In my example of what a diversified portfolio looks like, I used a 70% Stock portfolio as an illustration. To save you the time and math, I’ve started a series of posts that look at a range of diversified portfolios from 100% Stock to 0% Stock. I’ll break these portfolios down in 10% increments. Today we’ll take a closer look at a 70% Stock portfolio.

       Here’s a pie chart depicting the asset allocation for a diversified 70% Stock portfolio:

       Click here to learn how to invest in a diversified 70% Stock portfolio. Keep in mind that you’ll need $54,000 to meet the fund minimums for this particular portfolio. If you invest at Vanguard, the total expense ratio for this portfolio would be 0.25%.

       Here’s a chart showing the historical returns for this portfolio from 1927-2007:

Now for some quick facts about this 70% Stock portfolio:

• The highest calendar year return for this portfolio was 59.9% in 1933.
• The lowest calendar year return for this portfolio was -35.4% in 1931.
• From 1927 to 2007, the average annual return for a diversified 70% Stock portfolio was 10.0%.
• During any consecutive 3 years from 1927 to 2007, this portfolio lost money 8 times out of a possible 79 periods. In 2 of those 8 times, it lost less than 5.0% of its original value.
• The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about 54% of its original value.
• During any consecutive 5 years from 1927 to 2007, this portfolio lost money 5 times out of a possible 77 periods.
• During any consecutive 7 years from 1927 to 2007, this portfolio lost money only 2 times out of a possible 77 periods. These 7 year losing periods started in 1928 and 1929, near the beginning of the Great Depression.
• This 70% Stock portfolio never lost money during any consecutive 10 year period from 1927 to 2007.
• This portfolio never averaged less than a 7.6% annual return during any consecutive 30 year period from 1927 to 2007.
• In 44 of the 52 possible consecutive 30 year periods from 1927 to 2007, this portfolio had a return higher than its historical average of 10.0%. For nearly 85% of the time, you would have had a higher than average return over a 30 year time period.

       My hope is that this information will prepare you for the possible risk of investing in a 70% Stock portfolio while giving you some perspective during tough times. I think it’s really important to emphasize those last two quick facts. If you have a time horizon of 30+ years, there is no historical period where you would have averaged less than a 7.6% annual return. (Even if you started just before the Great Depression!!!) And 85% of the time, you would have had a higher than average return over a 30 year time period. Take comfort in those facts when the media barrages you with doom and gloom news every day.

       Diversification, index funds, low expenses, tax efficiency…they’re all so boring. Isn’t there a better way? Can’t I use research, insight, intuition, and intelligence to beat the market? Who actually believes this boring stuff anyway?

       The guy in the fancy suit on TV doesn’t seem to believe it. The writers of financial publications are constantly telling us which funds are going to be hot this year, or month, or week. There are millions of investment ideas on the Internet which include all kinds of fancy charts and systems and fantastic results. It doesn’t seem like anyone believes in index fund investing and boring ideas like diversification. Everyone seems to have some secret for how they’re going to beat the market, so why shouldn’t you as well?!

Look Who’s Talking

       Before you begin to think that index fund investing is only for schmucks, let’s take a minute to look at who supports these various investment ideals. First, the side of active management, market timing, and various other strategies to “beat the market”:

• Stock Brokers and Investment Managers – For a fee or commission (or both!), these guys will help you pick the “right” funds or stocks at the “right” time so you get nice returns every single year. They’ll even send you a gift card or free sports tickets every once in a while just to show you how much they appreciate you!
• Some Mutual Fund Companies – Sure they charge higher expenses than Vanguard does, but they’re giving you access to the “best” mutual fund managers in the world. With their team of 5,208 researchers, they’re bound to uncover information that will give them the ability to beat the market. And don’t forget about those mutual fund companies with a long family background of managers. All that experience is sure to come in handy.
• Market Timing & Stock Picking Newsletters – In the do-it-yourself mood? Just subscribe to one of the many market timing or stock picking newsletters, and Slick Sam will tell you exactly when you should get in and out of which stocks. He might even set you up with a service where his recommendations can be traded automatically in your brokerage account. You don’t even have to do a thing and you’ll make a 389% return in a matter of months!
• The Investment and Financial Media – Dow drops 600 points! Stock futures headed down this morning because the commissioner has a cold! Is your portfolio safe? Ah, the financial media. They constantly keep us up-to-date on the latest market news and even give us advice about the next top mutual funds. All we have to do is keep watching their shows or buying their newspapers and magazines and we can reap the benefits of all their knowledge.

