Investing 101, Part Four: Three-Fund Investing and Asset Allocation

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Friends, we’ve come a long way. You’re pretty much already an investing genius so far if you have read this series (if not, start here). There is something else to consider, though: asset allocation. We talked previously about how mutual funds help you hedge your bets against any single company or government failing. The stock and bond markets have highs and lows as a whole, however. The stock market averages a return of 8% a year, but that can mean it could earn 16% one year and be at -8% the following year. There’s still risk involved. Asset allocation helps us hedge our bets against losing too much money at an inopportune time. We don’t want to have all of our money invested in the stock market at age 65, and it take a dive the year we want to retire. While, based on historical precedent, we’ll eventually get that money back, it might take 10-15 years. We literally can’t afford to wait that long at 65.

That’s why we need investments spread across a few different types. If one big category declines (the US stock market, for instance), you don’t lose all of your money. One very simple way to get a fully-diversified portfolio is to use three types of index funds. Those three are:

  1. A total domestic (US) stock market index fund
  2. A total international stock market index fund
  3. A total bond fund

Let’s talk about why those three, and how to pick how much money to put in each type.

What’s Your Risk Tolerance?

We’ve talked about how investing involves risk. We’re trying insulate ourselves against risk as much as possible, but nonetheless, we don’t have much control over such events as the economic downturn of 2008. So, ponder how you would feel if you were invested in a total stock market index fund in 2008, and each morning you woke up and saw your portfolio balance decline?

A very risk-averse person is going to completely freak out and withdraw all of their investments or swap them into something more conservative. If this very risk-averse person stayed the course, they would earn their money back over time, plus have additional assets purchased at rock-bottom prices because of the crash. By pulling out, they locked in their losses, and will not recover their money. That said, staying the course when you are rapidly losing money is completely contrary to typical human behavior. It’s really hard, which is why you need to seriously consider what your “freak out” point is and tailor your asset allocation appropriately.

How do you do that? You can hedge your bets by investing more heavily in bonds. A general rule of thumb is that bond investments should form a percentage of your investments equal to your age. We talked before about how bonds are a more stable investment because they hold their value well, but in exchange they do not give the returns you need from the stock market in order to get your money growing for you. When you’re younger, you can afford to be riskier (i.e. invest more heavily in the stock market) because you have many years to continue to make money and to allow your investments to recover from a hit. The opposite is true as you age—the emphasis is on preserving, rather than creating, wealth. So, start with your age allotted to bonds, and if you know yourself to be more risk averse, raise that number a little. If you’re brave and positive you can weather the storm, maybe decrease it a smidge. Either way, you want a number that helps you to feel comfortable investing.

International Versus Domestic Investments

Once you have decided how to allocate your investing dollars between stocks and bonds, you need to decide how to split your investments between domestic and international stocks. This adds another element of diversity into your portfolio. If the US stock market takes a huge hit, you still have holdings elsewhere in the world (and vice-versa).

There doesn’t seem to be a clear rule of thumb on this one as to how much should be in domestic versus international stock. The general guideline seems to be that you need to have somewhere between 25% and 50% of your investment portfolio in international stock. The younger you are, the more you can risk a lower percentage invested internationally, because you can weather a big hit to the domestic economy better.

Keep Your Allocation in Line

Once you decide on how much to allocate to each of the three types of funds, you need to go in every year or two and rebalance your accounts back to your desired asset allocation. Even though you’re putting money into investments at your desired percentages, some investments will perform better than others. For instance, if domestic stocks are performing well, even if you are only telling 40% of your money to be placed in domestic stocks, the return on the investments might mean that domestic stock grows to represent 50% of the money you have invested. When you rebalance, you sell off the excess domestic stock (in this case) and invest it in your other types of assets to bring your allocation back to what you intended.

But wait, if an investment is performing well, why would I take money out of it? Because, odds are, it will not continue to perform well indefinitely. (Think back to that Morningstar study.) Have you heard the phrase “buy low, sell high”? That’s exactly what you’re doing when you rebalance. You’re selling the investments that are “high,” or performing well, and putting that money back into the investments that are “low,” or can be bought on a bargain because they are not performing as well. By doing so, when the winds of the market inevitably shift to favor another type of asset, you’ve acquired it cheaply, and you won’t lose nearly as much because you’ve already pulled your money out of the type of asset that was previously performing well. Win.

What About Other Types of Investments?

There are a whole lot of other types of investments that I haven’t talked about. There are real estate investments (REITs), ways to invest in stocks that seem like they will grow or that they are undervalued (“growth” and “value”), and ways to purchase stocks in only certain sizes of companies (“small-cap,” “mid-cap,” “large-cap”). There are also, once you’re investing beyond tax-advantaged accounts, reasons to consider what types of assets you’re putting into which type of account. None of that is necessary to get started with a perfectly well-diversified, great performing investment portfolio. In fact, it could even hinder you. Still, if you want to know more, I highly recommend The Bogleheads’ Guide to Investing (affiliate link, but your library might have it, too!) It explains everything I have talked about in greater detail, while remaining being concise and accessible to the average reader.

I still have one more part in this series for you! You might have noticed this blog is about how we do money. In part 5, I’ll give you a case study in how to implement what I’ve been talking about, by showing you how I chose the investments in my employer’s 403b.

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