otherwise you wouldn't invest in both).

The quest for the smallest number of funds seems arbitrary and misguided. What one wants is simplicity and sensibility. That could lead any given investor to any number of funds, from one to ten or so, even more if logistical constraints interfere. Two funds aren't inherently better than four funds; what works for an investor depends on multiple factors. And there's no free lunch. Investing a large percentage in a "fund of funds" such as the target retirement funds doesn't absolve you of the need to track their portfolio weights to make sure they make sense for you. Over time they might shift and you might need to reevaluate.

Chasing the smallest possible number of funds is no more sensible than chasing recent high returns.

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Re: The Two Fund Portfolio

Post by Valuethinker » Tue Apr 24, 2012 3:52 am

Senin wrote:In down market years, the Total will suffer, but the GNMA will keep you afloat.

Even in market crashes, the VFIIX rarely has a bad year.
Going by history is dangerous. There is a well understood set of situations where Mortgage Backed Securities (GNMA is a type of same) do badly. See Larry Swedroe's bond book and endless discussions we have had here.

You'd be better off in US Intermediate Term Treasuries *or* in a Total Bond Market fund.

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Re: The Two Fund Portfolio

Post by Trev H » Tue Apr 24, 2012 6:38 am

"Divide your portion to seven or even to eight, for you do not know what mis-fortune may occur on the earth". Ecclesiastes 11:2

You would only have two portions...

A bit short if you ask me or King Solomon who was obviously a slice-n-dicer !

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Re: The Two Fund Portfolio

Post by Senin » Tue Apr 24, 2012 10:50 am

The Total Stock Market had 2 negative years in the last decade.

I have heard all of the negative things about the GNMA but regardless, they always seem to bring in the money every years (meaning they have a positive year).

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Re: The Two Fund Portfolio

Post by mal » Tue Apr 24, 2012 11:08 am

Valuethinker wrote: Going by history is dangerous. There is a well understood set of situations where Mortgage Backed Securities (GNMA is a type of same) do badly. See Larry Swedroe's bond book and endless discussions we have had here.

You'd be better off in US Intermediate Term Treasuries *or* in a Total Bond Market fund.
Absolutely agree here. Can't deny that GNMA's have done well, but the more I consider the structure of them, the more I realize that I vastly prefer the Intermediate Term or Short Term Bond Index funds. I do, however, believe that treasuries may be a bad deal in tax sheltered space (or even a taxable account if you live in a no state income tax state) since the state tax benefit is not taken advantage (I guess the question is whether the tax benefit is a significant portion of the spread?).

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Re: The Two Fund Portfolio

Post by Lbill » Tue Apr 24, 2012 11:12 am

Trev H wrote:"Divide your portion to seven or even to eight, for you do not know what mis-fortune may occur on the earth". Ecclesiastes 11:2

You would only have two portions...

A bit short if you ask me or King Solomon who was obviously a slice-n-dicer !

Trev H
Trev - any suggestion from the Bible which asset classes to use, or do you just bury the proportions in different holes?
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Re: The Two Fund Portfolio

Post by pkcrafter » Wed Apr 25, 2012 12:01 pm

Senin wrote:The Total Stock Market had 2 negative years in the last decade.

I have heard all of the negative things about the GNMA but regardless, they always seem to bring in the money every years (meaning they have a positive year).
You seem to have some misconceptions about GNMAs and diversification. GNMAs are riskier than other high quality bonds as has been noted by others. Just because you have not experienced the risk is not a reason to believe it does not exist. Secondly, holding only GNMAs fails the diversification rule. Because GMNAs are different and contain their own specific risks they should never be the only bond fund in a portfolio.

Article on GMNA risk by EF Moody.

http://www.efmoody.com/investments/gnma.html

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Re: The Two Fund Portfolio

Post by nisiprius » Wed Apr 25, 2012 2:32 pm

There are several different questions that need to be asked about the use of the Vanguard GNMA fund (VFIIX) in place of the more-frequently recommend Vanguard Total Bond Market index (VBMFX)?

a) Does anyone really think it makes much difference, and if so, why?

b) Senin, what's your reason for preferring the GNMA fund? Please tell me it's something more profound than having earned an average 7.10% versus 6.79% over the past 25 years, i.e. more than simple greed. You say the GNMA fund kept chugging along, which it did, but where did it chug along any more steadfastly than Total Bond?

Image

c) The people who think the GNMA fund is riskier: does anyone really think it is much riskier? I once challenged Larry Swedroe on this. Quoting Bogle, "Successful investing involves doing just a few things right and avoiding serious mistakes," I asked him whether GNMAs would count as a serious mistake. His answer was no, but why make a mistake at all?

I say it's a slightly eccentric choice, Senin shouldn't kid himself that he's done anything wonderful by plugging in VFIIX instead of VMBFX, but that there's no reason to think it wouldn't work fine.
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Re: The Two Fund Portfolio

Post by YDNAL » Wed Apr 25, 2012 2:54 pm

Senin wrote:It consists of the Vanguard Total Stock Market (70%) and the Vanguard GNMA (30%). (Percentages can be adjustable).
The Equities are undiversifed, with home bias, missing ~55% of the World's investable universe. The Bonds are undiversified missing ~73% of US Bonds (Treasuries/Corporates), much more IF you consider Foreign Bonds.
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Re: The Two Fund Portfolio

Post by Muchtolearn » Wed Apr 25, 2012 8:11 pm

I hope this isn't a hijack by me. I like the 2 fund portfolio except that bonds should be "taxable bonds" in tax deferred and munis in taxable accounts. SO for me TSM is fine for all stocks. Some say use total world. Some say use TISM for 30%> I doubt it matters much. Here's the hijack:
I have substituted for the IRA the Intermediate investment grade rather than TBM. It has fewer treasuries. Although yields are low in both they are substantially proportionally higher in Intermediate investment grade. I think the risks are low and gains are higher.
So here it is:
Taxable: TSM, NJ muni fund
Tax deferred: TSM,Intermediate investment grade

Allocation is the most important by far rather than the specific fund.