       Do you see what I see? Every single one of these players has a vested interest in selling you something—especially in selling it to you again, and again, and again. My father once told me everyone has something to sell, and he’s right. Even the most objective advisor has to get paid somehow. But we have to look carefully at the seller’s motives before we buy—more so when the product is financial advice.

       Now what about the side of index fund investing, diversification, low expenses, and tax efficiency? Let’s look at the supporters of these really boring investment ideas:

• Dr. Harry Markowitz – A Nobel Laureate in Economics for his pioneering work in the theory of financial economics. He helped develop Modern Portfolio Theory, which looks at the effects of asset risk, correlation, and diversification on investment returns.
• Dr. William F. Sharpe – Also a Nobel Laureate in Economics for his pioneering work in the theory of financial economics. His work revolved around the ideas of the risk and return model and the Capital Asset Pricing Model, which is part of Modern Portfolio Theory.
• Dr. Paul Samuelson – Another Nobel Laureate in Economics. His findings can be summarized as: market prices are the best estimates of value, price changes follow random patterns, and future stock prices are unpredictable.
• Dr. Eugene Fama – A professor in economics and finance at the University of Chicago. His research covers the randomness and unpredictability of stock market prices, the Efficient Market Hypothesis, and the Fama-French Three Factor Model, which explores the factors that explain an investment security’s return.
• Dr. Kenneth French – A professor of finance at the Tuck School of Business, Dartmouth College and former professor at MIT, the Yale School of Management, and the University of Chicago Graduate School of Business. He is most famous for his work with Dr. Eugene Fama on the Three Factor Model.
• Dr. Michael Jensen – Former professor at the University of Rochester and Harvard Business School. He found that only 26 of 115 actively managed mutual funds outperformed the market in his paper “The Performance of Mutual Funds in the Period 1945-1964″.
• Dr. Burton Malkiel – A professor of economics at Princeton University. He authored A Random Walk Down Wall Street, which discusses the randomness of asset prices and the Efficient Market Hypothesis.
• John Bogle – Founder of The Vanguard Group
• Warren Buffet – Famous Investor. He recommends the average investor put his/her money in index funds.

       What do you notice in this group? A few less marketing gurus and a few more academics? So whose advice are you going to trust for the future of your retirement? A fast-talking salesman who rushes through the facts, or a research-driven Nobel Laureate whose life has been dedicated to teaching?

I know who I’m going with.

       If you’ve chosen one of the diversified portfolios I have discussed, you might be wondering how you can begin investing for your goals. I highly recommend using Vanguard to invest if at all possible. This could mean investing directly through Vanguard or buying their mutual funds in your retirement or brokerage accounts. Why Vanguard? They are by far the lowest-cost provider of Index Funds in the industry. Additionally, they have a long track record of great customer service. If you invest directly through Vanguard, you can avoid commissions and many other fees (especially if you sign up for their e-delivery option).

       So which Vanguard funds should you use to replicate the diversified portfolio you have chosen? Here’s the list (starting at the top and going around clockwise on the pie charts I’ve created):

       If you do not have enough money to meet the minimum investment amount for the portfolio you’ve chosen (so you can meet the fund minimums), then I recommend using one of Vanguard’s Target Retirement Funds until you have enough money in your account to implement the diversified portfolio you have chosen. You can view all of Vanguard’s Target Retirement Funds and find out more information here. You’ll need $3,000 to get started in one of Vanguard’s Target Retirement Funds.

       If you don’t have $3,000, you can begin investing in Vanguard’s STAR Fund with only $1,000. I’m not a huge fan of the STAR Fund for several reasons, but I’m using it myself until I get $3,000 in my Roth IRA to invest in the Vanguard Target Retirement 2050 Fund. Once my Roth IRA reaches $38,000, I’ll switch over to the diversified 100% Stock portfolio.

       If you don’t have $1,000 yet, I suggest you begin setting aside money every month in a high-yield savings account until you get there. I would recommend using The ING DIRECT Orange Savings Account. Great rates, no fees, no minimums. I personally use ING DIRECT and have had great satisfaction with their rates and service. Once you get to $1,000, you can open an account with Vanguard and begin investing in the Vanguard STAR Fund.

