Twice a year, I check my portfolio to see if any rebalancing needs to be done. I look at my allocations at the end of April and at the end of October to coincide with the start of the "worst six months" (May through October) and the start of the "best six months" (November through April). This week, I took the additional step of modifying the funds I hold in my 403(b) plan. (Since AAII is a nonprofit, our retirement plan falls under a different part of the tax code than 401(k) plans do.)
There were a few reasons for making the change, starting with the age of my 403(b) plan. When I started at AAII four years ago, I rolled over my 401(k) plan to an IRA. This meant my current 403(b) started off with a balance of $0. I also limited the number of mutual funds I chose initially because of a $15 per fund fee charged by Vanguard, which runs our plan. As the account balance grew from a combination of investment returns and regular contributions, I gradually increased the number of funds and altered how the contributions were invested.
Now that I am past the initial stage, I wanted to tweak the contributions so that they are spread evenly across all funds. I also gave thought to what number of funds strikes a good balance between diversification and ease of management. The latter decision reflected my desire to simplify things for my wife should she ever need to step in and take over management of the account. I settled on five funds because it is an easy number for her to work with and it limits the fees I'll pay to Vanguard in the future.
The allocation I use is 20% in each fund. As you go through the list of funds, keep in mind that I avoid making big bets on uncertain outcomes such as what future inflation will be like or whether the dollar will appreciate or depreciate. I don't know what the future will be like and neither does anybody else. Also keep in mind that I am in my 40s, have savings outside of my 403(b) plan and will rebalance my portfolio if any fund accounts for less than 15% or more than 25% of the account's balance. As such, my ability to tolerate market volatility and fluctuations in wealth may be very different from yours.
In addition to the funds I use, I've listed the lower-cost Vanguard Admiral Shares fund and exchange-traded fund, ETF, equivalents. Unfortunately for me, Vanguard restricts 403(b) participants from investing in either Admiral Shares or ETFs. Several other companies offer mutual funds and ETFs that follow similar strategies, and I would attempt to mimic the same allocation if our plan were run through a different fund company.
The five funds I use are:
Vanguard 500 Index Fund (VFINX): The S&P 500 is arguably the most frequently used benchmark. Since its long-term performance has historically proven to be very difficult for active fund managers to consistently beat, I consider it to be a very good default investment. Plus, this fund has a lower expense ratio and is less volatile than the other two stock funds I hold. An Admiral Shares version (VFIAX) and an ETF version (VOO) are available.
Vanguard Small-Cap Value Index Fund (VISVX): This fund tracks the CRSP US Small Cap Value Index. It holds more than 800 stocks with a median market capitalization of $2.7 billion. Small-cap value has realized the best long-term performance of any widely followed domestic stock strategy. Plus, small-cap stocks are not perfectly correlated with their large-cap brethren, giving me some diversification benefit. I did consider allocating more to this fund, and even excluding my weighting in the S&P 500 fund, but chose not to do both to reduce potential volatility and because small-cap value is not in favor every year. An Admiral Shares version (VSIAX) and an ETF version (VBR) are available.
Vanguard REIT Index Fund (VGSIX): Tracking the MSCI U.S. REIT Index, this fund invests in 127 real estate investment trusts. REITs have reduced correlations with stocks, though their return characteristics share more in common with stocks than bonds. (See The Role of REITS for Long-Term Investors for more information about this.) The fund does provide some income for my portfolio with a 3.75% yield, though any income received is automatically reinvested. An Admiral Shares version (VGSLX) and an ETF version (VNQ) are available.
Vanguard FTSE All-World ex-U.S. Small-Cap Index Fund (VFSVX): I changed over to this fund as a replacement for the Vanguard European Stock Index (VEURX) and the Vanguard Emerging Markets Stock Index (VEIEX) funds. I made the change both to reduce the number of funds I held from six to five and to get more thorough global exposure. The FTSE All-World ex-U.S. Small-Cap fund invests in stocks from over 40 countries, though the United Kingdom, Canada and Japan account for more than 40% of the fund's country allocation. An ETF version (VSS) is available, but not an Admiral Shares version.
I wrestled with the decision to include this fund because of its relatively short history (it was incepted in April 2009) and, more importantly, its cost. Vanguard charges both a purchase fee of 0.25% and a redemption fee of 0.25% to help cover the portfolio's transaction costs. Had I been able to invest in the FTSE All-World ex-US Index Admiral fund (VFWAX), I would have strongly considered it. Unfortunately, Vanguard won't let 403(b) participants into it. I preferred VFSVX over the investor class version of the FTSE All-World ex-US Index Fund (VFWIX) because the annual expenses were not much different and my expectation, based on historical U.S. stock data, is that international small-cap stocks will deliver better long-term returns than their larger-cap peers. (If I'm wrong, the decision only impacts the amount of return realized in one-fifth of my 403(b) portfolio.)
Vanguard Intermediate-Term Investment-Grade Fund (VFICX): Even with the ongoing interest rate uncertainty, I think bond funds are useful as a diversification tool. Both corporate bonds and Treasuries have historically been uncorrelated to stocks. During bull markets to stocks, the bond fund gives me a counter-weight I can rebalance into. During bear markets for stocks, the bond fund will reduce volatility and provide a source of investment dollars to reallocate into stocks with. I specifically chose this fund because it strikes a middle ground of providing a comparatively better yield than Treasuries, of not taking on too much credit risk and of keeping duration (interest rate sensitivity) at a moderate level. An Admiral Shares version (VFIDX) is available, but not an ETF.
Additional disclosure: I am long the mutual fund version of these ETFs.