Saturday, May 8, 2010

Implementing Portfolio 5: A Current Example

The investor who currently is invested in Portfolio 1 [about 50% Vanguard Total Stock Market Index (US) and 50% in Vanguard Total International Stock Index (non-US)] has decided to diversify into a more complex asset allocation, along the lines of Portfolio 5 (see my April 25 post, Some Real Portfolios). Here are my thoughts on how to implement this change.

The investor currently has about $17,000 in the Total Stock and Total International index funds in traditional and Roth IRA accounts at Vanguard.1 She is ready to make her 2010 IRA contribution of $5,000 over the next few months, and also will be starting her 401(k) contributions within the next month. First, we’ll look at options to implement the portfolio in IRA accounts, then we’ll look at integrating the 401(k) contributions.

It would take $50,000 to implement Portfolio 5 using Vanguard mutual funds.2 Clearly this is not an option for the investor at this time, but she can do it using ETFs (Exchange Traded Funds) instead of mutual funds.

Since she already has mutual fund accounts at Vanguard, I recommend that she open a Roth IRA brokerage account at Vanguard (rather than at Schwab), and use Vanguard ETFs to get exposure to the additional asset classes (see my May 5 post on Vanguard ETFs). I recommend the Roth IRA over traditional IRA because she will be making tax deductible contributions to her 401(k), so making the non-deductible Roth IRA contributions, but getting tax-free withdrawals in retirement, provides what some refer to as tax diversification (see posts IRAs: Traditional vs. Roth, and IRAs: Traditional vs. Roth, Part 2).

After she opens the Roth IRA brokerage account, she’ll deposit her 2010 IRA contribution into her existing Roth IRA money market account3, and will use this money toward the purchase of the ETFs.

Adding her 2010 IRA contribution of $5,000 to the approximate value of her current portfolio gives her about $22,000 to allocate among the different asset classes. The spreadsheet below shows two versions of how this could be done, the only difference being that Version 2 adds a REIT ETF (for a total of 8 asset classes). Click the Version 2 tab at the bottom to see Version 2.

Approximately $7,300 is required to purchase the ETFs4, $5,000 of which will come from the 2010 Roth IRA contribution, and the remainder will come from selling some of the existing Roth IRA mutual fund shares (technically, there will be an exchange from the stock mutual funds into the money market mutual fund, and then funds in the money market fund will be used to buy the ETFs).

The investor can either choose to do all of the exchanges and purchases at once to achieve the target asset allocation, or purchase the new funds over a period of time, perhaps using a value averaging approach. See my post Portfolio 2: The rest of the story for a brief discussion of value averaging.


There are only two low-cost index funds available in the investor’s 401(k): an S&P 500 index fund and an extended market index fund (extended market is basically most US stocks not included in the S&P 500). The only choice which fits well with the above asset allocation is the S&P 500 fund, which is in the large blend asset class, and this is the fund that will be used, at least initially.

As contributions are made to the S&P 500 index fund in the 401(k), the large blend asset class is likely to exceed its target allocation. The portfolio will be rebalanced periodically by selling shares of the Vanguard Total Stock Market Index fund (also in the large blend asset class), with the proceeds being used to purchase shares of whichever of the other Vanguard funds are most below their target allocations. This could be done as each 401(k) contribution is made (bi-weekly), or less often if the investor doesn’t want to spend that much time on it – perhaps only whenever large blend exceeds 60% of US stocks (5% above its target allocation).


1. Here is an approximate breakdown of the investor’s current portfolio:

  • Vanguard Traditional IRA:
    • Total Stock Market Index: $3,800
    • Total International Stock Index: $3,700
  • Vanguard Roth IRA:
    • Total Stock Market Index: $5,000
    • Total International Stock Index: $4,800
  • Rewards checking account (cash): 7,500

2. Since Portfolio 5 has 7 asset classes, with the smallest allocation (International small stocks) making up 6% of the total stock allocation, and the minimum mutual fund investment at Vanguard is $3,000, it would take $50,000 to implement Portfolio 5 using Vanguard mutual funds ($3,000 / 0.06 = $50,000).

3. With a Vanguard brokerage account, you must have a money market account linked to the brokerage account; this is known as a sweep account, since money is swept from or to the account when buying or selling ETFs (or other brokerage products such as stocks, bonds, or CDs). The investor already has a money market account in her Vanguard Roth IRA (not shown above since it’s a very small amount), so she will instruct Vanguard to use this money market account as the brokerage sweep account. Otherwise, she would need to deposit at least $3,000 to open the money market account.

4. The amounts shown in the spreadsheet are approximate, since the amount invested in any ETF will be a multiple of the ETF share price. For example, the share price of the Small-Cap ETF on May 7 2010 was $60.65, so purchasing 32 shares at this price would cost about $1,941, and purchasing 33 shares would cost about $2,001.

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