Author Topic: Beginning of Journey Asset Allocation Question  (Read 5626 times)

PencilMustache

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Beginning of Journey Asset Allocation Question
« on: November 13, 2013, 11:27:01 PM »
Hello Mustachians!

I just got finished reading "The Four Pillars of Investing" and am halfway through reading "The Intelligent Asset Allocator", both by William Bernstein, and I have come up with a rough draft for an asset allocation. If you would be so charitable, please tell me if I am making any glaring mistakes.

Currently my wife and I's combined income will soon be somewhere around $133k. We expect something like $110k after taxes, $80-90k of which we will save short term to complete a house purchase in around 3 years. After the house is completely paid off, we plan to start investing our excess money in tax-sheltered accounts and taxable accounts, filling up the former before the latter. We plan to be able to stop working sometime within 15 years to live on $40k per year passive income from our investments.

The asset allocation I have planned out goes as follows with Vanguard. In reality, our allocation in IRA might be much lower due to the contribution cap.

75% Stock
25% Bond

Taxable - 95% of Portfolio
Total Stock Market Index Fund              28.5%
Tax-Managed Small-Cap Index Fund   14.25%
European Stock Index Fund         9.5%
Pacific Stock Index Fund                 9.5%
Emerging Markets Stock Index Fund   9.5%
Limited-Term Tax-Exempt Fund      23.75%

IRA - 5% of Portfolio
Value Index Fund                    1.5%
Small-Cap Value Index Fund         1.5%
REIT Index Fund                    0.75%
Short-Term Corporate Fund         1.25%

There is the distinct possibility that somewhere during the next 10 years, we won't be able to contribute to an IRA because we exceed the income cap. My plan is to contribute to it every year that we can, but when we can't, to allocate the money entirely to the taxable account. We plan to rebalance every 2-3 years, as Bernstein suggests.

Is there anything glaringly obvious that I have forgotten while coming up with this asset allocation? Or is it a good starting point that reasonably won't end with our family living in the gutter?

Thank you for your help!

alanwbaker

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Re: Beginning of Journey Asset Allocation Question
« Reply #1 on: November 14, 2013, 08:24:30 AM »
Bill Bernstein is a deep thinker and an amazing guy.  On the first day of last month's Bogleheads conference he and Jack Bogle were scheduled for a dialog presentation but it didn't happen because Bernstein was in the hospital.  The next day he came directly from the hospital to present!

Anyway, your asset allocation of 75/25 is just fine.  But don't overthink those sector choices.  For most people (and especially mustachians) a portfolio of 3 or 4 funds will outperform a portfolio of 10.  See http://www.bogleheads.org/wiki/Lazy_portfolios.

One other thought...  For tax reasons fill up the IRA (5%) with bonds.

PencilMustache

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Re: Beginning of Journey Asset Allocation Question
« Reply #2 on: November 14, 2013, 11:51:14 AM »
Bill Bernstein is a deep thinker and an amazing guy.  On the first day of last month's Bogleheads conference he and Jack Bogle were scheduled for a dialog presentation but it didn't happen because Bernstein was in the hospital.  The next day he came directly from the hospital to present!

Anyway, your asset allocation of 75/25 is just fine.  But don't overthink those sector choices.  For most people (and especially mustachians) a portfolio of 3 or 4 funds will outperform a portfolio of 10.  See http://www.bogleheads.org/wiki/Lazy_portfolios.

One other thought...  For tax reasons fill up the IRA (5%) with bonds.

During the next 15 years of our family earning income, there is a high probability of us not being able to contribute to IRA for 7 of them. If my IRA allocation goes 100% to short term corporate fund (according to The Intelligent Asset Allocator, that is the best performing one), my overall bond allocation will vary widely year to year unless I add a variable amount of Limited-Term Tax-Exempt Fund every year to my taxable account to bring my yearly contribution to bonds back to 25%.

Does varying my yearly allocation to bonds in the taxable account (because I have made it 100% of the IRA account) sound like a good idea as opposed to keeping bonds as 25% of each my IRA and taxable so that it stays as 25% of my yearly allocation for both years where I am able to contribute to IRA and not?

alanwbaker

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Re: Beginning of Journey Asset Allocation Question
« Reply #3 on: November 14, 2013, 02:03:32 PM »

During the next 15 years of our family earning income, there is a high probability of us not being able to contribute to IRA for 7 of them. If my IRA allocation goes 100% to short term corporate fund (according to The Intelligent Asset Allocator, that is the best performing one), my overall bond allocation will vary widely year to year unless I add a variable amount of Limited-Term Tax-Exempt Fund every year to my taxable account to bring my yearly contribution to bonds back to 25%.

Does varying my yearly allocation to bonds in the taxable account (because I have made it 100% of the IRA account) sound like a good idea as opposed to keeping bonds as 25% of each my IRA and taxable so that it stays as 25% of my yearly allocation for both years where I am able to contribute to IRA and not?

