As mentioned previously (here and here), I am a huge fan of using index funds or ETFs to construct a portfolio. The natural follow-up question is, “Which index funds or ETFs should I buy?” To answer that question, we must first discuss the concept of asset allocation.
Asset allocation is your strategy for dividing your investments across various asset classes. The set of asset classes you use can be as simple as stocks, bonds, and cash. Or you can divide investments into smaller buckets, such as US stocks, foreign stocks, real estate, commodities, bonds, and cash. Next, you need to decide the percentage of your portfolio you want in each asset class–this is your target asset allocation. The goal is to set the percentages so that the risk and return profile of your portfolio is appropriate based on your investment horizon, risk preference, and financial situation.
How do you know what asset allocation is appropriate? The simplest way is to rely on Vanguard or another fund company to make the decision for you. On Vanguard’s site for Target Retirement Funds, they list their asset allocations by retirement date. Even if you don’t agree with their asset allocation, you can still use it as a starting point for your own. In general, you end up moving from stocks to bonds and then to cash as you get older.
The simplest way to implement your asset allocation strategy is to buy a target date fund, like the Vanguard Target Retirement Fund mentioned above. This is the ultimate “set it and forget it” solution. Obviously the fund is not custom tailored to your needs, but if it’s close enough for your liking, it couldn’t get any simpler.
If you want to implement your asset allocation strategy yourself, you need to decide three things: what investments to buy, what accounts to buy them in, and how frequently to rebalance. Some factors you should consider when selecting an index fund or ETF to buy are: expense ratio (lower the better), fund company (Vanguard and iShares are market leaders), structure (ETF vs index fund), and popularity (net assets and daily volume).
Once your investments are selected, you can decide to buy the right proportion in each account, or just enforce your asset allocation across your portfolio as a whole. If you decide to enforce your asset allocation at the portfolio level, you should buy the tax inefficient investments in your tax-advantaged accounts. Morningstar lists the Tax-Cost Ratio for ETFs and index funds to make this analysis easier.
Over time, some of your investments will do better than others, moving your portfolio’s asset allocation away from your target. Therefore you need to make two decisions regarding rebalancing: how often to check your asset allocation and how much you are willing to let your portfolio diverge from your target. You can choose to check your allocation as frequently as daily, or as little as every other year. Every time you check, you need to decide if the difference between your actual and target allocation warrants trading. The easiest way to set this hurdle is as a percentage (for ex, stocks should be at 50% plus/minus 5%). To minimize rebalancing trades, you can also use deposits and withdrawals to get your portfolio back to target.
If you want to learn more about asset allocation, William Bernstein’s The Intelligent Asset Allocator is a great book to get started. There are also tons of online resources that describe asset allocation. Here are a few: