Saturday, May 1, 2010

Portfolio 2: The rest of the story

In this post I conclude the story of portfolio 2. I review how the portfolio has performed, discuss some aspects of managing the portfolio, and talk a bit more about the asset allocation.


One really nice thing about a broadly diversified portfolio of index funds is that when the market does well, your portfolio does well. You eliminate the risk of an investment manager or fund manager screwing up, making the wrong bets, or taking too much risk. So, since the market has done quite well since our Portfolio 2 investors created their portfolio in December 2008, their portfolio has done well.

Since this is a relatively conservative portfolio, with only 40% in stocks, the return over the last 16 months hasn’t been as high as the more aggressive portfolios presented in my post on Some Real Portfolios, but this is by design. If the stock market tanks, this portfolio will hold up better, which is what is appropriate for these investors. The total investment return as a percentage of the starting portfolio value is about 26% (as of April 30, 2010). About 10% of the starting portfolio value has been withdrawn, so the current portfolio value is about 16% higher than the starting value.

The investors are quite happy that their portfolio is worth tens of thousands of dollars more now than it was 16 months ago, despite taking regular monthly withdrawals at an annualized rate of about 7%. Of course I caution them not to get too excited, knowing that it is highly probable that we’ll experience another significant market downturn in the next few years.


One aspect of the investment policy for this portfolio is to rebalance if the stock allocation deviates by 5 percentage points from the target allocation of 40%. For example, if stock values rise such that the stock allocation of the portfolio rises to 45%, then shares of the stock funds are sold to bring the allocation back down to 40%. This is exactly what has happened twice since the portfolio was created. This has added to the cash position, providing more funds for the monthly withdrawals, and also has maintained the desired level of risk.

If the stock allocation were to fall to 35%, the investors would buy shares of the stock funds to bring the stock allocation back to 40%, taking the money from either their money market or bond funds. However, this would be subject to keeping at least 5-6 years of withdrawals in their cash and bond funds.

International Allocation

When the rebalancing was done, the allocations to US and international stocks were also rebalanced to target levels; i.e., 65% US, 35% international. Although some investing experts recommend no more than a 20% allocation to international stocks, others recommend as high as 50%. I lean toward the higher end for the international allocation, but knowing that the Portfolio 2 investors were likely to hear from Vanguard and others that this was too high, I felt the 35% international allocation was appropriate. Many advisors agree that sticking to your plan is more important than trying to design the perfect plan (which is impossible anyway), and the Portfolio 2 investors have stuck to their plan perfectly.

Value Averaging

In a previous post, I mentioned that the investors were using a value averaging approach to build up their bond allocation. Most people have heard about dollar cost averaging, where you invest a fixed dollar amount at regular intervals (e.g., $500 per month). Value averaging is similar except that you add to your investment so that the value increases by a fixed amount at regular intervals. An example should help clarify.

Say you decide to value average so that the value of your bond fund increases by $500 per month. If the value of the fund increases by $100 in one month (before you add anything to it), you would add only $400 to it. If the value decreased by $100 you would add $600 to it. So, instead of adding $500 per month as with dollar cost averaging, the amount you add is variable, and depends on the change in the market value of the fund between contributions. If you can be disciplined and follow this approach, it forces you to invest more when prices drop, providing greater gains when prices rise.

According to finance theory, the optimal approach is to make a lump sum investment; i.e., invest all of your money at once. This is because the market historically has gone up about 2/3 of the time, so the odds are in your favor if you buy all at once. However, if you are unlucky enough to make your purchase just before a big decline, it can be very damaging emotionally and psychologically, and is very likely to discourage you from continuing to invest. Value averaging gets you in the habit of embracing market declines, viewing them as an opportunity to buy more shares at a lower price. This is an extremely valuable discipline to develop, as Warren Buffet and many other wise investors will confirm.

In addition to building investment discipline, a regular schedule of value averaging has helped our Portfolio 2 investors build confidence in the mechanics of making their own investments online.

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