Questions from the Mailbag - Segment 1

Below are some questions and answers based on e-mails or users' web searches that led them to the site:

Q: Should I hold TIPS in a taxable account?

A: Since bonds and bond funds are not very tax-efficient, they are best placed in tax-advantaged accounts such as a 401(k) or IRA. For tax efficient placement, consult this bogleheads article. Stock index funds tend to be the most tax efficient, while high yield bonds, REITs, and actively managed small caps lead to the most negative tax ramifications. Having said that, there are situations in which holding TIPS in taxable accounts makes sense. You should consider your portfolio as a single entity and determine your desired asset allocation. If, for instance, you decide that you want to dedicate 10% of your assets to Vanguard HY Corporate (VWEHX), 15% to Vanguard REIT Index (VGSIX), 10% to Vanguard Total Bond Market Index (VBMFX), and 10% to TIPS in the form of Vanguard Inflation Protected Securities (VIPSX), yet your retirement accounts only account for 30% of your total assets, then you have no choice but to place TIPS in a taxable account. Being the most tax efficient as possible is not nearly as important as maintaining your desired asset allocation based on your investing objectives, time frame, and risk tolerance. In the above hypothetical situation, High Yield Corporate Bonds and REITs are even more tax inefficient than TIPS, so it is the most logical to place those in tax-advantaged accounts first and purchase TIPS in taxable accounts. To make a long story short, ideally it is best to purchase TIPS in a tax-advantaged account if possible since they aren't the most tax efficient asset. However, there are certainly even more tax-inefficient investments and your asset allocation takes precedence. If the space in your tax-advantaged accounts don't allow for TIPS to be wholly purchased in them, then it is certainly a wise decision to purchase them in a taxable account over not purchasing them at all.

Q: How many assets should I have before investing in REITs?

A: There is no correct one size fits all answer to this question. I personally like REITs as a portion of one's portfolio as historically they have not been heavily correlated with other equities and returns have also been very strong. It's just a diversification argument; the more diversified you are, not only do you have greater protection against the downside, but the upside also has greater prospects. First, determine you desired allocation to REITs. Most plans allocate anywhere from zero to 20% of total assets. With a small amount of assets, I would recommend diversified REIT index funds as opposed to a single company. Vanguard REIT Index (VGSIX), for instance, requires a $3,000 minimum initial investment. For argument's sake, let's say you chose to dedicate 10% of your portfolio to REITs. In order to invest in this fund with your desired allocation (10% in this case), you need $30,000 in total assets. Further complicating this matter is the fact that REITS are incredible tax-inefficient and pay out 90% of their income in the form of dividends taxed at the normal income rate (i.e. not the 15% long-term capital gains tax rate). Thus, if you have no tax-advantaged accounts at all and a small amount of assets, I personally don't think the increased diversification is significant enough to overcome the tax burden and would just increase my allocation devoted to equities.

There are certainly other diversified REIT investments out there available besides the Vanguard fund. ETFs require no minimum investment and thus you could essentially have less than $100 and still devote some of your money to REITs. In that case, though, transaction costs would be prohibitively expense and ETFs make little sense for small purchases. Charles Schwab also offers the Schwab Global Real Estate Investor Fund (SWAIX) with just a $100 minimum. Thus, if you targeted a 10% allocation, your total assets just need to be $1000. And if you targeted a 20% allocation, you need just $500. That is certainly a viable alternative, although note that it has a fairly high 1.05% expense ratio and its performance has been largely different than Vanguard's "equivalent" fund (i.e. their investment choices are quite different than the index fund alternative; compare the charts and holdings information). Now, with such small amounts, it's not really going to make a big difference either way (i.e. choosing to invest in REITs or not), but getting invested in a diversified set of assets early could make sense to enforce good habits as long as you're keeping expenses low.

To that end, I typically recommend getting involved in REITs through a diversified index fund such as VGSIX with an allocation of 5-20%, so the absolute minimum assets that one should have before investing in REITs seems to be around $15,000, assuming you are comfortable with a 20% allocation. This is certainly not a set number for everybody and you should take your own personal circumstances into account, but it is a starting point at which I think diversifying with REITs will truly make a significant impact.

Q: Should I purchase a Total Bond Market Fund or TIPS?

