This article is an excerpt from the Shortform book guide to "The Simple Path to Wealth" by JL Collins. Shortform has the world's best summaries and analyses of books you should be reading.
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Do you want to get into investing? What factors should you consider as you decide what to do with your investment money? How much risk should you incur?
Two stages in your investing life determine the mix of assets in your portfolio: the wealth accumulation stage, and the wealth preservation stage. According to financial blogger J. L. Collins, if you are young, you should focus on accumulating wealth. When you are approaching the retirement age, you should focus on preserving it so you can continue to live on it. Once you’ve determined your investment stage and allocated the desired percentages to different assets, your next consideration is whether and when to rebalance your investment portfolio.
In this article, we’ll take a look at J. L. Collins’s tips on how to balance your investment portfolio between the two baskets, and whether and when to rebalance it.
The Wealth Accumulation Portfolio
When you’re young, you should focus totally on building wealth. In that regard, do two things:
- Accumulate your F-You Money as soon as possible.
- Then, focus on stocks, which, as we have seen, provide the best performance of all asset classes. Your best and simplest wealth-building vehicle is VTSAX, Vanguard’s Total Stock Market Index Fund.
Remember that the stock market goes up and down and discipline yourself to not panic and sell during downtowns. You may want to invest more money during downturns because stock prices are lower, but if you primarily focus on adding regularly to your nest egg over time, you’ll become wealthy.
Investing only in stocks at this point is aggressive but appropriate for the early wealth accumulation stage—it will deliver the greatest return over time. Don’t worry about bonds until you’re preparing to start living on your investments.
The Wealth Preservation Portfolio
When you’ve built your wealth and are ready to retire, your focus should be on preserving it so you can continue to live on it. You want to see fewer ups and downs in your portfolio value, even with the tradeoff of lower overall returns from taking a more conservative approach.
While the wealth accumulation stage is simple—put all your money in a stocks index fund—wealth preservation requires a few more steps:
- Adding a bonds index fund
- Determining the asset allocation—that is, what percentage of your money should be in stocks and what percentage should be in bonds. Also, you should review and adjust your allocation—referred to as rebalancing—once a year. It typically takes a few hours. Chapter 14 looks at asset allocation in more detail.
In semi-retirement, Collins allocates his assets this way:
- Stocks in VTSAX: 75%
- Bonds in VBTLX: 20%
- Cash in a bank account: 5%
This is a typical wealth preservation portfolio. You can adjust it to your circumstances: If you want less volatility, increase the percentage in bonds; if you want more growth and can tolerate market fluctuations, boost the percentage in stocks.
Rebalancing Your Portfolio
Your investment portfolio’s balance will change as a result of the differing growth rates of various assets over time. You may want to restore your original balance, or you may decide you prefer less risk and therefore want to increase the percentage of your portfolio held in bonds.
How to Rebalance
If you hold a mix of stocks and bonds, you should consider rebalancing your allocations once a year, or when the market swings 20% or more.
Rebalancing typically requires selling shares in the asset class that has grown (typically, stocks) and investing more in the slower-growth class (bonds). It can be done online with most investment firms and takes only a few hours. Like changing your car’s oil, it’s simple but valuable to do periodically.
Factoring in Risk
To determine what proportion of your nest egg you want to keep in bonds (that is, how conservative you want to be regarding risk), consider the following:
- Your temperament: Are you cautious by nature or are you comfortable taking risks?
- Your flexibility: If there’s a market downturn and your portfolio loses value, are you able to reduce spending, return to work, downsize, and so on? If adjusting your lifestyle isn’t an option, you want less risk and should put more into bonds.
- How much money you need to live on and how large your portfolio is (divide by 4% to determine what you could draw annually to live on without eroding your assets): The more you need, the more important it will be to preserve your assets from risk.
Questions and Answers
Following are some answers to typical questions about rebalancing toward bonds:
1) When should you shift toward bonds? This depends on your situation and risk tolerance.
- If you have a fixed retirement date, gradually shift a greater proportion of your portfolio into bonds five to 10 years before you retire.
- If your retirement date is flexible and you’re risk-tolerant, you could keep your entire nest egg in stocks until you retire. Your investment will grow faster, possibly enabling you to retire sooner. But if the market declines, you might have to delay retirement.
Whenever you shift between accumulation and preservation, you should adjust your allocations.
2) Does age matter? It’s more useful to think of life stages rather than age because circumstances may vary considerably among people the same age. However, as your age advances, it starts limiting your options—for example, due to limited physical ability or age discrimination, you won’t have the same employment options you had when you were younger. In addition, you’ll have less time to let your portfolio recover from downturns. These risk factors will influence how soon you diversify into bonds.
3) When should you rebalance? There isn’t a prescribed time, other than avoiding the beginning and end of the year—at these times, the market may be skewed by more people buying and selling for tax reasons. Just pick a time to rebalance each year that’s easy to remember, such as your birthday.
4) How do you rebalance between taxable and tax-advantaged accounts? This can be complicated, but usually you should sell in tax-advantaged accounts like IRAs to avoid taxes. But if you have capital losses, sell in a taxable account because then you’d have a tax deduction.
5) Does portfolio performance improve if you reallocate more frequently? Financial advisors who offer rebalancing as a service argue that it does. However, Vanguard’s research showed that portfolios rebalanced once a year performed only a little better than those not rebalanced at all—so rebalancing more frequently wouldn’t make much difference. Bogle considered rebalancing a personal choice, not one validated by performance data. Collins still rebalances annually.
Another Option: TRFs
If you don’t want the hassle of rebalancing, consider TRFs—Targeted Retirement Funds—which rebalance automatically. They cost a little more than a simple index fund that you rebalance yourself, but TRFs are still low-cost. Vanguard offers a series of TRFs, as do other mutual fund companies.
Each fund targets a range of retirement years—you just pick the year you plan to retire and select the fund that applies. All you have to do is add as much as you can to it and arrange withdrawal payments when you retire.
Here’s how TRFs work: Each TRF is a so-called fund of funds. Vanguard’s TRFs contain low-cost index funds, including stocks, bonds, and international index funds, plus an inflation-protected securities index fund. Based on your selected retirement date, the funds automatically adjust the asset balance, becoming increasingly conservative over time.
People differ on whether specific TRFs are too aggressive or too conservative for too long a period. In either case, you can adjust by picking a fund targeted to a different retirement date—for example, if you want a more aggressive allocation (a greater percentage of stocks), pick a fund targeted to a later retirement date.
TRFs are available in many employer-provided 401(k) and 403(b) retirement plans. In addition, interest and dividends aren’t taxed until money is withdrawn.
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- A simple road map to achieving financial independence and a secure retirement
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