(Note:  I do not work for Vanguard and gain nothing if you decide to use them except for the satisfaction of knowing I have helped someone save a ton of money and invest wisely at the same time. For full disclosure, I do get a commission if you sign up with ING DIRECT using the link I provided above. However, I would recommend them regardless of whether I receive any compensation. Click here to go directly to ING DIRECT’s website if you don’t want me to earn a commission when you sign up.)

       In my example of what a diversified portfolio looks like, I used a 70% Stock portfolio as an illustration. To save you the time and math, I’ve started a series of posts that look at a range of diversified portfolios from 100% Stock to 0% Stock. I’ll break these portfolios down in 10% increments. Today we’ll look at an 80% Stock portfolio.

       Here’s a pie chart depicting the asset allocation for a diversified 80% Stock portfolio:

       Click here to learn how to invest in a diversified 80% Stock portfolio. Keep in mind that you’ll need $47,000 to meet the fund minimums for this particular portfolio. If you invest at Vanguard, the total expense ratio for this portfolio would be 0.25%.

       Here’s a chart showing the historical returns for this portfolio from 1927-2007:

Now for some quick facts about this 80% Stock portfolio:

• The highest calendar year return for this portfolio was 67.7% in 1933.
• The lowest calendar year return for this portfolio was -40.3% in 1931.
• From 1927 to 2007, the average annual return for a diversified 80% Stock portfolio was 10.6%.
• During any consecutive 3 years from 1927 to 2007, this portfolio lost money 9 times out of a possible 79 periods. In 3 of those 9 times, it lost less than 9.0% of its original value.
• The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about 60% of its original value.
• During any consecutive 5 years from 1927 to 2007, this portfolio lost money 5 times out of a possible 77 periods.
• During any consecutive 7 years from 1927 to 2007, this portfolio lost money only 2 times out of a possible 77 periods. These 7 year losing periods started in 1928 and 1929, near the beginning of the Great Depression.
• This 80% Stock portfolio never lost money during any consecutive 10 year period from 1927 to 2007.
• This portfolio never averaged less than an 8.0% annual return during any consecutive 30 year period from 1927 to 2007.
• In 44 of the 52 possible consecutive 30 year periods from 1927 to 2007, this portfolio had a return higher than its historical average of 10.6%. For nearly 85% of the time, you would have had a higher than average return over a 30 year time period.

       My hope is that this information will prepare you for the possible risk of investing in an 80% Stock portfolio while giving you some perspective during tough times. I think it’s really important to emphasize those last two quick facts. If you have a time horizon of 30+ years, there is no historical period where you would have averaged less than an 8.0% annual return. (Even if you started just before the Great Depression!!!) And 85% of the time, you would have had a higher than average return over a 30 year time period. Take comfort in those facts when the media barrages you with doom and gloom news every day.

       In my example of what a diversified portfolio looks like, I used a 70% Stock portfolio as an illustration. To save you the time and math, I’ve started a series of posts that look at a range of diversified portfolios from 100% Stock to 0% Stock. I’ll break these portfolios down in 10% increments. Last week’s post was about a 100% Stock portfolio, and today’s post is about a 90% Stock portfolio.

       Here’s a pie chart depicting the asset allocation for a diversified 90% Stock portfolio:

       Click here to learn how to invest in a diversified 90% Stock portfolio. Keep in mind that you’ll need $60,000 to meet the fund minimums for this particular portfolio. If you invest at Vanguard, the total expense ratio for this portfolio would be 0.26%.

       Here’s a chart showing the historical returns for this portfolio from 1927-2007:

Now for some quick facts about this 90% Stock portfolio:

• The highest calendar year return for this portfolio was 75.5% in 1933.
• The lowest calendar year return for this portfolio was -45.3% in 1931.
• From 1927 to 2007, the average annual return for a diversified 90% Stock portfolio was 11.0%.
• During any consecutive 3 years from 1927 to 2007, this portfolio lost money 10 times out of a possible 79 periods. In 2 of those 10 times, it lost less than 1.5% of its original value.
• The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about two-thirds of its original value.
• During any consecutive 5 years from 1927 to 2007, this portfolio lost money 5 times out of a possible 77 periods.
• During any consecutive 7 years from 1927 to 2007, this portfolio lost money only 3 times out of a possible 77 periods. All three of these 7 year losing periods were during the Great Depression.
• This portfolio averaged double digit annual returns (10% or more) for 52 of a possible 67 consecutive 15 year periods from 1927 to 2007.
• This 90% Stock portfolio never lost money during any consecutive 15 year period from 1927 to 2007.
• This portfolio never averaged less than an 8.3% annual return during any consecutive 30 year period from 1927 to 2007.
• In 45 of the 52 possible consecutive 30 year periods from 1927 to 2007, this portfolio had an average annual return equal to or higher than its historical average of 11.0%. Nearly 85% of the time, you would have had a higher than average return for a 30 year time period.

