User:BeBH65/Portfolio construction

After settling on your asset allocation you can turn to selecting funds that flesh out your desired asset allocation and place them in the most tax efficient manner.  is best guided by the principles of the Bogleheads® investment philosophy. The best and lowest cost way to buy in a widely diversified and simple way is with whole market index funds. Bogleheads create a good plan, avoiding attempts to time the market, and then stick with it and stay the course. This consistently produces good outcomes over the long term.

It is usually best to consider all of your investments together. If you are married, you should usually blend accounts held by both spouses into one unified portfolio.

In summary the process is:
 * The first step in constructing a portfolio is to make a list of all your current investment accounts and the investments in each account.
 * Next, start with the account types that offer the most limited investment choices. 401k and 403b type plans normally offer limited fund choices, so starting here and building around a plan's best fund choices is often the best idea. Look at all the funds available in your 401k and list the ones from each category (US equity, international equity, bonds, etc) with the lowest expense ratio, then validate that they satisfy the Bogleheads® principles of simplicity, diversity and low-cost.
 * Finally, you must consider the tax consequences of investing, especially in taxable accounts. Generally, the most tax efficient way to use your different accounts is:
 * 1) Invest as much as possible in your tax-deferred and tax-free accounts.
 * 2) Put the most tax-inefficient funds in your tax-deferred and tax-free accounts.
 * 3) Use only tax-efficient funds in taxable accounts.
 * 4) If all else is equal, put funds with higher expected returns in tax-free (Roth) accounts in preference to tax-deferred (traditional 401(k), 403(b), traditional IRA) accounts.

Introduction
Investing comes after you have a sound financial footing. You need to save money to invest. This means spend less than you earn and have a sound financial lifestyle. Investing should only commence after you have established an emergency fund.

The first step when starting an investment program is to choose your asset allocation, basically your allocation to stocks, bonds, and cash. The asset allocations should reflect your need for portfolio return balanced against your tolerance for risk. Risk tolerance is an investor’s emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep. Risk and return are directly related, a higher expected return will necessitate a higher level of risk. The asset allocation should reflect one’s unique ability, willingness and need to take risk. This balance is a key factor in creating a portfolio that will allow investors to stay the course during the inevitable market downturns.

Document your chosen asset allocation in your investment policy statement, if you would not yet have completed it.

After settling on your primary asset allocation you can turn to selecting funds that flesh out your desired asset allocation and placing them in the most tax efficient manner.

Bogleheads® principles for portfolio construction
The Bogleheads® investment philosophy includes a few principles directly focused on portfolio construction. These principles lead to a preference for simple, low-cost, tax-efficient total-market index mutual funds, because each contains thousands of securities and as such limit the number of funds needed to invest in the complete investable stock market. These index funds achieves maximum diversification in a simple and low-cost way

Diversify

 *  Watch the video

Rather than trying to pick the specific securities or sectors of the market (US stocks, international stocks, and US bonds) that will outperform in the future, Bogleheads buy funds that are widely diversified, or even approximate the whole market. . This diversification lowers risk, because the failure of any one securities does not have a big effect.

It is not necessary to own many funds to achieve effective diversification. A single total stock market index fund contains thousands of stocks, including all styles and cap-sizes. A total bond market index fund contains thousands of bonds of various types and maturities.

Simplicity

 *  Watch the video

A simple portfolio has many advantages. It almost always lowers costs (including taxes), makes analysis easier, simplifies rebalancing, simplifies tax-preparation, reduces paper-work and record-keeping, and enables caregivers and heirs to easily take-over the portfolio when necessary. Best of all, a simple portfolio allows you to spend more time with family and friends, and less time managing your finances.

