About to start investing - need advice on my asset allocation

[TwoWheels]

Over the past several months I've been working my way through investing books when I've had free time, and at long last, I've hammered out a rough asset allocation plan. I thought I'd run it by you smart folks and hopefully also get some advice about the finer points of allocating among taxable and sheltered accounts.

I'm thinking about an 80%/20% stock/bond allocation. Here's what I've decided on…

Stocks (percentage of stock allocation/percentage of total portfolio)
Domestic
Large market (S&P 500): 20%/16%
Large value: 25%/20%
Small market: 10%/8%
Small value: 15%/12%
REITs: 10%/8%
Foreign
European: 5%/4%
Pacific: 5%/4%
Emerging markets: 5%/4%
International value: 5%/4%

Bonds (percentage of bond allocation/percentage of total portfolio)
Treasury bills: 50%/10%
Short-term corporate bonds: 50%/10%
I'm also looking into municipal bonds. If I decide to buy those, I'll split my bond money equally into 3 parts.

As for the actual funds, my aim is to use Vanguard index funds for most of these. Their expense ratios are awesome, especially once you get into the "admiral shares" territory.

Now for the complicated part…
I currently have $45k sitting in a savings account earning squat. I have about $10k invested in a few index funds and individual stocks from when I was playing around with investing several years ago. I've been maxing out my 401(k), and it currently has around $20k in it, which is invested in one of those "targeted retirement date" funds that becomes more bond-heavy over time (good if that's your entire portfolio, but not good if you're building your own). By my projections, if I continue to max out my 401(k), I can conservatively expect 1/4 to 1/3 of my portfolio to be sheltered by the time I decide to retire. I'm also probably going to max out a Roth IRA every year, which bumps the sheltered fraction up a tad.

I've debated quite a bit with myself about what I want to do with my 401(k) – leave it untouched until I'm old enough to withdraw penalty-free (like MMM), or deal with the complexity of a Roth IRA rollover and 5-year pipeline when the time comes. I've ended up favoring the latter strategy because I can spread my entire asset allocation over taxable and sheltered accounts, using the sheltered accounts exclusively for asset classes with higher turnover (seems to me that if I planned on only using my taxable money until I'm old enough to crack open the 401(k), I would want two "copies" of my asset allocation – one in a taxable account and one in a sheltered account). The tax savings should net me more money in the long run. It also eliminates the question of whether I'm putting too much into my 401(k). If anyone has more thoughts on this I'd love to hear them.

So with that said, this is how I'd ideally like to split my asset classes across my accounts:
Taxable account
bonds, large market, small market, European, Pacific, emerging markets

401(k)
large value, small value, and international value funds

Roth IRA
REIT fund

Unfortunately, there are complications with this strategy due to my shitty 401(k) options:
- The only large value fund offered by my 401(k) plan is the T. Rowe Price Equity Income Fund. This is not an index fund, is not entirely domestic, and has a .92% expense ratio. Is holding this fund in a sheltered account better than a low-cost Vanguard fund (say, VIVAX) in a taxable account? I think the answer is yes - I'm unmarried and make about $100k a year, so I'm getting whacked pretty hard on income tax.
- I have no option for a small value fund in my 401(k). Would it be a good idea to try and squeeze some small value into a Roth IRA alongside my REIT fund? I would definitely fall short of my desired allocation for small value stocks (due to the IRA contribution limit), so maybe I could look for another somewhat equivalent asset to put in my 401(k) instead.
- I will likely be leaving my current job in about 6.5 months. I have yet to do any research into how that will change my options. At that point, can I just roll my 401(k) over into a Roth IRA and have the full range of Vanguard funds available to me, or is it more complicated than that?
- I plan on buying a house in a few years. I'll probably be investing in bonds to save for the down payment. Should I consider this separate from the rest of my portfolio (as in, don't count my down payment money as part of my 20% bonds)?

If you took the time to read this, thanks a lot and I appreciate your help!