A: I encourage the purchasing and allocation of funds to both. Just as advisers preach diversification across sectors and types of stock, it is important to diversify across the bond market. One might argue that the Total Bond Market (VBMFX) is enough diversification, but I personally believe TIPS (VIPSX) are also an important component of one's portfolio. If you don't have enough assets to invest in both, however, I'd most definitely start with the Total Bond Market fund. Many people encourage 2/3 of the bond allocation going towards Total Bond, while the remaining 1/3 goes to TIPS. Others say a 50/50 allocation makes more sense. Decide what makes the most sense for you. Another alternative to the Total Bond Market/TIPS split, is a Treasury fund (short-term or intermediate-term)/TIPS split in similar proportions. Some believe only Treasury bonds are fully dependable and thus avoid the corporate and mortgage related bonds. If somebody's bond portfolio was 50% Vanguard Intermediate-Term Treasury Fund (VFITX) and 50% Vanguard Inflation Protected Securities (VIPSX), I'd give that the go ahead most likely depending on their personal circumstances. Likewise, 2:1 or 1:1 Total Bond:TIPS ratio is also a well-rounded strategy as a play on the bond market.

Q: Would it be advisable to place my emergency savings in a short-term bond index fund?

A: Most financial advisers would tell you "no." Emergency savings are there in case disaster strikes, and you need the assets to be available and liquid, they argue. Bond funds do carry risk and you can certainly lose principle. Savings and money market accounts are safe, FDIC-insured, and reliable. I am, however, going to go against conventional wisdom and argue that in this current economic climate (i.e. extraordinarily low interest and money market fund rates), I think it does make sense for certain individuals to invest a portion of one's emergency savings in a short-term bond index fund, assuming the potential losses are acceptable. For example, placing 3-months living expense in a savings account and 6-months living expenses in a short-term bond fund (in which you plan to hold longer than the duration of the bond issues) assuming you can handle a 5% loss on your investment in those months would be an acceptable level of risk for the increased potential for returns, in my opinion. Note that typically advisers encourage a 6-month expenses emergency account, but in the current employment market, most have increased that to at least 9-months.

In taxable accounts, where emergency savings are typically placed (although it's possible to come up with a strategy to place them in tax-advantaged accounts), it might make sense to check out tax-free municipal bonds since other bond funds are typically not very tax efficient. Use a tax-equivalent yield calculator, such as the one found here, to find out if it makes sense based on current yield rates and your tax bracket. If so, I'd stash a portion of emergency savings in Vanguard Limited-Term Tax-Exempt (VMLTX) or something similar. If not, Vanguard Short-Term Treasury (VFISX), Vanguard Short-Term Bond Index (VBISX), or Vanguard Short-Term Investment Grade (VFSTX) are good choices. Jason Zweig argues in this September 19th Wall Street Journal article, that current conditions make Treasuries the riskiest type of bond right now ("If the economy improves and rates rise, [Treasuries] will get hammered. The longer the bond, the harder the hammering") and recommends Vanguard Short-Term Investment Grade (VFSTX), which currently yields 4.17% and has a duration of 1.97. You should not chase yield, however, under any circumstances. And with distributions coming up at the end of this year, you should be cautious when entering a bond fund at this juncture.

Q: Can Mutual Funds be shorted?

A: No, however, there are inverse mutual funds that increase in value when their market benchmarks go down. I do not recommend such funds. But if you're interested, the largest ones are offered by Rydex, ProFunds, and Direxion. There are also inverse ETFs and leveraged ETFs (that go twice the inverse the benchmark on a daily basis). For a list of inverse funds and ETFs, see here. I especially hate leveraged ETFs. They are extremely dangerous and do not behave the way most investors would expect. These should also be avoided. ETFs can be shorted, however. I likewise do not personally recommend such an action.

Q: Should I invest in index funds or actively managed funds?

A: Index funds have outperformed 60-70% of actively managed funds after taking expenses into account year after year after year. Those active funds that do outperform on any particular year, typically perform worse the next year. Chasing "hot" funds proves to be costly and index fund investing has shown to be a better, more cost efficient method. I subscribe to the "dollar cost averaging into diversified low-cost index funds over the long-term based on your objectives and risk tolerance" philosophy of investing.

Q: Should I hold Vanguard LifeStrategy Funds in a taxable account?

A: LifeStrategy Funds are all-in-one fund-of-funds that are designed to simplify investing and designate one's assets to various asset classes based on risk tolerance. Vanguard LifeStrategy Growth (VASGX) is the most aggressive fund, currently allocating 81% to stocks and 12% to bonds, while Vanguard LifeStrategy Income (VASIX) is the most conservative fund, allocating 22% to stocks and 65% to bonds. Since bonds are inefficient from a tax perspective, it does not make sense to hold a fund heavily invested in bonds in a taxable account. Due the simplicity of such a fund, one with an aggressive portfolio (i.e. skewed towards equities), a smaller number of assets, doesn't want to rebalance, or just wants an extremely simplified approach to dollar cost averaging or investing in general might choose a single all-in-one fund. However, because LifeStrategy funds hold the Vanguard Asset Allocation Fund, which adjusts its allocation and thus realize capital gains, these all-in-one funds are not as tax efficient as the Vanguard Target Retirement Funds, which do not hold the asset allocation fund. Thus, for those seeking an efficient all-in-one fund for a taxable account, look into the Target Retirement Fund with your desired asset allocation for the taxable portion of your assets. Ignore the year in the name; just look at the stock/bond percentages. You should still strive to hold most of your bonds in tax-advantaged accounts, but holding some in taxable accounts is okay. In the end, the Target Retirement Funds are better than the LifeStrategy fund for taxable accounts. Just make sure to revisit the allocation in the future as the target retirement funds automatically adjust as they get closer to the end date, unlike LifeStrategy funds. The tax advantages of TR funds, however, outweigh this negative.

Please send any investing questions to theinvestingguy (at) gmail (dot) com!

Lazy Portfolios

Lazy Portfolios are passive investing techniques that use a diversified set of index funds to perform well in all market conditions. Such portfolios are suitable for most investors during the accumulation phase of their lifetimes as they typically possess 30-40% bonds. They require very little maintenance (rebalancing once or twice a year) and due to low fees associated with index funds, frequently outperform actively managed funds as well as the S&P 500 more generally. An even simpler way to have a lazy portfolio is simply to choose Vanguard LifeStrategy or Target Retirement funds (don't pay attention to the year in the name, choose based on your preferred bond allocation) and perhaps supplement it with an index fund or two to skew it in the direction of your liking.

As of 9/30/2009, all eight Lazy Portfolio's as tracked by MarketWatch's Paul Farrell have outperformed the S&P 500 for the trailing 1-, 3-, and 5-year periods as seen below.

Why have they performed so well? The key is that these portfolios offer protection against the downside and should perform well in a variety of market conditions, unlike the S&P 500. Since the stock market has been in a bearish phase the past five years, these portfolios have greatly outperformed. This may not continue in the future, but there is nobody that can predict the future, and these portfolios offer true diversification, which is key to long-term sustained reliable growth.

(Update: Looking at the portfolio performance through 10/27/09 when the S&P 500 is up over 28% in the last year further strengthens the argument to hold such diversified portfolios. Although the market has been on a tear the past year, all of these funds except one have outperformed the S&P 500 despite that fact that most hold 30% or more bond funds; admittedly, bonds have also had a huge upswing in recent months. Aronson Family Taxable and Second Grader's Starter have approximately outperformed the S&P 500 by 10% in the past year. As they say, past performance does not guarantee future results. However, these results illustrate how these portfolios can perform well in bear and bull markets over the long-term. See graph to the right for complete results through 10/27/09.)
Some investors may want to supplement a lazy portfolio with individual stock picks if they have the time and knowledge base to do so. Just don't expect to pick winners every time - studies have shown that few people can reliably do so. But having 90% of your portfolio dedicated to a Lazy Portfolio and 10% dedicated to individual stock picking seems reasonable to me if you have the desire to do so. Note that these portfolios contain anywhere from 3 to 11 funds, all of which offered by Vanguard as they are the flagship low-cost index fund provider. Some of the funds are repetitive and can be consolidated (e.g. owning small growth and small value can just as easily be held by owning twice as much small blend) to get around the $60,000 minimum portfolio size required of the 11-fund portfolios.

There is no need to blindly follow such portfolios without considering your own personal goals and risk tolerance. The exact percentages are also not important - being in the ballpark is what is significant and rebalancing once a year is preferred. Using these as guides and modifying them slightly to suit your own needs is actually ideal, in my mind.

