Wednesday, April 25, 2012

One Goal, One Portfolio

“In which mutual funds should I invest in my new IRA?” This is typical of one type of question we get a lot on the Investing Help subforum of the  Bogleheads investment forum. The answer is: “we can’t advise you until you tell us about all of your investment accounts” (e.g., IRA, 401k, 403b, individual, etc.). This is because the decision to hold an investment in one account should not be made in isolation; it should be based on all investments related to a particular goal; e.g., retirement. It may make sense to design separate portfolios for separate goals, for example college expenses, a house down payment, and retirement, but there should be one portfolio for each investment goal, regardless of the number of accounts used. A portfolio is simply the collection of investments designated for a particular investment goal.

Making investment decisions in isolation, by account, is one common mistake. A related mistake is to focus too much on the performance of individual investments rather than the overall portfolio. This mistake is harder to avoid if different investments are held in different accounts. For a portfolio consisting of equal portions of Fund A and Fund B, it doesn’t matter much if fund A is down 5% while fund B is up 15%; the overall portfolio is up 5%, which is what matters most. It does not matter if funds A and B are held in separate accounts. (It may seem that the portfolio is up 10%, since 15% – 5% = 10%, but it is the weighted-average of the returns that determines the portfolio return: (1/2)(15%) + (1/2)(-5%) = 7.5% – 2.5% = 5%, or alternatively for this simple case (15% – 5%)/2 = 5%).

One principle of effective portfolio design is to include assets that have low correlations with each other (i.e., one may zig when the other zags). A consequence of following this portfolio design principle is that some assets are bound to do better or worse than others. It is counterproductive to obsess about the underperformance of a particular fund over a particular time period; it is to be expected in a well-designed portfolio.

One way to help avoid obsessing over the performance of individual assets in a portfolio is simply to hold an all-in-one fund that combines different asset classes in a rational fashion. The Vanguard Target Retirement and LifeStrategy funds are good examples. However, this may not be feasible if you are using multiple investment accounts, such as 401k and IRA, to invest for your retirement goal.

The primary decision is to establish an asset allocation (AA) based on your risk tolerance. A secondary decision is how to execute your AA using different funds in different accounts. If you are lucky enough to have a decent choice of all-in-one funds in all of your tax-advantaged accounts (IRA, 401k, 403b, etc.), and all of your retirement investments are in these accounts, then using the appropriate all-in-one fund in each account is fine.

However, if this is not the case then you should select the best funds in the account with the worst choices (typically your 401k or 403b), then flesh out your AA with better funds in the accounts with better choices (typically your IRA). I will discuss selection of funds in an employer-sponsored, defined-contribution retirement plan (i.e., 401k, 403b, etc.) in a subsequent post, but here is a simple example.

Many 401k and 403b plans offer a decent, relatively low-cost index fund that invests in the stocks of large US companies; an S&P 500 index fund is a typical example. However, the plan may not offer a decent fund that invests in the stocks of international companies or smaller US companies. One solution is to open an IRA account (traditional or Roth) at a firm that offers a good selection of low-cost index funds, and use that account to include some international and small company US stocks in your portfolio. Your AA determines how much of each fund to own (most investors will want to include a bond fund as well).

So remember, design and maintain one portfolio for each investment goal, regardless of the number of investment accounts used.

If anything here is not clear, or you have any questions about this or any other investing topic, don’t hesitate to leave a comment on my blog (, or send me an email at I enjoy following up with individual investors on their specific questions and issues.

1 comment:

  1. Great information about the investment, I hope it might be helpful to investors.