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Constructing a good portfolio can be simple. It is not necessary to own many funds to achieve effective diversification. Using total market funds limits the number of funds needed to invest in the markets.
 * A total stock market index fund invest in the complete investable stock market. It contains thousands of stocks, including all styles and cap-sizes, weighting stocks according to their market capitalization.
 * The most complete total international index funds invest in both developed market and emerging market stocks, and hold market allocations to large-cap, mid-cap, and small-cap stocks.
 * In the US, a total bond market index funds contains thousands of bonds of various types and maturities. It commonly benchmarked to the Barclays Capital US Aggregate Bond Index, which benchmarks investment grade taxable bonds. These include treasury and government agency bonds, investment grade corporate bonds, mortgage-backed securities and asset-backed securities.

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In his Little Book of Common Sense Investing, Mr. Bogle recommends a simple portfolio of only two funds for many investors: Vanguard Total Stock Market Index Fund and Total Bond Market Index Fund.

A portfolio held by many Bogleheads forum members is the three fund portfolio, which allocates investments among a U.S. Total stock market index fund, a Total International stock market index fund, and a U.S Total bond market index fund. Many Bogleheads extend the bond portion of this portfolio to include a fourth asset class, U.S. inflation-indexed bonds. As Bogleheads author William Bernstein says in reference to the three fund portfolio: "Does this portfolio seem overly simplistic, even amateurish? Get over it. Over the next few decades, the overwhelming majority of all professional investors will not be able to beat it."

If your entire portfolio is in a tax-advantaged account, you can simplify even further by owning a single Target date fund or LifeStrategy fund. Each of these "all-in-one" funds combines several underlying index funds into a single fund with a specified stock/bond ratio, so you can select a fund with the appropriate amount of risk. This makes it even easier for you beginners to get started with a simple, low-cost, highly diversified indexed portfolio.

The target date funds have the additional benefit that they automatically move to a more conservative asset allocation over time. Avoiding the need to personally need to decide on changes of the asset allocation over time.

Some Bogleheads use more than three or four funds in their portfolios, implementing a lazy portfolio. As with all investment decisions, you should be aware of the risks and costs before doing so.

Keep costs low



 *  Watch the video

It is critical to keep investing costs low. Individual Mutual funds incur many costs to operate the fund, sales charges associated with each fund purchase as well as costs buying and selling securities for the fund. These costs are ultimately charged to the investor.

The effect of the compounding costs over an investing lifetime is enormous. Investors need returns compounding for their own benefit, not the benefit of fund companies who skim unnecessary fees off the top. Figure 2. is an example showing that 1% of additional costs will reduce available retirement funds by 10 years.

Minimize taxes

 *  Watch the video

Perhaps the reason that Bogleheads focus carefully on tax efficiency is that no one controls how equity markets might perform in a given year. Rather than obsessing over the unknowable, you should focus on areas where your decisions can save money: by preserving money for retirement what would otherwise go to taxes.

The most important rule for tax efficiency is to take full advantage of tax-advantaged accounts such as 401(k)s and  IRAs. These allow your money to grow, using the magic of compound interest, without a portion being removed every year to pay taxes. Many investors have large enough tax-advantaged accounts to hold all of their retirement savings, and so never need to worry about tax efficient placement.

But for those who also have taxable accounts, look carefully at the tax efficiency of each holding. Some fund types, like total market equity index funds, are extremely tax-efficient, because they produce very low dividends and capital gains. By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate.

Tax-efficient fund placement matters. The same funds can produce hundreds of thousands of dollars more for your retirement if you place them in a tax efficient manner. So Bogleheads put tax-inefficient funds (like high yielding bond funds) into tax-advantaged accounts. Other tax-inefficient funds that should usually go in tax-advantaged accounts are REITs, small value funds, and actively managed funds that frequently churn their holdings. If there's not enough room for bonds in tax-advantaged accounts, and you are in a higher tax bracket, holding tax-exempt municipal bond funds in a taxable account may be a good choice.

Bogleheads who hold taxable accounts also often make use of tax loss harvesting, which is a technique to turn market downturns into immediate tax savings.