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Re: The Two Fund Portfolio

Post by abuss368 » Wed Apr 25, 2012 8:30 pm

Hi Muchtolearn,

I think you have a really nice two fund portfolio.

My only considerations:

1) I would consider the Intermediate Tax Exempt bond fund instead of the NJ tax exempt fund. True, you will pay some additional tax, but the diversification is much better. Unless you are ok with being 100% New Jersey. We have opted for this fund rather than our state fund. The tax is not bad at all.

2) The additiona of an International index fund would diversify your portfolio even more. However, if you are content with the two fund portolfio, I would not try to convince you otherwise.

Good luck.
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Re: The Two Fund Portfolio

Post by Spades » Wed Apr 25, 2012 8:35 pm

Senin wrote:I have heard about a lot of portfolios-- the Lazy Portfolio, the Three Fund Portfolio, etc.

How about the Two Fund Portfolio?

It consists of the Vanguard Total Stock Market (70%) and the Vanguard GNMA (30%). (Percentages can be adjustable).

In up stock market years the Total will soar and the GNMA will just be steady.
In down market years, the Total will suffer, but the GNMA will keep you afloat.

Even in market crashes, the VFIIX rarely has a bad year.

While I'm a fan of GNMAs, this is a bad plan. GNMAs solely focus on the mortgage market. Your bond portfolio is not diversified at all. If you're serious about this and aren't seriously taking advice against it, then I don't think I'll argue much.

Mal, there is only room enough for one of our avatars!

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Re: The Two Fund Portfolio

Post by tj » Wed Apr 25, 2012 9:29 pm

I thought Total World didn't include small-caps. Was the index updated? Intriguing. I wonder how many people would switch to that 2 fund portfolio (Total World / Total Bond), if I did that - I would hold a lot more international than I currently am - I don't know if that's good or bad, or if it really makes much of a difference in the long term.

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Re: The Two Fund Portfolio

Post by momar » Wed Apr 25, 2012 9:35 pm

Senin wrote:Then the proxy tanked!
Yeah, which means your 70/30 TSM/GNMA would have also tanked.
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Re: The Two Fund Portfolio

Post by tj » Thu Apr 26, 2012 3:37 pm

I'm really curious about Total World vs TSM / TISM. With Total World - you would always have global market cap.

The experts at Vanguard seem to not recommend Total World to the masses as they don't hold global market cap within the Target Date and LifeStrategy funds.

Hmmm....it's a good question though, should I hold more stock of X company just because it's American?

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Re: The Two Fund Portfolio

Post by Muchtolearn » Thu Apr 26, 2012 3:46 pm

abuss368 wrote:Hi Muchtolearn,

I think you have a really nice two fund portfolio.

My only considerations:

1) I would consider the Intermediate Tax Exempt bond fund instead of the NJ tax exempt fund. True, you will pay some additional tax, but the diversification is much better. Unless you are ok with being 100% New Jersey. We have opted for this fund rather than our state fund. The tax is not bad at all.

2) The additiona of an International index fund would diversify your portfolio even more. However, if you are content with the two fund portolfio, I would not try to convince you otherwise.

Good luck.
Thanks for the feedback. I "know" you are right about not being state specific. I just hate the 6.37% NJ tax (to be exact). I was thinking that I would have some of that and then start with a national fund (I guess that gets me to 3 funds). You might want to analyze intermediate muni vs long term muni. The long term isn't really long term in that the duration I think is only about a year more and the yield about 0.4% more. It might be worth it.

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Re: The Two Fund Portfolio

Post by G-Money » Thu Apr 26, 2012 4:12 pm

Muchtolearn wrote:
abuss368 wrote:Hi Muchtolearn,

I think you have a really nice two fund portfolio.

My only considerations:

1) I would consider the Intermediate Tax Exempt bond fund instead of the NJ tax exempt fund. True, you will pay some additional tax, but the diversification is much better. Unless you are ok with being 100% New Jersey. We have opted for this fund rather than our state fund. The tax is not bad at all.

2) The additiona of an International index fund would diversify your portfolio even more. However, if you are content with the two fund portolfio, I would not try to convince you otherwise.

Good luck.
Thanks for the feedback. I "know" you are right about not being state specific. I just hate the 6.37% NJ tax (to be exact). I was thinking that I would have some of that and then start with a national fund (I guess that gets me to 3 funds). You might want to analyze intermediate muni vs long term muni. The long term isn't really long term in that the duration I think is only about a year more and the yield about 0.4% more. It might be worth it.
Vanguard's (national) Long-Term Tax-Exempt fund is yielding 2.53%. Vanguard's NJ Long-Term Tax-Exempt fund is yielding 2.24% (with nearly identical duration). Even on an after-tax basis, wouldn't you come out ahead with the national fund (2.37% v. 2.24%)?
Don't assume I know what I'm talking about.

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