- 50% Total Stock Market Index (US stocks)
- 50% Total International Stock Index (non-US stocks)
Risk Tolerance
Willingness: The investor doesn't worry about changes in the portfolio value. She understands that this is an investment for the very long run, and simply doesn't worry about month to month or even year to year changes. Hence, she has a high willingness to take risk.
Ability: She has job skills that are in high demand, and are likely to be so in the future, so employment security is high. The investor is in her mid-20s, and this portfolio is for retirement (in an IRA), so her investment horizon is 35-70 years: She is unlikely to start withdrawing funds from the portfolio for 35-40 years, and assuming an average life expectancy, the portfolio may continue to be a source of funds for as long as 70 years. The portfolio value is tiny compared to her human capital (lifetime earning potential), so even a devastating loss at this point would not have a large impact on her long term wealth. Thus, she has a high ability to take risk.
Need: Having a very small net worth and a goal of growing her net worth as much as possible while adhering to a rational investment strategy, her need to take risk is high.
Considering her willingness, ability and need to take risk, the investor's 100% allocation to equities is appropriate. This portfolio was funded with earnings from part time work while attending college. Now that she's graduated and is working full time, the investor is building up her cash reserves, so technically she does now have an allocation to fixed-income.
Asset Allocation
Now let's discuss the high allocation to non-US (international) stocks. Portfolio theory would suggest that an allocation of at least 50% to non-US stocks is appropriate, since non-US stocks make up more than half of the value of all stocks worldwide. However, the advice you will often hear is to allocate no more than 20%-40% of your stock allocation to international stocks. The reasons typically given are that international stocks are riskier and more expensive to own, and that the currency risk is not appropriate since you spend your money in the US. This is not the place to get deeply into these arguments, but I would recommend sticking with a lower international allocation unless you have done enough research to feel comfortable with a higher allocation. My default recommendation today would be 30%-40% of your stock allocation in international stocks (and the Vanguard Total International Stock index fund would be a fine way to do it).
Considering the investor's lack of investing experience, and the small amount of money the portfolio was started with, a simple two-fund portfolio is appropriate. These are both low-cost index funds, and with these two funds, you own a representative slice of most of the stock value in the world. It's a very diversified portfolio, yet very simple. New contributions have been directed so that the 50/50 balance between the two funds has been maintained.
Performance
How has this portfolio fared over the last few turbulent years? Quite well, considering that we've been through one of the worst bear markets in the last 80 years. The portfolio was started in 2007, and maximum IRA contributions of $5,000 were made each year (actually, the contribution for the 2006 tax year also was made in 2007). Thanks in part to the contributions made in early January 2008, which were relatively large compared to the portfolio size at the time, despite a significant decline in value at the depth of the recent bear market, the portfolio has a net positive investment return as of April 2010, and the 1 year return as of March 2010 is over 45%. This is a real example of how a young investor can afford to take high risk, and if she remains dedicated to her investment plan, continuing contributions even during a severe bear market, how the portfolio can recover from severe losses (in this case, quite quickly).
Another worthwhile point to make is that the majority of the investment return is from dividends! The capital gain actually is slightly negative, but the dividends more than make up for it. It's important not to forget about the contribution of dividends to long term investment returns.
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