In addition, these don't specify if they are held in taxable or tax-deferred (i.e. retirement accounts) except for the Aronson Family Taxable. These should thus be seen as overarching percentages of all accounts combined. Based on tax-efficient investing, one should place certain securities in their retirement account over a taxable account and vice versa. For example, REIT funds should be exclusively in retirement accounts, bond funds should mostly be in retirement accounts due to tax inefficiency (except for muni bond funds), while the majority of your equity stake should be in taxable accounts. Consult this bogleheads wiki article for Principles of Tax Efficient Fund Placement and particulars.

Let's further examine the asset allocation of these eight portfolios more closely based on data available from the MarketWatch site.

Aronson Family Taxable
  • Ted Aronson manages $25 billion of assets with AJO Partners
  • 11 funds
  • 0.27% aggregate weighted net expense ratio
  • 70% Stocks / 30% Bonds
  • 15% Vanguard Pacific Stock Index (VPACX)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX)
  • 15% Vanguard 500 Index (VFINX)
  • 10% Vanguard Extended Market Index Fund (VEXMX)
  • 10% Vanguard Long-Term Treasury Fund (VUSTX)
  • 10% Vanguard Emerging Markets Stock Index Fund (VEIEX)
  • 5% Vanguard High-Yield Corporate Fund (VWEHX)
  • 5% Vanguard Small-Cap Growth Index Fund (VISGX)
  • 5% Vanguard European Stock Index Fund (VEURX)
  • 5% Vanguard Total Stock Index Fund (VTSMX)
  • 5% Vanguard Small-Cap Value Index Fund (VISVX)
Comments: One could easily combine 15% VFINX and 5% VTSMX to just 20% VTSMX as they are essentially the same. Likewise, you could combine 5% VISGX and 5% VISVX to be a 10% stake Vanguard Small-Cap Index (NAESX). These consolidations would make this a more manageable 9-fund portfolio. The small value and growth funds used to track different index than the small blend, but they have since all been aligned to track the same benchmark so performance should be similar. Note the absence of an REIT fund that is popular in the other Lazy Portfolios. This is most likely because this portfolio is explicitly for taxable accounts.

Fundadvice Ultimate Buy & Hold
  • Paul Merriman of
  • 11 funds
  • 0.29% aggregate weighted net expense ratio
  • 60% Stocks / 40% Bonds
  • 20% Vanguard Intermediate-Term Treasury Fund (VFITX)
  • 12% Vanguard Short-Term Treasury Fund (VFISX)
  • 12% Vanguard International Value Fund (VTRIX)
  • 12% Vanguard Developed Markets Index Fund (VDMIX)
  • 8% Vanguard Inflation-Protected Securities Fund (VIPSX)
  • 6% Vanguard Small-Cap Index (NAESX)
  • 6% Vanguard Small-Cap Value Index Fund (VISVX)
  • 6% Vanguard Value Index Fund (VIVAX)
  • 6% Vanguard 500 Index Fund (VFINX)
  • 6% Vanguard Emerging Markets Stock Index Fund (VEIEX)
  • 6% Vanguard REIT Index Fund (VGSIX)
Comments: Again, the exact percentages are not imperative. This is a more conservative portfolio with 40% bonds, and skewed towards shorter duration treasuries (which I generally prefer as well).

Dr. Bernstein's Smart Money
  • Dr. William Bernstein is a financial adviser for HNW individuals and wrote an article outlining this portfolio in SmartMoney ten years ago
  • 9 funds
  • 0.26% aggregate weighted net expense ratio
  • 60% Stocks / 40% Bonds
  • 40% Vanguard Short-Term Treasury Fund (VFISX)
  • 15% Vanguard Total Stock Index Fund (VTSMX)
  • 10% Vanguard Small-Cap Value Index Fund (VISVX)
  • 10% Vanguard Value Index (VIVAX)
  • 5% Vanguard Emerging Markets Stock Index Fund (VEIEX)
  • 5% Vanguard European Stock Index Fund (VEURX)
  • 5% Vanguard Small-Cap Index (NAESX)
  • 5% Vanguard Pacific Stock Index (VPACX)
  • 5% Vanguard REIT Index Fund (VGSIX)
Comments: Again, skewed towards short-term treasuries as well as small-cap, value, and emerging markets (typically, Europe accounts for 50% of total international funds, Pacific is 30%, and EM is 20%). Fairly conservative with a 40% bond allocation, all of which is going to Short-Term Treasuries, a non-diversified bond portfolio. I personally would swap in Vanguard Short-Term Bond (VBISX) or Vanguard Total Bond Market (VBMFX) for VFISX for increased diversification.