       My hope is that this information will prepare you for the possible risk of investing in a 90% Stock portfolio while giving you some perspective during tough times. I think it’s really important to emphasize those last two quick facts. If you have a time horizon of 30+ years, there is no historical period where you would have averaged less than an 8.3% annual return. (Even if you started just before the Great Depression!!!) And nearly 85% of the time, you would have had a higher than average return over a 30 year time period. Take comfort in those facts when the media barrages you with doom and gloom news every day.

       If you think your time horizon is shorter because you’re close to or in retirement, consider this: if you are 60 years old and your life expectancy is 90, you have 30 years left. The time horizon for your retirement portfolio is 30 years! That’s why there’s such a wide range of possible portfolios for a successful retirement (see this post about what asset allocation you should use in retirement).

       Finally, if you think a 90% Stock portfolio is much safer than a 100% Stock portfolio, you should realize that the 10% in Bonds only reduces your risk slightly. Historically speaking, the standard deviation (a measure of risk) for a 100% Stock portfolio is 23.3%. The 90% Stock portfolio has a standard deviation of 21.0%—not much difference.

       If the small decrease in volatility (how wildly the value of the portfolio moves) really makes you feel better, then go ahead and invest in the 90% Stock portfolio. But realize that it’s not much safer than the 100% Stock portfolio, and you’ll be giving up an additional 0.4% return (historically). That might not sound like much, but it could mean having 11.4% less after 30 years. (After 30 years, an investment of $1,000 would grow to $25,500 in a 100% Stock portfolio but only $22,890 in a 90% Stock portfolio. This is based on historical averages which do not represent guaranteed future returns.)

       My article, “Ripped Off: Can You Trust Your Financial Adviser?” was included in the most recent Carnival of Personal Finance hosted by Mighty Bargain Hunter. Here are some of the best posts this week, in my opinion:

• Monogamoney talks about five things to do if you get laid off. These seem like good recommendations overall, but I haven’t actually been following them myself. What do you think?
• Four Pillars discusses the so-called “death of index investing” and some other silly stats. If you believe you can pick the right stocks or mutual fund managers, or that someone else can do it for you, I invite you to read that post and follow up to the challenges.
• And finally, The Digerati Life asks “When Is the Right Time to Start a Business?” She makes some great points about why tough times might be a good time to get into entrepreneurship.

       In other news, The Oblivious Investor asks “Why Not Go 100% into Stocks?” Young investors should consider his post.

       Thanks for reading, and have a great weekend!

       In my example of what a diversified portfolio looks like, I used a 70% Stock portfolio as an illustration. To save you the time and math, I’m going to do a series of posts that look at a range of diversified portfolios from 100% Stock to 0% Stock. I’ll break these portfolios down in 10% increments, so today’s post will be about a 100% Stock portfolio, the next in the series will be a 90% Stock portfolio, then 80% Stock and so on.

       Here’s a pie chart depicting the asset allocation for a diversified 100% Stock portfolio:

       Click here to learn how to invest in a diversified 100% Stock portfolio. Keep in mind that you’ll need $38,000 to meet the fund minimums for this particular portfolio. If you invest at Vanguard, the total expense ratio for this portfolio would be 0.27%.

