This is a continuance of my thoughts from ‘Asset Allocation'

http://socialize.morningstar.com/NewSocialize/forums/1/2508002/ShowThread.aspx?mrr=1208117890

In what I offer as a ‘Know-nothing Portfolio', all I am concentrating on is diversification with the possibility of some higher returns. The forward market could offer higher returns for large caps again as it did in the 80s and 90s, and components such as precious metals and energy will most likely see more periods of underperformance of the market as I mentioned with commodities earlier. It is not my intention to offer this fund up as an optimal portfolio, or anything of the nature. All I really want to do is offer my thoughts on asset allocation, and allow the reader to consider them, reject them, or possibly begin a conversation in which we can learn a little something together. It is only this, my thoughts -- no expert opinion here.

Before getting into the stock asset allocation, I'd like to say a quick word for my reasoning on the fixed income allocation. In the fixed income, the focus is more on safety than returns, but safety in the sense of the highest risk I see, and I think most see in a portfolio going forward, and that is ‘Inflation'. Historically, if you look at the periods when stocks suffer short-term and even longer term losses, such as 1973 - 1982, it is due to inflation. The more recent bear market, 2000 - 2002 was not an inflation bear market, but the threat of tightening by the Fed did offer the catalyst needed for the correction. Even though it was not an inflation bear market, TIPS proved to offer comparable diversification to longer-term bonds in the Flight to Safety effects of pretty much any bear markets. Though we do not have actual long-term data for TIPS, I think most accept the idea that when the market goes down, the available coupon for TIPS is going to go down with it, offering a more diluted commodities effect from TIPS.

In line with the same concern over inflation, I personally chose to take the advice of Larry Swedroe and William Bernstein to shorten the duration of fixed income. The longer the maturity of a bond fund, the higher the inflation risks and correlation to stocks. I have no problem with Taylor's 4fund portfolio for an individual who does not hold high percentages in stocks, as the long-term bonds and mortgage backed securities in the Total Bond Market (TBM) would not matter as much if you only held 25% or 30% stocks. For others such as myself who might be a little more lion-hearted in their stock allocations, it makes sense to keep durations short. The 5 yr. T-bond offers the sweet spot in treasuries, but you can go shorter with investment grade corporate bonds and match the coupon rate for the treasuries while accepting minimal default risks, and lower term risks.

The fixed income portion of your portfolio, like the commodities I mentioned earlier should be focused on protecting from the risks you face investing in equities, where taking risks make more sense -- offer more reward.

I see no reason to go outside Vanguard for these funds, as Vanguard offers low expense ratios, and any higher expected returns you would get from going with a managed fund can take you out of your preferred asset allocation and offer higher risks. For the fixed income portion of the Know-nothing Portfolio, I went with;

• Vanguard Inflation-Protected Securities Fund (VIPSX)
  Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX)

These, of course, like the commodities I mentioned earlier need be held in a tax advantaged account. If you do not have room in your tax advantaged account for both, you can go with I-bonds, built over time in place of the TIPS. If you do not have room for either in a tax advantaged account, you can go with munis or a low cost Vanguard annuity;

• Vanguard Variable Annuity - Short-Term Investment-Grade Portfolio

The expense of 0.45 is more than reasonable for someone wishing to defer taxes IMHO.

As I mentioned earlier, the more risk you take in stocks in your portfolio, the higher the need for fixed income. The Total US Market (TSM) makes more sense here, as it offers both less tax consequences and less risk offering an ability to reduce the percentages of less tax efficient fixed income such as TIPS while you are building your I-bond allocation. You might also want to go with a Developed Markets International Fund, with some Emerging Markets and Tax Managed Small Caps;

• Vanguard Total Stock Market Index (VTSMX)
• Vanguard Developed Markets Index Fund (VDMIX)
• Vanguard Emerging Market Index (VEIEX)
• Vanguard Tax-Managed Small-Cap Fund (VTMSX)

The small caps fund is about the only tax managed fund worth considering, once again IMHO, Vanguard offers. DFA offers more tax advantaged funds than Vanguard, but if you have a balance high enough to go with DFA, it might be questionable as to whether it would be advantageous to take the immediate tax hit to switch if you are now in fairly tax efficient funds.

Another annuity that makes sense in a taxable account is REITs. REITs have proven to be excellent diversifiers, offering returns similar to the S&P 500, while offering excellent diversification. Just a quick look found this;

The Vanguard REIT annuity offers an expense ratio of 0.6%, a little high, but the diversification benefits of holding something like 7% to 10% REITs in a portfolio should offset the small difference this is going to make in the overall total expense ratio;

• Vanguard Variable Annuity - REIT Index Portfolio.

As I offered earlier, the commodities funds are not tax efficient. Though possibly not as effective as adding commodities to a portfolio, precious metals and energy equities represent the two bookends of commodities and offer returns closer to that you might expect from businesses dealing in these commodities. In a taxable account, this is about all you have to choose from;

• Vanguard Precious Metals (VGPMX)
  Vanguard Energy Fund (VGENX)

So, I guess now, as opposed to sticking with fixed income only, I have gotten into talking about investing in a taxable portfolio as well, huh?

Our taxable portfolio looks something like this;

Stocks

• 35% Vanguard Total Stock Market Index (VTSMX)
• 25% Vanguard Developed Markets Index Fund (VDMIX)
• 10% Vanguard Emerging Market Index (VEIEX)
• 10% Vanguard Tax-Managed Small-Cap Fund (VTMSX)
• 10% Vanguard Variable Annuity - REIT Index Portfolio
• 5% Vanguard Precious Metals (VGPMX)
• 5% Vanguard Energy Fund (VGENX)
  

Fixed Income

• 50% Vanguard Variable Annuity - Short-Term Investment-Grade Portfolio
• 50% I-bonds (built over time)

The percentages, or even funds I have chosen are not written in stone. Like I said, this is just offerings of my ideas. Choose your own reality. And, as it should go without saying, if you cannot build the 50% allocation in I-bonds over the time you are allowed, the 50% is not written in stone either.

Chin

originally posted here;

http://socialize.morningstar.com/NewSocialize/forums/1/2508002/ShowThread.aspx?mrr=1208117890