Use index funds when possible
Low-cost, tax-efficiency, and simplicity are recognized as advantages of index funds. Index funds based on broad indexes, like total-market indexes, provide a large diversification because each contains thousands of securities. The best and lowest cost way to buy the whole stock market is with index funds (either through traditional mutual funds or ETFs).
 *  Watch the video


 * Low-cost: Index funds typically have the lowest expense ratios in their category. Stock market index funds can reduce transaction costs through low broker commissions, low fund turnover, and cross trading with other index funds


 * Tax efficiency:Due to lower fund turnover and longer holding periods stock market index funds tend to exhibit greater tax efficiency. Many funds, like total market index funds and large cap index funds, rarely realize and distribute a capital gain. The deferral of capital gains tax liabilities results in a tax-efficient index fund providing higher after tax returns to investors. In addition, many of these funds have been successful in providing investors with 100% qualified dividends, which are taxed at lower tax rates.


 * Asset class style consistency: Index funds make suitable building blocks for asset allocation purposes because they can be trusted to remain reliably close to their declared style parameters.


 * Reduced manager risk: The performance of an index funds does not depend on one fund manager, as index funds are managed by an investment team and indexing limits the decision that need to be taken.


 * Simplicity: The low cost,  high tax efficiency, and long term consistency of performance advantages of indexing greatly simplify the task of fund selection and fund monitoring in an investment plan.

By combining these characteristics, index funds almost guarantee they will deliver the average return of all investors. Being average might sound bad, but it is actually a great thing. That's because most investors perform worse than average after taking into account the high fees for investing in individual funds or that they can pay for actively managed funds. If there were no fees, then every year, half of all actively managed funds would outperform the index (because the index is the average). It might seem like an investor would just want to invest in those outperforming funds. But there is no persistence to the results. Funds that outperform one year tend to underperform in the next. And in the real world, investors pay high fees on managed funds. That means a majority of actively managed funds underperform index funds over the long haul.

Asset allocation portfolios
DUPLICATION WITH ABOVE ON SIMPLICITYH AND DIVERSIFICAATION xx focus more on funds than on asset-classes

Strategic asset allocation strategies range from simple to complex. Lazy portfolios are designed to perform well in most market conditions. Most contain a small number of low-cost funds that are easy to rebalance. They are "lazy" in that the investor can maintain the same asset allocation for an extended period of time, suitable for most pre-retirement investors.


 * John Bogle is a proponent of simple asset allocation portfolios. He frequently advises that most investors should allocate investment portfolios using two asset class index funds: a U.S. total market stock index fund, and a U.S. total bond market index fund.


 * A widely held portfolio among Bogleheads® Forum members is the three fund portfolio allocating investments among a U.S. Total market stock market portfolio; a Total International stock market portfolio, and a U.S Total bond market portfolio.  This portfolio is frequently expanded to include a fourth asset class, U.S. inflation-indexed bonds.


 * Some strategic asset allocation funds add additional asset classes or sub-asset classes to the asset mix. For equity investments these additions can include value stock funds, real estate funds (U.S. and international), gold, and commodity futures funds. Fixed income additions to the asset class palette include U.S high yield bond funds, international developed market bond funds, and emerging market bond funds. In addition, depending on an investor's risk tolerance preferences or tax situation, bond market allocations can be restricted to U.S treasury bonds or investment grade municipal bonds.

More example Portfolios
xx focus more on funds than on asset-classes

Bogleheads advocate investments in well-diversified, low-cost index funds. The following articles provide examples of simple broadly diversified investment portfolios.
 * Target date retirement funds - all-in-one funds that adjust the asset allocation over time, aimed for investors who want simplicity of managing their investments.
 * Three-fund portfolio - often recommended by Bogleheads attracted by "the majesty of simplicity" (John Bogle's phrase), and for those who want finer control and better tax-efficiency than they would get in a target date fund.
 * Four-fund portfolio - Vanguard recommends a four-fund portfolio for global diversification by adding international bonds
 * Lazy portfolios - lists more examples of portfolios designed to perform well in most market conditions. These contain a small number of low-cost funds that are easy to rebalance. They are "lazy" in that the investor can maintain the same asset allocation for an extended period of time without needing adjustments and are suitable for most pre-retirement investors.

Tools and calculator
Investors should look at all of their accounts as a unified portfolio to construct a portfolio that is low cost, well diversified, and tax efficient. You can use various utilities to design and manage portfolios. Most tools cannot automatically compose your ideal portfolio, but you can use the tools to enter two or three models that you composed, and then you can compare and contrast the results, looking in particular at the blended expense ratios and the totals of each asset class. Alternatively using a spreadsheet to maintain a portfolio can be another way of easing the burden.

Morningstar X-Ray
A tool for breaking down a portfolio into asset allocations and style box box views. See the main article for additional information.

Vanguard Portfolio Watch
A tool in the Vanguard website for Vanguard clients that breaks down portfolio into asset classes; see main article for more information and caveats/limitations of the tool.

Spreadsheet

 * Using a spreadsheet to maintain a portfolio
 * Asset Allocation Spreadsheet - a Google spreadsheet created by Hoppy08520, with a link to documentation, that can help setup a multi-account portfolio.

Selecting the fund from a plan
In constructing a portfolio one often does not have a full freedom in selecting the funds. Often a plan (like 401(k)) or account (like IRA) has a limited choice of good funds. The process starts by (knowing the desired asset allocation) reviewing the available funds, then selecting the appropriate funds to create the portfolio.

Employer plans can have many investment options, presenting investors with a long list of unfamiliar names. For an example of a plan with a mixture of index funds and active funds on the plan fund menu, see the fund options in the plan revealed in Any good funds in this list, forum discussion. (Open table to reveal fund options and expense ratios.) (Extended illustration in footnotes).For the chosen asset allocation one then needs to review the available funds and select the appropriate ones. The following checklist can help you find the offerings that can help fill your desired asset allocations. For portfolios following the Bogleheads investment Philosophy, we would be looking for low-cost diversified index funds matching our targeted asset classes.

Preparation

 * For each item in the plan fund list, find the available asset class exposure that the funds provide and their expense ratios. The fund's fact sheet will list the asset allocation information and the expense ratio.

Shortlisting funds

 * Look for the desired asset class categories, such as US stock, international stock, small cap stocks, value stocks and US bonds. Funds marked "fixed income" or "guaranteed income" counts as bonds; company stock funds count as stock. Some bond funds may be listed as "inflation protected."


 * Scan your fund listings and identify the index funds.
 * Look for the word index in the name.
 * In most cases, the lowest-expense funds will be index funds.
 * For international stocks, which sometimes have an alphabet soup of acronyms like MSCI EAFE.

Selecting the funds
If no good funds are available then you will need to approximate them as explained in the sections below.

Select a suitable US-domestic stock fund
Within the shortlisted US-domestic stock fund look for an S&P 500 index fund and/or a Total US Stock Index fund.
 * Note that the actual name of the fund might not actually be S&P 500 Index Fund. It might be called 500 Index, Equity Index, Large Cap Index or some other name. You may need to read your plan information carefully determine the fund’s composition.
 * If the expense ratio of the Total US Stock Index fund is not much higher than the S&P 500 Index fund, then use it (you get a higher diversification)
 * If you don't have a Total US Stock Market Index Fund, but you have a 500-index fund then you may want to approximate the total market by using funds that "complete" the S&P 500 index with for instance an extended market index fund, or a combination of small- and mid-cap index funds.

Selecting a suitable International stock fund
Within the shortlisted US-domestic stock fund look for a fund with a name like International Index, Total International Index, International Equity, Global, World, MSCI All-World ex US, or other fund names that suggest a total market international fund.
 * Generally, if there is an index fund, it will be the least expensive international fund in the plan. You may need to study your funds carefully to find the right fund.
 * Plans often provide international exposure with a developed market index fund, which lacks the emerging market stocks and small cap international stocks included in international total market funds. One can approximated total international funds with these.