       Here’s a chart showing the historical returns for this portfolio from 1927-2007:

Now for some quick facts about this 100% Stock portfolio:

• The highest calendar year return for this portfolio was 83.4% in 1933.
• The lowest calendar year return for this portfolio was -50.3% in 1931.
• From 1927 to 2007, the average annual return for a diversified 100% Stock portfolio was 11.4%.
• During any consecutive 3 years from 1927 to 2007, this portfolio lost money 12 times out of a possible 79 periods. In 4 of those 12 times, it lost less than 5% of its original value.
• The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about 70% of its original value.
• During any consecutive 5 years from 1927 to 2007, this portfolio lost money 6 times out of a possible 77 periods.
• During any consecutive 7 years from 1927 to 2007, this portfolio lost money only 3 times out of a possible 77 periods. All three of these 7 year losing periods were during the Great Depression.
• This portfolio averaged double digit annual returns (10% or more) for 53 of a possible 67 consecutive 15 year periods from 1927 to 2007.
• This 100% Stock portfolio never lost money during any consecutive 15 year period from 1927 to 2007.
• This portfolio never averaged less than an 8.5% annual return during any consecutive 30 year period from 1927 to 2007.
• In 47 of the 52 possible consecutive 30 year periods from 1927 to 2007, this portfolio had a return higher than its historical average of 11.4%. A little over 90% of the time, you would have had a higher than average return over a 30 year time period.

       My hope is that this information will prepare you for the possible risk of investing in a 100% Stock portfolio while giving you some perspective during tough times. I think it’s really important to emphasize those last two quick facts. If you have a time horizon of 30+ years, there is no historical period where you would have averaged less than an 8.5% annual return. (Even if you started just before the Great Depression!!!) And 90% of the time, you would have had a higher than average return over any 30 year time period! (That’s quite amazing if you think about it.) Take comfort in those facts when the media barrages you with doom and gloom news every day.

       If you think your time horizon is shorter because you’re close to or in retirement, consider this: if you are 60 years old and your life expectancy is 90, you have 30 years left. The time horizon for your retirement portfolio is 30 years! That’s why there’s such a wide range of possible portfolios for a successful retirement (see this post about what asset allocation you should use in retirement).

       Two good questions when we invest money are:

1. How long until I know I’ll get a positive return?
2. How long until I’ll get close to the average return?

       Since we can’t predict the future, the easiest way to answer these questions is to look at what happened in the past. Keep in mind we’re looking at the worst case scenarios for each of these questions.


How Are You Invested?

       Your investment returns and risk (volatility) greatly depend on your asset allocation. The more of your portfolio that’s invested in stocks, the higher your risk will be. Higher risk means it will take longer to know for certain you’ll have a positive return over any given time frame. It also means it will take longer to know for certain that you’ll get your required return over any given time frame.

       To answer these questions accurately, we have to look at the mix of stocks and bonds in your portfolio. Assuming you’re invested in a diversified portfolio, the answers to your questions are given below.


How Long Until I Know I’ll Get a Positive Return?

       Put another way, this question is: “What’s the minimum amount of time I need to be invested in a specific portfolio to be fairly certain I won’t get a negative return?”. Here are the answers based on historical investment results since 1927.

• 0% in Stocks (100% in Bonds): 3 Years
• 10% in Stocks: 5 Years
• 20-50% in Stocks: 7 Years
• 60-80% in Stocks: 10 Years
• 90-100% in Stocks: 15 Years

       Again, these answers assume you’re using a diversified portfolio as defined in this post.


How Long Until I’ll Get Close to the Average Return?

       This question can also be posed as: “How long do I need to invest so I can be reasonably sure I’ll get a return somewhere close to the historical average?”. The first step to answering this question is to define “close to the historical average”. For the purposes of this article, we’ll define close to the historical average as 75% of the historical average. For example, if the historical average for a given portfolio is 10%, then we’d consider 7.5% as being “close to” that average. So what’s the minimum amount of time we would have to stay invested in order to get close to the average?

• 0-10% in Stocks: 55 Years
• 20% in Stocks: 50 Years
• 30% in Stocks: 45 Years
• 40% in Stocks: 35 Years
• 50-100% in Stocks: 30 Years

       Now, it’s important to remember we’re looking at the worst case scenario in both of these analyses. In reality, we’re likely to experience better results than these worst case scenarios. Most of these worst case scenarios occurred during the Great Depression.

       Historically speaking, a 100% Stock portfolio only experienced single digit returns twice over any 30 year period. Both of those single digit periods were during the 30 year periods beginning in 1928 and 1929—the worst times in history to begin investing.

       These time periods are good to keep in mind especially when we’re experiencing difficult times (like right now). When it feels like your investments aren’t performing as they should, just remember that it can take many years before you can expect to get a positive or average return in the worst case scenario. In the future, we’ll look at actual distribution of returns so we can see just how unlikely it is that we’ll ever experience the worst case scenario.