I’ve written several times about how much I enjoy the Bogleheads forum. While there’s a wide variety of investing-related discussion there, my favorite posts are the simple nuts and bolts ones in which an investor outlines his/her portfolio and other forum members give feedback.

I think it’s fun to see a jumbled mess of a portfolio get cleaned up into something that’s more diversified, lower-cost, and easier to manage. That’s why, when I’m checking out a portfolio, there are three questions I seek to answer:

1. Is the overall asset allocation appropriate?
2. Are there any opportunities to cut costs (including taxes)?
3. Are there any opportunities to simplify?

When answering these three questions, it’s important to remember is that it’s all one portfolio. By implementing your desired asset allocation at the portfolio level (as opposed to in each individual account), you often create opportunities for cost savings and simplification.

Checking the Asset Allocation

As we’ve discussed before, asset allocation is not a precise sort of thing (nor, for that matter, is the concept of risk tolerance, on which an investor’s allocation should be based). As a result, for a given investor, there are countless possible allocations that could be acceptable.

So, for the most part, this step is just a quick check to make sure that there’s nothing that’s clearly wrong (such as a very large allocation to one individual stock or an extremely stock-heavy allocation when the investor has provided no information that would indicate that he/she has a super-high risk tolerance).

Cutting Costs: Start with the 401(k)

When searching for cost saving opportunities, the first place to look is your 401(k). The reason to start here is that all your other accounts (that is, IRAs and regular brokerage accounts) can be held at your brokerage firm of choice, thereby giving you access to low-cost investments in each asset class in these accounts, whereas you don’t always have great options in a 401(k).

So we start with the lowest-cost fund in the 401(k) and allocate as much as possible to that fund without messing up the desired overall allocation. For example, if:

• an investor’s 401(k) makes up 25% of her portfolio,
• the lowest-cost fund in the plan is a diversified U.S. stock fund, and
• her desired asset allocation necessitates holding 30% of her portfolio in U.S. stocks,

…then we’d allocate the entire 401(k) to that U.S. stock fund, and then use the other accounts to fill in the other necessary portions of the desired allocation.

In contrast, if we change the above example so that the investor’s 401(k) made up 40% of her total portfolio, then we would no longer want to allocate the entire 401(k) to the U.S. stock fund (because she only wants 30% of her portfolio in U.S. stocks). Instead, we’d allocate 3/4 of the 401(k) — or 30% of her total portfolio — to that fund in order to achieve her desired U.S. stock allocation. Then we would look for the next-lowest-cost fund in the plan and proceed from there.

Cost Savings: Tax-Efficiency

After doing everything possible to use low-cost investment choices, the next way to look for savings is to try to make things as tax-efficient as possible. The overall goal is to tax-shelter your least tax-efficient assets (REITs, high-yield bonds, and other taxable bonds) by putting them in your tax-sheltered accounts (IRA, 401(k), etc.) before tax-sheltering your more tax-efficient assets.

For most index fund or ETF portfolios, the most tax-efficient asset class is international stocks, so if you only need to leave one asset class in a taxable account, that’s likely to be your best bet.

Simplifying

With regard to simplification, the first and most obvious step is to minimize the number of accounts involved — combining all your non-401(k) accounts at one brokerage firm. (Personally, I like Vanguard. But they’re not the only good choice.)

The next step is to work to reduce the number of funds involved. In many cases this means using just 1 or 2 funds in each account, with the exception of one account (often the biggest one) in which you would hold each asset class and in which the necessary rebalancing would take place to keep the entire portfolio in line with the desired allocation.

January 30, 2012 11 comments

Housekeeping note: Last Wednesday, I upgraded the hosting service for this site. Unfortunately, I messed up the email server in the process and didn’t notice it until Friday. So if you sent me an email last week and did not get a reply, please accept my apologies and resend the email, as I probably never received it.

When it comes to mutual funds, as we all know, past performance is not indicative of future results.

But past performance can still be useful information. One of my favorite ways to use such data is to get a quick, first-glance look at how similar two funds are.

For example, a reader recently asked about whether Fidelity Total Bond Fund (FTBFX) would be a suitable replacement for Vanguard Total Bond Market Index Fund (VBMFX) — he had wanted to use the Vanguard fund, but the Fidelity fund appeared to be the best bond fund available in his 401(k).

The following chart (produced via Fidelity’s website — see the end of this article for instructions on making similar charts) shows us how an investment of $10,000 in each of the funds would have done over the last 10 years.

Conclusion: They’re certainly not the same thing, but they don’t appear to be wildly different either. It’s at least close enough to merit further research (like comparing the funds’ holdings by looking up each fund on Morningstar and viewing the “portfolio” tab).

Or what if your 401(k) had access to Vanguard’s Large-Cap Index Fund (VLACX), rather than a total stock market fund? The following chart compares the fund’s performance since inception to the performance of Vanguard Total Stock Market Index Fund (VTSMX) over the same period.

Conclusion: “High correlation” would be an understatement. In terms of performance, these two funds are virtually identical — which makes sense, given the degree of overlap between the funds’ holdings.

Or what if you’re feeling tempted to switch from a short-term treasury fund to a long-term treasury fund in order to grab a couple extra percentage points of yield, but you want to get a quick feel for how much additional risk you’d be taking on? The following chart compares the 10-year performance of Vanguard’s Short-Term Treasury Fund (VFISX) to that of Vanguard’s Long-Term Treasury Fund (VUSTX).

Conclusion: These two funds are very meaningfully different. By reaching for that additional yield, you take on a pile of additional risk. (Remember how we discussed that the volatility of a bond fund is proportional to its average duration? This picture shows the difference between a 2-year average duration and a 15-year average duration.)

Important Caveats

Of course, the above past-performance-based comparisons come with some important caveats.

First and most importantly, this is just a first-glance sort of analysis. Before investing in a fund, you’d want to actually take a look at its expenses and its portfolio makeup.

Second, the more actively-managed a fund is, the less reliable this sort of comparison will be. For example, an actively managed stock fund could have performed very similarly to the S&P 500 in the past, but there’s no guarantee that would be the case going forward.

Finally, for index funds, such comparisons become much less meaningful if the fund has switched the index it tracks over the course of the period in question — like Vanguard Total International Stock Index Fund, for example. And the same goes for “funds of funds” that have changed their composition (like the Vanguard LifeStrategy funds and Target Retirement funds).

To make such charts on your own: Visit Fidelity’s website, then click “research,” then “mutual funds.” Then enter the ticker symbol for one of the funds in question. Then, under the resulting chart, enter the ticker symbol for the second fund in the field for “compare funds.”

Credit where credit is due: Boglehead forum member nisiprius has been using such visual comparisons in his posts for years. I’ve often found them to be quite enlightening, so I thought I’d share the idea with you.

January 23, 2012 2 comments