[k9]

Aren't you overengineering your stock allocation ? I mean, 9 indexes for 80% of your portfolio, that seems a lot to me. With, say, 30% MSCI ACWI, 30% SP500, 30% Russel 2000, 10% REIT you will have something very close to your allocation but much easier to deal with. Other combos of 3 ETFs would do the same, I guess. If you prefer yours for some reason, I think it is sound anyway.

The bond allocation sounds good.

[TwoWheels]

Well, I modeled my allocation off of the examples in William Bernstein's "The Four Pillars of Investing". His argument was that if your nest egg is large enough, you can and should slice the stock market into smaller pieces to increase diversification. It also allows me to construct a value-heavy portfolio, an attractive concept to me both because of the observed market anomaly (value stocks may offer slightly higher risk-adjusted returns, despite the efficient market hypothesis) and because it fits quite well with my understanding of human nature.

[k9]

OK then this is probably OK if this is a well thought decision. Having different ETFs has the advantage that you can rebalance between them when they start to diverge quite a lot, for a slightly better yield at the cost of very little more work.

[hoppy08520]

TwoWheels, you're off to a good start. I think your plan is pretty good, but a couple of general observations:
* I'm not one to counter anything Wm. Bernstein writes, but his major investing books came out 10+ years ago before Vanguard had a total international stock market index fund. For that reason, if only to simplify your portfolio a bit, I'd consider going with Vanguard's total international stock market index fund rather than slice-and-dice on the international sectors.
* Similarly, with bonds, I'd consider just going with a Vanguard Total Bond Market Index Fund, or another fund that tracks the Barclay's intermediate term bond index, just for simplicity.
* Even if you want to slice-and-dice, sometimes you're constrained by limited or too-expensive options in your 401(k). If that's the case, you have to work with the options you have, not with what you wish you had. That might mean you have to make some adjustments. In most cases, your 401(k) will have better options with US stocks; hopefully you at least have a decent 500 index fund.
* At any rate, if you're leaving your company soon, then you can do what's called a "rollover" from your 401(k) into a pre-tax (aka "traditional") IRA (at Vanguard or elsewhere), if your 401(k) is a pre-tax 401(k) and not a Roth 401(k). After that, you may choose to convert some/all of your traditional IRA into a Roth, but at your income level, that would probably be a bad idea; better to leave it in a traditional IRA and withdraw/convert later when you're retired and in a lower tax bracket. This means that you'll have two IRA's: one traditional and one Roth. See http://www.obliviousinvestor.com/should-i-rollover-my-401k-into-an-ira/ more more nuances on rolling over a 401(k); there can actually be some cases where you'll want to transfer your 401(k) into your new 401(k), but these are generally exceptions (e.g. you'll want to do a "backdoor" Roth IRA). As a single filer, you're getting close to the income limits for Roth IRAs, so you might want to look into the backdoor Roth IRA in the future, which means you might be better off transferring your current 401(k) into your new 401(k), or just leave it in the current 401(k). Google "backdoor roth ira" to learn more about why this is the case.
* Generally, you don't want to hold bonds in a taxable account as bonds are not a tax efficient asset class; neither are REITs. Ideally, you'll hold either international stock mutual funds or US stock mutual funds in your taxable investment account.
* Generally, I think the conventional wisdom about asset allocation is that when you say you're 80/20, that's within your assets targeted for retirement. As a 23-year-old, that's probably a good ratio. I wouldn't consider your house down payment fund part of that 20%, because as soon as you buy the house, then all of a sudden your AA jumps up to 95/5 (or whatever) and you'll need to rebalance. Short/near-term savings you should mentally separate from your retirement AA (even if some of the money is mingled in the same accounts as savings targeted toward retirement).

[TwoWheels]

Finally getting back to this now that I have some free time.

I think you're probably right that I'd be better off with the Vanguard Total International fund and Total Bond fund. Given how long I've been putting this off and how eager I am to get started, the simplicity is quite appealing.

I'm quitting my job in less than three months. At that point I'll roll my 401(k) over into a traditional IRA and have better investment options for that money. So I'll probably leave the tax-sheltered portion of my portfolio alone until then and focus on just the taxable part for now.