  • Bill Schultheis is a former Smith Barney broker and author of The Coffeehouse Investor
  • 7 funds
  • 0.25% aggregate weighted net expense ratio
  • 60% Stocks / 40% Bonds
  • 40% Vanguard Total Bond Market Index (VBMFX)
  • 10% Vanguard Small-Cap Value Index Fund (VISVX)
  • 10% Vanguard REIT Index Fund (VGSIX)
  • 10% Vanguard Total International Stock Index Fund (VGTSX)
  • 10% Vanguard 500 Index Fund (VFINX)
  • 10% Vanguard Value Index (VIVAX)
  • 10% Vanguard Small-Cap Index (NAESX)
Comments: This strategy uses a diversified total bond fund to gain access to treasuries (25%), mortgage-backed (35%), corporate (18%), and foreign (5%) bonds.

Yale U's Unconventional
  • David Swensen manages Yale's endowment
  • 6 funds
  • 0.24% aggregate weighted net expense ratio
  • 70% Stocks / 30% Bonds
  • 30% Vanguard Total Stock Index Fund (VTSMX)
  • 20% Vanguard REIT Index Fund (VGSIX)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX)
  • 15% Vanguard Long-Term Treasuries Fund (VUSTX)
  • 15% Vanguard Developed Markets Index Fund (VDMIX)
  • 5% Vanguard Emerging Markets Stock Index Fund (VEIEX)
Comments: The relatively high exposure to REITs have hurt this funds return in the past couple years. However, the REIT fund offers yet another diversification tool as REITs historically have not had high correlation values with the rest of the market. Swensen utilizes a more common 3:1 Developed:Emerging Markets ratio. Vanguard Developed Markets is about 65% Europe and 35% Pacific.

Dr. Bernstein's No Brainer
  • 4 funds
  • 0.24% aggregate weighted net expense ratio
  • 75% Stocks / 25% Bonds
  • 25% Vanguard Total Bond Market Index (VBMFX)
  • 25% Vanguard 500 Index Fund (VFINX)
  • 25% Vanguard European Stock Index Fund (VEURX)
  • 25% Vanguard Small-Cap Index (NAESX)
Comments: This is a super simple, four fund evenly split portfolio. It again skews towards small-cap, but doesn't have any exposure to Pacific, emerging markets, or REITs, which I feel can offer potential for increased returns and diversification. With increased globalization of the financial markets, European and US Markets typically correlate very well. It's the emerging markets that typically differ. Replacing Vanguard European Stock Index Fund (VEURX) with Vanguard Total International (VGTSX) or Vanguard FTSE All-World ex-US Index (VFWIX) would be a wise decision, in my opinion. Then, adding a small position in Vanguard REIT Index (VGSIX) (reducing the small-cap fund percentage by the same amount) would make this a great 5-fund portfolio.

  • Scott Burns developed this portfolio for the Dallas Morning News
  • 3 funds
  • 0.26% aggregate weighted net expense ratio
  • 67% Stocks / 33% Bonds
  • 34% Vanguard Total Stock Index Fund (VTSMX)
  • 33% Vanguard Total International Stock Index Fund (VGTSX)
  • 33% Vanguard Inflation-Protected Securities Fund (VIPSX)
Comments: This is also an incredibly simple portfolio that makes a lot of sense. This overweights the international market more than all-in-one funds such as LifeStrategy or Target Retirement funds, and provides exposure to nearly every part of the world. This portfolio is also a good hedge again increased inflation, which is not a bad bet in this current economic status. But the bond allocation certainly isn't diversified.