Think of your accounts (taxable & non-taxable) first as a whole.  The IRA is only part of your bond allocation, so I would fill up the IRA with bonds, then tweak the taxable accounts no more than annually to maintain the asset allocation.  With your income I don't see an advantage to using the tax exempt fund in your taxable account.  Even with no contributions to the IRA for 7 years I wouldn't expect your 75/25 asset allocation to have wide swings.  More income is lost than gained in tweaking, so if the AA stays within about 5%, I'd leave it alone.

brewer12345

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Re: Beginning of Journey Asset Allocation Question
« Reply #4 on: November 14, 2013, 02:07:29 PM »

During the next 15 years of our family earning income, there is a high probability of us not being able to contribute to IRA for 7 of them. If my IRA allocation goes 100% to short term corporate fund (according to The Intelligent Asset Allocator, that is the best performing one), my overall bond allocation will vary widely year to year unless I add a variable amount of Limited-Term Tax-Exempt Fund every year to my taxable account to bring my yearly contribution to bonds back to 25%.

Does varying my yearly allocation to bonds in the taxable account (because I have made it 100% of the IRA account) sound like a good idea as opposed to keeping bonds as 25% of each my IRA and taxable so that it stays as 25% of my yearly allocation for both years where I am able to contribute to IRA and not?

Think of your accounts (taxable & non-taxable) first as a whole.  The IRA is only part of your bond allocation, so I would fill up the IRA with bonds, then tweak the taxable accounts no more than annually to maintain the asset allocation.  With your income I don't see an advantage to using the tax exempt fund in your taxable account.  Even with no contributions to the IRA for 7 years I wouldn't expect your 75/25 asset allocation to have wide swings.  More income is lost than gained in tweaking, so if the AA stays within about 5%, I'd leave it alone.

+1.  I would further suggest that when you dump money in each year that you allocate new money to reblance things rather than selling some to buy others.  This is a particularly big deal for you as you will have the bulk of your money in a taxable account.

No 401k or 403B available to you?  That would make a lot of this less painful.

Why do you want to completely pay off your house before you start investing?

PencilMustache

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Re: Beginning of Journey Asset Allocation Question
« Reply #5 on: November 14, 2013, 04:00:12 PM »
+1.  I would further suggest that when you dump money in each year that you allocate new money to reblance things rather than selling some to buy others.  This is a particularly big deal for you as you will have the bulk of your money in a taxable account.

No 401k or 403B available to you?  That would make a lot of this less painful.

Why do you want to completely pay off your house before you start investing?

That's what we are planning on doing with our "rebalancing", just adding amounts of money to each fund that will make each go to the right percentages. She will be working for a pretty new company, so I'm not certain of her 401k prospects. About the house payments, we just felt it would make us feel less stressed out to own our house faster.

Think of your accounts (taxable & non-taxable) first as a whole.  The IRA is only part of your bond allocation, so I would fill up the IRA with bonds, then tweak the taxable accounts no more than annually to maintain the asset allocation.  With your income I don't see an advantage to using the tax exempt fund in your taxable account.  Even with no contributions to the IRA for 7 years I wouldn't expect your 75/25 asset allocation to have wide swings.  More income is lost than gained in tweaking, so if the AA stays within about 5%, I'd leave it alone.

If I'm not using the tax exempt fund in my taxable account, should I just replace it with the Short-Term Corporate Fund? During those 7 years that we might not be able to put money in the IRA, we could be making anywhere from 160k to 210k, which I thought might make the tax exempt fund a better deal for us.

And thank you everyone for your great advice!
« Last Edit: November 14, 2013, 04:03:48 PM by PencilMustache »

PencilMustache

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Re: Beginning of Journey Asset Allocation Question
« Reply #6 on: November 14, 2013, 09:31:45 PM »
That's what we are planning on doing with our "rebalancing", just adding amounts of money to each fund that will make each go to the right percentages. She will be working for a pretty new company, so I'm not certain of her 401k prospects. About the house payments, we just felt it would make us feel less stressed out to own our house faster.

We actually just discussed paying off the house vs. investing when I got home today, and then read http://www.mrmoneymustache.com/2012/02/24/pay-down-the-mortgage-or-invest-more-a-winwin-question/, and we are now thinking more about investing instead of paying the house off all at once. Also, she will get a 401k in January, so we will invest in that up until employer matching. I will not have a 401k for at least another year. We are in our early 20's and we have a lot of changes going on with financial situation currently, which is why nothing is set in stone yet.

alanwbaker

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Re: Beginning of Journey Asset Allocation Question
« Reply #7 on: November 14, 2013, 09:48:27 PM »

If I'm not using the tax exempt fund in my taxable account, should I just replace it with the Short-Term Corporate Fund? During those 7 years that we might not be able to put money in the IRA, we could be making anywhere from 160k to 210k, which I thought might make the tax exempt fund a better deal for us.

And thank you everyone for your great advice!

It's worth thinking about those 7 years, but you'd have to be in a much higher tax bracket to make tax-exempt funds worthwhile.  Tax-exempt funds are an especially poor investment while interest rates are low.

