Financial Advice for My Son


Asset Allocation

Example of a simple asset allocation for long-term investors

If you won't need this money for at least 8 years, the following is a reasonable portfolio:


Note that you should use tax-free bonds if their return beats the after-tax return of taxable bonds, and cash stands for cash-equivalent investments such as CDs, savings accounts, T-bills, money-market accounts, etc.

This portfolio gives you an expected real return of 5.2%/yr (return minus inflation), with a sigma of 17%/yr, using the historical returns from 1926-1982. (100% stocks would give an expected real return of 8.4%/yr, but with a sigma of 22%/yr.) Note that there is some chance that the return could be higher now, since investors have demanded significant real returns from bonds after the inflation problems of the 1970s.

Check up on your percentage allocations once a year or so, and when things become too unbalanced, correct the unbalance by either selling assets in one category and putting them in another (modest imbalances can be corrected immediately without doing it gradually), or by changing your contributions to each category until the imbalance is corrected.

Slightly more complicated asset allocation

If you want to match T. Chester exactly, here is my model portfolio:

Asset TypeAllocationFund Examples
Index Fund10-30%Vanguard Index 500; 800-662-7447; $3,000 minimum initial investment; $100 minimum subsequent investments
Small Stocks10-30%Babson Shadow Stocks; 800-TBS; or Vanguard Index-Extended; see above
International10-30%Vanguard World; see above
Bonds Tax-Free10-30%Dreyfus Ca. Tax Free; 800-645-6561; $2,500 minimum initial; $100 subsequent; or zero-coupon Treasuries; Benham Target Maturities Trust 1990-2015; 800-227-8380; $1,000 initial; $100 subsequent

T. Chester ideal allocations as of October 1989:
Index Fund20%Stocks are near fair evaluation
Small Stocks20% 
International10%Japan stock market is in a speculative bubble now!
Bonds20%It isn't clear what interest rates will do in near future

Note that in the first issue of this document in February 1989, I had 30% in bonds, speculating that interest rates would decline, and as of now had made about 40% in that short time period using 30 year Treasury zeros! I don't promise continued similar results!

Inside JPL's TDA, the best bet for cash is probably Fidelity Cash Reserves (money market) and Fidelity Magellan for stocks. Magellan is probably the best of the alternatives and will probably perform very close to the S&P 500 now that it is so large. Unfortunately, its expense ratio is high, but fortunately, we don't have to pay the 2% load that salesmen rake off your investment if you invested in Magellan outside of the TDA!

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