Second Grader's Starter
  • 3 funds
  • 0.23% aggregate weighted net expense ratio
  • 90% Stocks / 10% Bonds
  • 60% Vanguard Total Stock Index Fund (VTSMX)
  • 30% Vanguard Total International Stock Index Fund (VGTSX)
  • 10% Vanguard Total Bond Market Index (VBMFX)
Comments: Similar to the Margaritaville portfolio, except the TIPS fund has been substituted with a TBM fund. This portfolio has underperformed the others not as a function of its simplicity, but due to its high exposure to equities (90%) unlike the other portfolios. Obviously, stocks have underperformed in the past five years. One could easily use this strategy as a starting point and skew it to the appropriate bond allocation based on your objectives and risk tolerance. (A typical bond allocation is your age in bonds or some say 110 minus your age equals an appropriate stock allocation.) If this had simply been a 33%/33%/33% split, it would have performed remarkably similar to the Margaritaville portfolio over the 5-year period. The total bond market index is more diversified and thus less volatile than the TIPS fund. Over the past 5 years, TBM has returned 5.18% annually, while TIPS have returned 4.67% annually. So, it would have outperformed Margaritaville had it had the same bond allocation. This is a Lazy Portfolio I highly recommend based on its simplicity, broad diversification, low expenses, and easy flexibility. I do like some exposure to REITs in retirement account, however, and this has none. Adding Vanguard REIT Index Fund (VGSIX) to this three fund portfolio to create a tailored four fund portfolio would make a lot of sense.

Investing Guy's Lazy Portfolio
  • 6 funds
  • 0.25% aggregate weighted net expense ratio
  • 70% Stocks / 30% Bonds
  • 25% Vanguard Total Stock Index Fund (VTSMX)
  • 25% Vanguard Total International Stock Index Fund (VGTSX)
  • 20% Vanguard Total Bond Market Index (VBMFX)
  • 10% Vanguard Inflation-Protected Securities Fund (VIPSX)
  • 10% Vanguard REIT Index Fund (VGSIX)
  • 10% Vanguard Small-Cap Value Index Fund (VISVX)
Comments: This portfolio utilizes my preference for the a small-cap/value tilt on US equities, as well as exposure to REITs and TIPS. It also exposes you to foreign small caps unlike the other Lazy Portfolios as this should provide greater diversification and expected return. (Note: This statement is no longer true since Total International now includes small-cap international.  See more details below).  I attempt to keep it as simple as possible to make re-balancing and accounting easier, while also exposing you to nearly all portions of the market. (Some may argue that commodities are missing, but this is an area that shouldn't be touched by the average investor.)

The bond percentage is not a one size fits all, in my opinion. You should adjust that percentage (just increase or decrease VBMFX) based on your age, timeframe to retirement, and risk tolerance, and modify the rest accordingly. I use VFWIX over VGTSX (Total International Market) since it is slightly more tax-efficient (eligible for the foreign tax credit since it holds securities directly) and contains Canada (6%) unlike Total Int'l. However, VGTSX recently changed from being a fund-of-funds to also holding the stocks directly, so its tax efficiency should be nearly the same as VFWIX going forward and the blurring between these two funds gets even stronger. (I'd expect Vanguard eventually combines them.) If you want to slightly overweight Emerging Markets by holding a small position in Vanguard Emerging Markets Stock Index Fund (VEIEX) or further slice and dice into a Vanguard Developed Markets (VDMIX)/VEIEX blend instead of a single holding in VFWIX, that would look good to me as well.

As stated above, I recommend holding some small-cap international through a fund such as Vanguard FTSE All-World ex-US Small Cap Index (VFSVX; ER 0.78%; 0.75% purchase and redemption fees) or ETF such as VSS (ER 0.55%), Schwab International Small-Cap ETF (SCHC; ER 0.35%), or iShares MSCI EAFE Small Cap (SCZ; ER 0.4%). All are good choices, although too much slicing and dicing can over complicate your portfolio, so if this makes things harder to keep track of and maintain for you, then it's best to avoid it. Keep it simple. I'd see nothing wrong with moving that 5% to the large cap international fund (VFWIX) to make large cap international a full 25%. The various funds and ETFs mentioned at the beginning of this paragraph may track different indicies, so that's something to be aware of, although the differences will most likely be small. A reasonable percentage of small-cap international is about 20-25% of your total international holdings. (Simply reduce or increase your large-cap international holding by the same amount. That is, keep your total international target the same.) Thus, if you have a relatively small portfolio (<$100,000), then your small-cap international holding probably won't make a significant difference in the long run.