Generally, you don't want to hold bonds in a taxable account as bonds are not a tax efficient asset class; neither are REITs.

REITs I understand, but I thought one of the main reasons for holding bonds was to have some relatively stable money to fall back on in case of a prolonged bear market. What good is it if it's locked up in a sheltered account? (Aside from allowing me to purchase cheap stocks for the sheltered part of my portfolio, of course.)

[the fixer]

The problem with holding bonds in a taxable account is you pay full income taxes on the dividends (they aren't qualified). What I do is hold some of a tax-exempt muni bond fund (VWITX) in my taxable account as a happy medium between having extra money if I needed it and losing return on bonds in taxable. I still hold VBMFX within my IRAs to get the allocation where I want it.

[orangeclocker]

Finally getting back to this now that I have some free time.

I think you're probably right that I'd be better off with the Vanguard Total International fund and Total Bond fund. Given how long I've been putting this off and how eager I am to get started, the simplicity is quite appealing.

I'm quitting my job in less than three months. At that point I'll roll my 401(k) over into a traditional IRA and have better investment options for that money. So I'll probably leave the tax-sheltered portion of my portfolio alone until then and focus on just the taxable part for now.

Generally, you don't want to hold bonds in a taxable account as bonds are not a tax efficient asset class; neither are REITs.

REITs I understand, but I thought one of the main reasons for holding bonds was to have some relatively stable money to fall back on in case of a prolonged bear market. What good is it if it's locked up in a sheltered account? (Aside from allowing me to purchase cheap stocks for the sheltered part of my portfolio, of course.)

Read about the Three Fund Portfolio: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=88005
Then read about the principles of tax-efficient fund placement: http://www.bogleheads.org/wiki/Principles_of_Tax-Efficient_Fund_Placement

This will establish your investment strategy for life.

[TwoWheels]

Thanks for the links, orangeclocker. The second one was really helpful. As for the three-fund portfolio, I'm aware of the arguments for and against additional "slicing and dicing" of the market beyond a very basic portfolio, and I've decided that it's worth the additional effort.

I've worked out the specifics of what assets I'm going to own. Any input would be much appreciated.
I'm going to be investing $62.5k, of which $32.5k is sheltered and $30k is unsheltered.

Asset	Fund	Amount	Account type	% of asset class	% of total portfolio
Bonds	VBTLX	$12,500	Sheltered	100%	20%
Foreign stocks	VTMGX	$10,000	Taxable	20%	16%
Large market	VFIAX	$10,000	Taxable	20%	16%
Small market	VTMSX	$10,000	Taxable	20%	16%
Large value	VVIAX	$12,500	Sheltered	25%	20%
Small value	VISVX	$2,500	Sheltered	5%	4%
REITs	VGSIX	$5,000	Sheltered	10%	8%

A few things to note:

• The assets in my taxable account are what I'm going to buy now. When I leave my job in two months, I will roll my 401(k) over into an IRA, sell my shares in the target-date fund, and buy the "sheltered" assets listed above.
• Since the asset allocation I initially came up with did not fit well with my taxable/sheltered ratio, I settled on a compromise: owning 20% small market and 5% small value rather than my original 10% and 15%. This is quite a bit less value-heavy than I would have liked, but I'm out of space in my sheltered account and it wouldn't make sense to own a small value index fund in a taxable account.
• I hate looking at the growth charts for these funds as it's clear that I'll be buying into the market at a time when it's quite expensive. Should I wait? (I'm guessing the answer is "Hell no! Jump in, stick to your chosen allocation, and don't try to time the market.")

[the fixer]

I think you should try to own a portion of as many of your funds as you can in your sheltered accounts. This makes rebalancing easier. OTOH it makes your allocation using lots of funds next to impossible until you get way more money. That should at least make you stop and think about whether optimizing it to this extent is really worth it.

