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Build a portfolio that pays when you need it
This time-laddered approach increases the odds that money will be there when it has to be, for college or weddings, yet assumes enough risk to pay off over the long run.
By Timothy Middleton
One of the most common queries we get in our Start Investing Community is about how to invest for varying time periods. One recent post from a member named Tyler said he was only 20 and therefore could invest for the long term. But, he added, It would be nice if I could use some (of the money) for marriage, kids, school, etc.
These are time-dependent goals, meaning you cant afford to get caught short when the alarm clock rings. That in turn means you have to manage risk more aggressively in a time-centric portfolio.
Managing risk is tough. Naive investors think they can do it through holding cash, as in a money-market fund, but thats deceptive: In a world where money-fund returns are less than the rate of inflation, let alone taxes on interest, you actually lose purchasing power. As Yogi Berra might say, thats the same thing as losing money.
In my personal portfolio, I use a time-laddered approach to investing. Anything I wont need for more than 15 years I put into equity mutual funds. Im confident the markets generally upward bias will overwhelm shorter-term bull and bear cycles in the meantime. Anything I need sooner goes somewhere else.
My time ladder has four other rungs. At the bottom, in a fairly conventional mix of stock and bond funds, is money that Ill need between 11 and 15 years from now. On the next step is a more conservative mix aimed at a window of seven to 11 years. The next time-step is labeled three to seven years, and the top rung is money Ill need in three years or less.
Seeking active managers
So-called lifecycle funds do something similar to this automatically, becoming more conservative as they age. But I dont use them because I want to control risk another way, which is by switching when appropriate from indexing to active management.
Conventional approaches to investing treat indexing versus active management as an off-on decision: You favor one over the other or you dont. My approach is different. I have more confidence in active management over intermediate periods than long ones.
I can have great confidence that a fund I buy today will still be managed in the same way by the same people five years from now. But I cant be confident that will be true in a decade. By then, todays managers could have retired and sold their firm to Scandals R Us.
Also, only a minority of even the very best fund managers can consistently beat the market. Of the 1,868 mutual funds in Morningstars database that ranked in the top performance quartile over the 10 years ended July 31, only 605 maintained that top-25% performance throughout the intervening one, three and five years. And only four of those were large-capitalization blend equity funds, which are the core of most investment portfolios.
But looking at a five-year horizon, some 1,373 funds managed top records over one, three and five years. From these data I draw this conclusion: I can have far more confidence in an actively managed fund over shorter rather than longer periods. Saying the same thing a different way, I can recommend accepting manager risk for five years, but not for 10.
The climb
Heres my ladder, and the funds I would use to construct it:
Eleven to 15 years: My idea of a no-brainer long-term investment is Vanguard Total Stock Market Index Fund (VTSMX), and I use it in my family accounts. For that portion of the portfolio that I want to tap in less than 15 years, however, I establish a mix that is equivalent to 88% Total Stock Market and 12% Vanguard Total Bond Market Index Fund (VBMFX).
Over the 10 years ended July 31, this blend would've delivered total returns of 10.2%, compared with 10.7% for Total Stock Market by itself. But the standard deviation, or price volatility, of the mix is correspondingly less, so I am basically paying around 40 basis points, or hundredths of a percentage point, per year for insurance that in the worst case my portfolio will be down only 9/10ths as much as a bad market.
Seven to 11 years: The closer I come to the top rung of my time ladder, the less risk I take. At this stage, I want 75% exposure to stocks and 25% to bonds, which I achieve by rebalancing the Total Stock Market and Bond Market Index in this ratio.
This mix has delivered annual average returns of 9.8% in the last 10 years, which means I am not paying a huge penalty in lost performance in order to decrease the volatility of my portfolio by 25%.
Plenty of confidence
Three to seven years: Given this time span, I can have a high degree of confidence that the active managers I select today do a fine job throughout this period. So at this point I abandon index funds and switch 100% into a top-drawer balanced fund, which has 60% exposure to stocks and 40% to bonds.
My pick would be Dodge & Cox Balanced Fund (DODBX). The five-year standard deviation, or average price volatility, of this fund, of 10.8, is nearly 40% less than that of Vanguard Total Stock Market. And in practice the risks are even less.
The five-year annualized returns of the Dodge & Cox fund were 9.7%, as of July 31. In that same period, which included the worst bear market in modern times, Total Stock Market actually declined more than 1% annually.
And active management has more than paid for itself. Vanguard Balanced Index (VBINX), the index equivalent to Dodge & Cox Balanced, eked out annual gains of 2.4% over each of the last five years. Going forward, you cant expect an actively managed fund to quadruple the performance of its index, but that result is obviously possible.
The short term
Three years or less: Ultra-short bond funds are the usual picks for money you need in just a few years, whether its to pay for a wedding or the first year of college. But short-term interest rates are at 50-year lows; only nine of these funds delivered total returns of more than 2.875% in the three years ended July 31, according to Morningstar, and none of them accomplished that over the last 12 months.
Why do I choose a return of 2.875%? Because thats the rate ING Direct is offering for a two-year certificate of deposit. This online bank has the most aggressive rates Ive been able to find for no-minimum accounts.
If you can meet a $10,000 minimum, Countrywide Bank of Alexandria, Va., is offering a rate of 3.56% for a 2 year CD. Barrons publishes a list of top CD rates weekly. In todays low-rate environment, specialty borrowers such as these offer above-market interest rates with the bonus that they are FDIC-insured, something investments lack.
These goals can be achieved in different ways; in my personal portfolio I dont happen to own any Total Bond Market currently, but I do own Vanguard Balanced Index, as well as all-bond funds. As is probably true in your household, I have multiple accounts, taxable as well as tax-deferred retirement plans, and my individual choices are a jumble of decisions influenced by whats available in those accounts.
But this basic strategy is simple and requires no tinkering with at all for years at a time. The great strength of this system is that since some choices will inevitably be bad, the fewer I have to make, the better off I am.
At the time of publication Timothy Middleton owned or controlled the following securities mentioned in this article: Vanguard Total Stock Market Index Fund, Vanguard Balanced Index Fund.
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