Update 10/25/10: Vanguard is adjusting their Total International Index (VGTSX) to track the MSCI All Country World ex USA Investable Market Index in the near future.  This new fund will include the market share of small-caps (~15%) and thus is a perfect all-in-one solution for foreign exposure.  This fund's investor expense ratio is 0.32% and will also be offering admiral (>$10,000 investment) and ETF class shares for even cheaper.  When these changes will take place it still uncertain, but people are speculating they will occur sometime in Q1 2011.

Update 1/31/11: Vanguard's international fund now follows the above mentioned index.  Thus, I have modified it to simply including one international fund instead of a large-cap international and small-cap international.  Fewer holdings should make it easier to track.

If the seven funds make it too complicated to re-balance, keep track of, or dollar cost average for you, I'd go with a VTSMX (40%), VBMFX (25%), VFWIX  VGTSX now (25%), and VGSIX (10%) portfolio assuming you want a 75/25 stock/bond split. That four fund portfolio (as I said in the comments for Second Grader's Starter) is perfect for many individuals and I recommend it highly. Vanguard recommends holding 20-40% of your equity stake in foreign markets, and I have it at approximately the 36% mark, if you count REITs as part of US equity (which some may and others may not). The market cap of non-US equities has climbed to 59% of the global market cap (check out the X-Ray of Vanguard Total World Stock Index, VTWSX) and Vanguard suggests that as an upper limit. However, their analysis indicates there is incremental benefit in having more than 40% in international stock based on the increased risk (such as currency volatility), so they substitute 40% as the recommended upper limit. Just choose something you are comfortable with and stick with it. Try to hold as much of the bond and REIT portions of your portfolio in tax-advantaged accounts as these are not very tax efficient. Stock funds are very tax efficient so you should hold these in taxable accounts.

Overall comments: Note the expense ratios hover around 0.25%. That is certainly very low, but still above Target Retirement funds which are approximately 0.20%. This 0.05% difference is only $5 difference a year for every $10,000 invested, so it's certainly nothing to worry about, but the point is that from a fund expense standpoint, the self contained fund-of-funds indexing (i.e. TR funds) is not any worse than the do-it-yourself approach (i.e. Lazy Portfolios).  Also note that these expense ratios are for investor class shares, but Vanguard reduced the investment amount to qualify for the lower-cost Admiral shares to only $10,000 in October 2010.  Thus, if your portfolio is a decent size, you could easily take advantage of these lower costs and lose even less of your investment gains to fees.

The Lazy Portfolios just give you more flexibility to choose the percentages as you see fit and allow you to hold the funds in a more tax efficient manner. One should be aware of the potential tax consequences of holding bond funds in taxable accounts if you go the single fund approach. It's also interesting to examine some commonalities between the various portfolios; they are typically skewed towards small-cap, value, REITs, international, emerging markets, short-term treasuries, and/or TIPS moreso than the TR/LifeStrategy Funds.

Here is a graphical representation of all the eight aforementioned portfolios' asset allocations based on the categories of the particular funds:

You can dissect these and go back and forth on what you think is the best approach forever, but in the end, just choose a strategy and stay the course. One is not significantly better than the other; the key thing to determine is your age and tolerance for risk, which should determine your bond allocation. Don't deviate from your plan. That has proven time and time again to be catastrophic. Choosing one of these portfolios requires perhaps a one hour time commitment a year to rebalance and monitor the performance. It's really a great way to beat those attempting to time the market, make individual stock picks, etc. And you'll rest easy at night and have time to dedicate to more important things in life.

If you want to dollar cost average over time into funds and don't want to rotate which fund you set up for an automatic investment plan, it might make sense to invest in a Target Retirement or LifeStrategy fund that has an appropriate allocation of bonds and then supplement it with index funds that you find appropriate. These funds contain the Total US Stock Market, the Total Bond Market, the European Market, Pacific Market, and Emerging Markets. You can supplement that core holding with small-cap, value, TIPS, REIT, and perhaps more international equities or short-term treasury funds. It's easy to personalize it and you can dollar cost average into the core fund, which won't significantly alter your asset allocation.

Do some research and choose a Lazy Portfolio that's right for you or create your own. You won't regret it.
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