[Joet]

I would suggest a simple 3-fund portfolio [total US, total foreign, total US bond] with maybe 1-tilt for now [REIT], as you pass 6 figures maybe add a small value tilt, and then maybe mid-6 figures some of the others you are considering.
Muni funds probably make sense if you are completely unafraid of the real possibility of your state defaulting and are in a state with high state taxes and you're in the Fed 33% or so marginal bracket

Sounds like a giant headache

Have you read the boglehead guide to tax-efficient portfolios? Doesnt look like it.
Bonds always go in tax-advantaged space. When you run out [a good problem to have], also consider Ibonds/EE bonds [in fact, consider them anyways].
Next, foreign indexes go into taxable [for the foreign tax credit], and then following a KISS principle round out the rest of your portfolio where possible. You want some funds in taxable to support tax-loss harvesting where possible. EG swap out one foreign index fund for another if it drops 10% or so. Do it again if it keeps falling and bank that tax loss. Avoid the wash sale.

[TwoWheels]

I think you should try to own a portion of as many of your funds as you can in your sheltered accounts. This makes rebalancing easier. OTOH it makes your allocation using lots of funds next to impossible until you get way more money. That should at least make you stop and think about whether optimizing it to this extent is really worth it.

So in other words, I would have some of the same funds in both my sheltered and taxable accounts? (Or the equivalent tax-advantaged funds in the taxable account, where applicable.) That's an interesting idea - I'll give it some thought. But why would it make my allocation more difficult until I have way more money?

Muni funds probably make sense if you are completely unafraid of the real possibility of your state defaulting and are in a state with high state taxes and you're in the Fed 33% or so marginal bracket

Yeah, I decided to just go with VBTLX for bonds (like I said in my earlier post).

Have you read the boglehead guide to tax-efficient portfolios? Doesnt look like it.
Bonds always go in tax-advantaged space. When you run out [a good problem to have], also consider Ibonds/EE bonds [in fact, consider them anyways].
Next, foreign indexes go into taxable [for the foreign tax credit], and then following a KISS principle round out the rest of your portfolio where possible.

It sounds like you may have read my first post and not the most recent one - like I said, I'm putting bonds in my sheltered account and my foreign index in the taxable one. I'm going to do some reading on tax-loss harvesting - thanks for the tip.

Would a 3-fund portfolio have any advantages over the one I'm considering, other than simplicity? There are good reasons to believe that a portfolio weighted toward small stocks and value stocks will produce slightly higher risk-adjusted returns in the long run. I understand that I could be doing a fair amount of extra work for little to no benefit, but I have no problem taking that chance. In fact, I'm starting to find that I really enjoy this stuff.

[rjack]

• I hate looking at the growth charts for these funds as it's clear that I'll be buying into the market at a time when it's quite expensive. Should I wait? (I'm guessing the answer is "Hell no! Jump in, stick to your chosen allocation, and don't try to time the market.")

I would do some sort of value averaging:

http://en.wikipedia.org/wiki/Value_averaging

Also, I liked your higher percentage in value indexes that you had originally, but I'm pretty biased towards value. You can see my asset allocation here:

http://assetallocationcentral.com/asset-allocation-tutorials/my-asset-allocation/

Good luck!

[seanquixote]

Thanks for the links, orangeclocker. The second one was really helpful. As for the three-fund portfolio, I'm aware of the arguments for and against additional "slicing and dicing" of the market beyond a very basic portfolio, and I've decided that it's worth the additional effort.

I've worked out the specifics of what assets I'm going to own. Any input would be much appreciated.
I'm going to be investing $62.5k, of which $32.5k is sheltered and $30k is unsheltered.

