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In Praise of Balanced Funds

As regular readers have probably noticed, Darrow Kirkpatrick of Can I Retire Yet is one of the writers most frequently included in my weekly roundups. I’ve been enjoying his writing since I first encountered it, so when I met Darrow in person at the Financial Blogger Conference this year, I invited him to author a guest article for this site. I hope you enjoy it.

Balanced funds are mutual funds that combine stocks and bonds into a single investment. Generally they stick to a fixed asset allocation, within certain ranges. Balanced funds have traditionally been favored by conservative investors looking for safety, income, and modest growth. In a word, they’re boring!

For most of my journey to early retirement, I had no interest in balanced funds. I dabbled in individual stocks, then gradually shifted to passive index funds during my heavy accumulation years. Towards the end of that time, as I focused more on safety and retirement income, balanced funds appeared on my radar.

At some point I took a small position in Vanguard Wellesley Income. Then something curious happened. Whenever I had free cash to invest, I’d scrutinize my existing holdings plus my investing “wish list.” After some research, number crunching, and pondering, I’d often just put the money in Wellesley Income! Over time, that one fund has grown to constitute about one-third of my portfolio.

Why did I keep choosing this one balanced fund? Because, regardless of the economic cycle, market cycle, or my own personal life cycle, it was nearly always an appealing investment.

The bond component of a balanced fund tends to dampen out the volatility of the stock market. A balanced fund won’t rise quite as high in the good times, but it will fall far less in the bad times, and you’ll generally make back those dips in reasonable order. So, over time, a balanced fund can limit the stock market’s swings, while delivering much of its returns.

And, while it’s not guaranteed, the stock component of a balanced fund makes the fund more likely to keep up with inflation than a bank CD, a bond, or a bond fund.

Helping You Avoid Mistakes

Another research-documented reason to like balanced funds: They help you to avoid common behavior that leads to investing mistakes.

To appreciate the evidence for this, you first need to understand the concept of investor returns as distinguished from fund returns. We’re all familiar with the annual returns that mutual funds report in their glossy ads. But investor returns are what the average investor actually earns from the fund.

Why would those numbers be different? Consider a fund that has a great quarter and goes up 5% early in the year. That’s approximately a 20% annual return. Investors see that great return and pile in. Then the fund flat lines for the rest of the year. So it winds up the year by earning 5%, while most of its investors earned nothing. That’s investor returns.

In 2011 Morningstar completed a study on the gap in investor returns — how individual investors do compared to their funds’ overall returns. Here’s a snapshot of what they found: In 2010, the average domestic stock fund earned a return of 18.7% compared with only 16.7% for the average fund investor — a 2% difference. For the trailing three years, that gap was 1.28%.

However it was a different story for balanced funds: The gap between investor and fund performance in 2010 was only 0.14%, and just 0.08% for the trailing three years. Results were even better for the trailing 10 years. And results were similar for target-date funds and moderate- and conservative-allocation funds — close kin to balanced funds. As anybody who has crunched retirement numbers knows, a 1-2% difference in annual return over long periods can easily add up to tens of thousands of dollars!

Why do individual investors do better when they are buying and holding balanced funds? It’s probably because balanced funds don’t tend to incite fear or greed — two emotions that can be lethal to investment performance. Balanced funds are easier to live with.

It’s like the difference between a family sedan and a race car. The race car might have awesome performance, in the right hands. But, for those of us who aren’t full-time professional drivers, there are much better vehicles for driving around a city. It’s the same with investing: For most people, a vehicle with predictable behavior, that they can handle, will produce better results. [Mike’s note: That’s my bolding.]

Using a Balanced Fund In Your Portfolio

Should a balanced fund (or a target-date or allocation fund) make up your entire portfolio? That’s a viable option for many. But it may not be possible, given the investment choices in your retirement plan. Or you might want the level of control offered by individual index funds or ETFs. But a balanced fund could still play a useful anchoring role in your portfolio, while serving as a mechanism to diversify or automate part of your rebalancing strategy. That’s how Wellesley Income functions in my portfolio.

Which balanced fund might be best for you? Vanguard Wellington and Wellesley Income have long and enviable track records, and have worked well for me. But note these are actively managed funds. While they have extremely low expenses — 0.25% for Wellesley Income investor shares and 0.18% for Admiral shares, for example — their managers do trade positions in an attempt to enhance performance. Mike makes a good case for the passive index-based Vanguard LifeStrategy Moderate Growth Fund, largely because of the increased international exposure. And if I had it to do over, I’d probably choose one of the LifeStrategy funds too.

In the end, only you can choose what’s right for you. But, whatever you decide, remember this principle: your long-term investing behavior is far more important to success than the exact investments you pick, the exact asset allocation you choose, or the rebalancing strategy you implement. As it turns out, balanced funds just make it easier for you to behave well!

Darrow Kirkpatrick is an author, software engineer, and investor who retired at age 50. He now writes regularly about saving, investing, and retiring at Can I Retire Yet? He is married to a schoolteacher, has a son in college, and is an experienced rock climber and enthusiastic mountain biker.


Comments

  1. For me. this was a very timely article!
    Less than a month ago I put 90% of my IRA into Wellington (aprox 65/35). I did this for one major reason. I felt my carefully constructed AA would be to complex for anyone who had to take this over should I die or become incapacitated. In other words I was aiming for simplicity, even at the cost of a (very) slightly higher expense ratio. I went with the more aggressive Wellington over the less aggressive Wellesley based on Wade Pfau’s analysis of the effects of annuities (in my case pension fund and Soc Sec) on efficient asset allocations.