More generally, don't overdo allocating to particular bond or stock sectors.  The goal should be to own the whole market, not to pick the sector that is out-performing at the moment.  For example, consider a total bond market fund rather than narrowing down to short-term corporates.  This is one reason that a "lazy" portfolio outperforms a highly-tuned one.

PencilMustache

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Re: Beginning of Journey Asset Allocation Question
« Reply #8 on: November 15, 2013, 01:22:50 AM »
It's worth thinking about those 7 years, but you'd have to be in a much higher tax bracket to make tax-exempt funds worthwhile.  Tax-exempt funds are an especially poor investment while interest rates are low.

More generally, don't overdo allocating to particular bond or stock sectors.  The goal should be to own the whole market, not to pick the sector that is out-performing at the moment.  For example, consider a total bond market fund rather than narrowing down to short-term corporates.  This is one reason that a "lazy" portfolio outperforms a highly-tuned one.

Would Vanguard Total Bond Market Index be good to use here? Am I correct that a good asset allocation would look like this now:

75% Stock
25% Bond

Taxable - 95% of Portfolio
Total Stock Market Index Fund              28.5%
Tax-Managed Small-Cap Index Fund   14.25%
European Stock Index Fund                    9.5%
Pacific Stock Index Fund                         9.5%
Emerging Markets Stock Index Fund       9.5%
Vanguard Total Bond Market Index      20.00%

IRA - 5% of Portfolio
Vanguard Total Bond Market Index         5.00%

wtjbatman

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Re: Beginning of Journey Asset Allocation Question
« Reply #9 on: November 15, 2013, 02:03:10 AM »
I didn't see you and your wife's age anywhere (I may have missed it), but I definitely get the impression you're younger (younger than, say, 60. If you're older, stop reading). Then you might want to read this: http://jlcollinsnh.com/2012/05/12/stocks-part-vi-portfolio-ideas-to-build-and-keep-your-wealth/

Basically, your 75/25 allocation is too conservative. Ok, that's not true, your allocation should only be as risky/conservative as you want it to be. So if 75% in equities is all you dare risk, then rock on! But for the best performance, and I feel that's what you're looking for since you and your wife are planning on FI in 15 years, you might want to be more aggressive with your investments. You have plenty of time to weather any storms, and your money is going to grow that much faster. Heck jlcollinsnh is at 50/25/20/5 (stocks/real estate/bonds/cash) for his personal allocation and he's in his 60's!

PencilMustache

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Re: Beginning of Journey Asset Allocation Question
« Reply #10 on: November 15, 2013, 09:48:34 AM »
I didn't see you and your wife's age anywhere (I may have missed it), but I definitely get the impression you're younger (younger than, say, 60. If you're older, stop reading). Then you might want to read this: http://jlcollinsnh.com/2012/05/12/stocks-part-vi-portfolio-ideas-to-build-and-keep-your-wealth/

Basically, your 75/25 allocation is too conservative. Ok, that's not true, your allocation should only be as risky/conservative as you want it to be. So if 75% in equities is all you dare risk, then rock on! But for the best performance, and I feel that's what you're looking for since you and your wife are planning on FI in 15 years, you might want to be more aggressive with your investments. You have plenty of time to weather any storms, and your money is going to grow that much faster. Heck jlcollinsnh is at 50/25/20/5 (stocks/real estate/bonds/cash) for his personal allocation and he's in his 60's!

You are right, we are 22/23. I had previously been thinking about something like 100% stocks, but I started feeling like moving farther away from that once I started reading the intelligent asset allocator.

okiedoke

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Re: Beginning of Journey Asset Allocation Question
« Reply #11 on: November 15, 2013, 03:57:10 PM »
Here's what I would do if I were you (i.e., early 20s, over 10-year horizon before you'lll need the $, 95% in a taxable account, 5% in tax-deferred):

Taxable (95%):  VT (Vanguard world stock market ETF).  Or, alternatively, 60% VTI (US broad stock market ETF) and 40% international stock ETF.
Tax-deferred (5%):  BND (Vanguard total bond fund EF), or something similar. 

Easy, clean.  Two or three funds tops.  I'd leave it like that for a while (like, until you're near (early) retirement). 

The only reason I could see to get any more fancy/complicated, would be if you want to do tax-loss harvesting in your taxable accounts, so splitting up your investments into multiple funds might facilitate that. 

alanwbaker

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Re: Beginning of Journey Asset Allocation Question
« Reply #12 on: November 16, 2013, 06:56:51 PM »
Basically, your 75/25 allocation is too conservative. Ok, that's not true, your allocation should only be as risky/conservative as you want it to be.
Investing has two elements:  economics and psychology.  Asset allocation should consider both.  A 75/25 allocation is too conservative for a risk-taker who doesn't fear a 50% drop in the market and it's too aggressive for a risk-averse investor who does.  Your asset allocation should be whatever allows you to sleep well.