Asset	Fund	Amount	Account type	% of asset class	% of total portfolio
Bonds	VBTLX	$12,500	Sheltered	100%	20%
Foreign stocks	VTMGX	$10,000	Taxable	20%	16%
Large market	VFIAX	$10,000	Taxable	20%	16%
Small market	VTMSX	$10,000	Taxable	20%	16%
Large value	VVIAX	$12,500	Sheltered	25%	20%
Small value	VISVX	$2,500	Sheltered	5%	4%
REITs	VGSIX	$5,000	Sheltered	10%	8%

A few things to note:

• The assets in my taxable account are what I'm going to buy now. When I leave my job in two months, I will roll my 401(k) over into an IRA, sell my shares in the target-date fund, and buy the "sheltered" assets listed above.
• Since the asset allocation I initially came up with did not fit well with my taxable/sheltered ratio, I settled on a compromise: owning 20% small market and 5% small value rather than my original 10% and 15%. This is quite a bit less value-heavy than I would have liked, but I'm out of space in my sheltered account and it wouldn't make sense to own a small value index fund in a taxable account.
• I hate looking at the growth charts for these funds as it's clear that I'll be buying into the market at a time when it's quite expensive. Should I wait? (I'm guessing the answer is "Hell no! Jump in, stick to your chosen allocation, and don't try to time the market.")

I would just like to interject 3 things:

1) Godamn!!! 23 and you have and are thinking about a "portfolio".  Fuck all when I was 23 I had passing interest in ERE...but my beer drinking and general assing-off won out.

2) Thank you for posting these links. It is VERY helpful for people such as myself (who are just beginning to dip the toes in) to be able to go straight to the funds one is discussing.  I find when reading through various investing related posts I find myself unsure of exactly which particular fund a person is truly discussing.  So thanks.

3) Good on ya!! If I had pulled my head out of my ass as early as you...I would already BE where I want to get to.

Hope I didn't thread-jack too badly.

[seanquixote]

I would suggest a simple 3-fund portfolio [total US, total foreign, total US bond] with maybe 1-tilt for now [REIT], as you pass 6 figures maybe add a small value tilt, and then maybe mid-6 figures some of the others you are considering.
Muni funds probably make sense if you are completely unafraid of the real possibility of your state defaulting and are in a state with high state taxes and you're in the Fed 33% or so marginal bracket

Sounds like a giant headache

Have you read the boglehead guide to tax-efficient portfolios? Doesnt look like it.
Bonds always go in tax-advantaged space. When you run out [a good problem to have], also consider Ibonds/EE bonds [in fact, consider them anyways].

Next, foreign indexes go into taxable [for the foreign tax credit], and then following a KISS principle round out the rest of your portfolio where possible. You want some funds in taxable to support tax-loss harvesting where possible. EG swap out one foreign index fund for another if it drops 10% or so. Do it again if it keeps falling and bank that tax loss. Avoid the wash sale.

Joet,

Newb question...are you talking about something along the lines of these

(VTSMX)
(VGTSX)
(VBMFX)


With possibly (VGSIX) thrown in?

I too look at the OP's allocation and think giant headache.  But TwoWheels take that for what it's worth...I am simply in one of the Vanguard's target retirement date funds so what the hell do I know.

[TwoWheels]

^ Yep, those funds will give you the portfolio Joet was talking about.

Thanks for the input, rjack, and I totally agree about the higher value percentage. So I'm actually thinking about sticking with what I originally had planned (10% of stocks in small market, 15% in small value) and holding part of one of the value funds in my taxable account. I've read some stuff suggesting that it's not such a crazy idea after all (and one of the Bogleheads links from earlier in the thread classifies value index funds as relatively tax-efficient). I'll need to do a bit more research on that.

I would just like to interject 3 things:

1) Godamn!!! 23 and you have and are thinking about a "portfolio".  Fuck all when I was 23 I had passing interest in ERE...but my beer drinking and general assing-off won out.

2) Thank you for posting these links. It is VERY helpful for people such as myself (who are just beginning to dip the toes in) to be able to go straight to the funds one is discussing.  I find when reading through various investing related posts I find myself unsure of exactly which particular fund a person is truly discussing.  So thanks.

3) Good on ya!! If I had pulled my head out of my ass as early as you...I would already BE where I want to get to.

Hope I didn't thread-jack too badly.

Lol thanks. I wish I had done this earlier since I'd have been able to take advantage of the giant run up in the market this year...but I definitely feel fortunate to have run across MMM when I did.