    I also manage a trust for my mother which still has a complex AA. I plan to move that all to Wellesley but am still considering the tax implications of the tilt towards taxable income. (Since my mother is in a 15% tax bracket I don’t think this is a real issue, but still thinking.)

    with both these funds one gets decent diversification and low cost — the main ingredients of successful investing.

    For my IRA I kept my REITs and even bumped them from 5% to 10%. Real estate just appeals to me.

  2. Glad you enjoyed the article Bob! I share that concern about how my heirs would manage if I were gone, and agree that a balanced or all-in-one fund is a reasonable solution, short of an annuity. I also keep a real estate fund on the side in about the proportion you mention.

  3. Thanks for the article, its a coincidence that I just recently downloaded the free ebook file on Darrows site. Needless to say its site that is succinct and simple which is what most of the investors would need.

    I see that the the stock holdings in wellington/wellesley are large cap . My question is what is the difference in holding one of these balanced funds versus having some large cap funds and some bond holdings separately? The only difference I personally see that be that you would have keep an eye on asset allocation if you manage them separately? Any other benefits or drawbacks you would see? Why dont we see small cap/international/midcap as well in the balanced fund? Wouldn’t that be more balanced?

    But one thing I really like the idea is that its easy to manage for heirs/spouses who are not involved in these matters.

    Thanks and I hope this is not the last guest article I would see here…

  4. SJ,

    The stocks are large-cap-value funds. Here is what Wellesley says:

    ==== quote ====
    Focuses on large-company value stocks with above-average dividends and potential for income growth. Using fundamental research, the advisor typically invests in fewer than 100 stocks, generally with low price/earnings and price/book ratios, and stable or improving fundamentals
    ==== end quote ====

    and here is Wellington
    ==== quote ====
    Fundamental research identifies high-quality large- and mid-capitalization companies in out-of-favor industries. These stocks typically offer above-average dividend yields, low valuation multiples, and improving fundamentals.
    ==== end quote ====
    (Not sure if those will always be classed as *value* companies, but I think so.)

    So they are not index funds. But they are well diversified, with reasonable asset allocations, and are inexpensive. For example my weighted average of expense rations of my six-fund portfolio was 0.12% and Wellesely (Admiral) is only slightly higher at 0.18%.

    That 6 basis points pays for them doing the “watching” for you and, if you believe active management has some value (I believe this) it pays for that as well. Almost every discussion of why index funds beat active funds includes the consideration that active funds have high expense ratios, “swamping” any value-add. With Wellesely and Wellington, the expenses are not a significant factor. Tax consequences of higher turnover are also not a problem in tax-advantaged accounts nor taxable accounts in a low tax bracket.

    One other thing with (almost) all your assets in one fund it is easier to reach Admiral status.

  5. Bob,

    Thank you for providing such an excellent answer! (I’ve been busy all day with events at the Bogleheads conference and am only now getting to the day’s emails.)

  6. Bob, thanks for clearing that up for me. Appreciate it

  7. This was a great article, the only main point that I disagree with is that your long term investing behavior will determine is far more important than AA. Though I’m not sure exactly what long term investing behavior means?? I think AA is far and away the most important factor in deciding your returns(other than rate of contribution).

    The gap in investor returns for stock funds and balanced funds is very interesting, thanks for pointing that out. I think that shows the tendency that people have(like you mention) to jump on a hot stock or fund after its had good returns.

  8. Hi Harry, thanks for your comment. I really appreciate that.

    The idea that AA is the single largest contributor to portfolio success has been conventional wisdom for a while. I’ve repeated it myself. But, within a broad range of reasonable allocations, I’m not sure it stands up. Jim Otar devotes a chapter in his “Unveiling” book to debunking the importance of AA, especially in distribution portfolios. I can also say, having read numerous studies on safe withdrawal rates, that moderate changes in AA seem to have little difference on portfolio success.

    I agree with you about the factors in long-term investing behavior. To me it’s a combination of savings rate, buying out of season, and not chasing recent performance.

  9. Harry and Darrow,

    In support of Harry’s point here is a link to Wm. F. Sharpe’s “Adaptive Asset Allocation Policies” paper of 2009: http://www-leland.stanford.edu/~wfsharpe/retecon/wfsaaap.pdf.

    In it (in my probably muddled paraphrase) Sharpe contends that the *real* risk (and therefore expected reward) of a portfolio is not its specific numerical AA, but the relationship of that AA to the overall market AA which (in my view) is surprisingly volatile!.

    The wide variations in market AA is shown in figure 2 of the paper (page 18). It shows a high of 75/25 and a low of 45/55 over 33.5 years. The average is almost exactly 60/40. In 2009 (date of the paper) it was near its low point (45/55) but rising.

    Thus, a static AA does not map to a static risk/reward ratio. That is a moving target so a non-moving AA cannot always point directly at it!

    One thing to note is that if you do NOT rebalance and your AA drifts it will drift in the same directions as the market AA. I think, therefore, that NOT rebalancing will maintain a more steady risk/reward ratio (the thing you actually want to exert control over) than rebalancing will give you. The math is more complicated than that and a bit above my pay grade without some more hand-holding. See the paper!

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