Selecting a suitable Domestic bond fund

 * Within the shortlisted bond funds, look for a bond fund with "index" or "total" in its name. You will likely need to study your funds more closely to see if there is an index fund in your plan. Look for a fund that tracks the Barclays Capital US Aggregate Bond Index, which is the same index the Vanguard Total Bond Market Index Fund (VBMFX)tracks.
 * Select the fund that matches your desired duration and quality

Special cases

 * Note that if you hold multiple accounts, you need not hold each of your portfolio's asset classes within the employer plan, unless you prefer to mirror the allocation in each account. The allocations can be spread across accounts (as an example: holding the bond allocations in an employer plan; the US stock investments in a personal IRA, and holding international investments in a taxable account.)


 * Some plans may have a self directed brokerage account that provides access to a wider selection of indexed investment options, but be sure to calculate the expected cost of utilizing this service, taking into account all fees that would apply and compare it to the cost of using the fund choices in the qualified plan in order to help guide the decision.

401k Choices Seem Expensive, forum discussion reveals a 401(k) plan offering only active funds. (Open table to reveal fund options and expense ratios).
 * The plan may only contain actively managed funds. In this circumstance one should select the lowest cost stock funds and highest grade bond funds that approximate the targeted assets classes. For example,

In this instance, an investor could minimize costs and fashion a three fund portfolio of large cap US stocks, developed market international stocks, and an investment grade intermediate bond fund:

Funds that implement target asset allocations
An asset-allocation fund or a balanced fund is a mutual fund that holds multiple asset classes in a single portfolio. Typically these funds hold a stock component; a bond component, and in some instances, a cash component. Many balanced funds maintain a fixed asset allocation; some pursue a variable allocation policy, changing asset weightings according to market conditions. Target date funds are balanced funds that gradually change asset class weightings in harmony with an investor's supposed changing need for a lower risk profile over time. .

These funds attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

Choices for equity
xx focus more on funds than on asset-classes

For equity allocation a US investor needs to choose the split between domestic (=US) and international (=ex-US) stocks. At the same time the investor needs to decide whether to follow the full market or to select a portion (large-cap, mid-cap or small-cap); or to tilt in style (value, blend or growth); or to allocate among sectors or favor REITS.

Choices for bonds
xx focus more on funds than on asset-classes

Bogleheads like to own bond funds instead of individual bonds for convenience and diversification. Using individual corporate or municipal bonds require a very large holding in order to achieve the broad diversification and increased safety of a bond fund. The high number of different bonds in bond funds let you ignore the risk of any one bond defaulting. Interest rate risk can be managed if you select funds with short and intermediate-term duration, while default risk can be managed by selecting funds with high credit ratings. The central idea here is that your bond holdings are for safety, to reduce violent up and down swings in overall portfolio value. Bogleheads tend to take risks on the equity side, not the bond side.

Bogleheads typically divide bond allocations between just two categories: nominal bonds such as the Vanguard Total Bond Market Fund, and U.S. Treasury Inflation Protected Securities (TIPS) such as the Vanguard Inflation Protected Securities Fund. The use of a TIPS fund provides additional diversification as well as inflation protection.

I-Bonds are also an attractive alternative to TIPS. They are sold directly to investors by the U.S. Treasury; can be bought using your IRS tax refund; don't need to be held in a tax-protected account; and accrue interest tax-deferred for up to 30 years. There are annual limits on how much you can buy in I-bonds.

Approximation of desired funds

 * Approximating Vanguard target date funds - explain +links
 * approximate total stock market - explain +links
 * approximate total international - explain +links
 * approximating 3 or 4 fund portfolios - To approximate a 3 or 4 fund portfolio the same procedure can be followed as explained to approximate a Vanguard target date fund

Tax Considerations
Consideration should be given to tax efficiency; which is an approach to minimize the effects of taxes on your portfolio. Tax efficiency should be considered after you select your asset allocation.

New contributions
Dividends

Maintain your portfolio
Once you have your portfolio, it's important to rebalance when your funds deviate (more than 5%-10%) from your asset-allocation plan. This is accomplished by transferring from over-allocated asset classes to under-allocated asset classes. Target date retirement funds automatically rebalance for you.