Vanguard has a new article titled The importance of saving more, which tries to address evidence that investors may believe that “choosing investments that offer the possibility for relatively higher returns—and accepting the accompanying greater degree of risk—is a more viable alternative than saving more.”

In addition, the last few months probably have many of us re-examining the amount of risk we are comfortable with in our portfolios. I know I have. So what can we do?

Taken from the article, the figure below shows hypothetical outcomes for different portfolios based upon the following scenario: A 35 year-old individual begins saving 4% (grey bars) of his gross annual salary ($50,000, adjusted annually for inflation) each year for 30 years. In the red bars, the same individuals instead saves 6% of his salary. I highlighted two of the more interesting situations with the green arrows:

Here you see that based on historical data, the combination of a 50% stock/50% bond allocation and a 6% contribution rate leads to a similar range of outcomes as a 100% stock allocation and a 4% contribution rate. In fact, the former has a slightly better median outcome with much smaller swings over the years.

For example, a 50/50 asset allocation this year would have been down only around about 20%, instead of the stomach-churning 40% drop of a 100% stock portfolio. Wouldn’t that have been nice?

Higher savings provides a higher probability of success by shifting some of the responsibility for accumulation from the less-certain return stream of risky assets to a more-certain savings stream. In the end, if an investor is trying to maximize future wealth, a marginally higher savings rate rather than a substantially higher risk portfolio is the most likely path to retirement success.

As opposed to many rules of thumb, not everyone at the same age has to have the same asset allocation. Savers may get to take less risk and sleep better at night. 🙂 Something to think about…

I’ve been trying to re-balance my portfolio using my recent 401k contributions, but I ran into some speed bumps, so here is a brief interim update.

* denotes 401(k) holding given limited investment options

Contribution Details
For 2008, we have finally both contributed the annual maximum of $15,500 each towards our respective 401ks. We have not made any 2008 IRA contributions, but we did make 2007 contributions in April 2008. We will likely do our 2008 contributions in April 2009 deadline.

YTD Performance
The 2008 year-to-date time-weighted performance of our personal portfolio is now -42.5% as of 12/8/08.

For reference, the Vanguard S&P 500 Fund has returned -36.69% YTD, their FTSE All World Ex-US fund has returned –47.98% YTD, and their Total Bond Index fund is +2.20% YTD as of 12/8/08. The Vanguard Target 2045 Fund has returned -35.79 YTD, primarily due to a small international allocation.

Investment Changes
In my wife’s 401k plan, a few new investment options were added, including the Fidelity Extended Market fund (FSEMX). This is a nice complement to their in-house S&P 500 index fund. If you take 75% S&P 500 and 25% Wilshire 4500 Completion Index, you pretty much get the Total US Market, so we have moved our investments to that and sold off the bit that we had in the actively-managed Dodge & Cox fund. Nothing else in that 401k is terribly appetizing.

We have used our new contributions to bring us back towards our asset allocation target, with a 85% stocks/15% bonds split. This means I have been buying more International, REIT, and Small Cap. I have also been swapping funds around to make things “fit” better, due to the limitations of spreading money across different accounts.

You’ll notice that I am really below-target in my US allocation, and have $4,500 in cash. This is because the fund minimum for the Fidelity Spartan Total US index fund is $10,000 (in my 401k). In early 2009, I hope to add enough money to reach the minimum. I could buy ETFs instead or another more expensive Fidelity fund as a tracker, but not sure if I want to pay the roundtrip commissions given that it will be less than a month. Currently on the fence.

You can view all my previous portfolio snapshots here.

Vanguard has recently announced the details of their Individual 401(k) plan – otherwise known as Solo 401k or Self-Employed 401k. Although you can’t apply yet it seems, many of us passive investors have been waiting for Vanguard to offer this for a long time.

The Vanguard® Individual 401(k) plan is a retirement plan for self-employed individuals. This plan is available only to sole proprietors or partners in business who have no common-law employees. The only other participant allowed in this plan would be a spouse of the business owner if he or she works for the business. Business owners should not establish this plan if they have common-law employees, including their children.

There is some confusion as to whether this includes the sole owners of an S-Corporation, but I’m betting it does as it is a passthrough entity and we are essentially self-employed. Here are some more Vanguard-specific details, along with some comparison with the Fidelity Self-Employed 401(k) which I currently have:

• Seems like you can buy any Vanguard fund with no commissions, and there is “no minimum initial investment required to open most funds” (emphasis mine). It doesn’t seem like you have the option to buy ETFs through their brokerage service. At Fidelity, the Fidelity funds are also free, but I am subject to minimum initial investments. However, I do have the ability to buy any ETF with a $12-$20 commission, as well as buy individual bonds.
• The Vanguard Individual 401(k) will accept three types of employer and employee contribution sources: individual employee salary deferral contributions (pre-tax money), traditional employer contributions (pre-tax money), and Roth salary deferral contributions (post-tax money). Roth is available! Fidelity does not have this.
• Employees can move money between different Vanguard funds by phone or in writing only. This is kind of a pain. I can manage my Fidelity Self-Employed 401(k) online like a regular brokerage account, with limit trades and everything.
• There are no set-up fees charged to the employer for a Vanguard Individual 401(k) plan. Vanguard charges employees a $20 annual account service fee for each mutual fund held in an account within the Vanguard Individual 401(k). If you like to own multipole funds, that can add up quickly! (Note: If at least one participant in a Vanguard Individual 401(k) plan qualifies for Flagship™, Voyager Select™, or Voyager™ Services, the account service fee will be waived for all participants in the plan.) Fidelity has no setup fees, and no annual account fees at all.
• Rollovers are permitted out of the Vanguard Individual 401(k), but not into it. Not sure why this is the case.

This is only a superficial review, but so far I’m not planning to try and open one. It turns out that I am quite happy with my Fidelity Solo 401k, as it provides a lot of flexibility, great customer service, and reasonable costs. Vanguard has a wider array of index funds, but I can also buy the equivalent Vanguard ETFs at Fidelity. If I buy in large enough chunks, the commission is balanced out by the lower annual expense ratios. Besides, if you are at not at least Voyager ($50k in assets), the $20 fee per fund from Vanguard costs as much as two trades anyway.

The main thing going for Vanguard is the Roth option, which I must admit should be very attractive for most people. But for us, our current tax bracket is high enough that I prefer pre-tax contributions.

Via Guzzo the Contrarian and Bogleheads.

This past week, I made some minor tweaks to my investments. No, I didn’t go all cash! Previously, I had set the bond portion of my portfolio to be 50% short-term Treasury bonds and 50% Treasury inflation-protected bonds (TIPS). I use the mutual funds VFISX and VIPSX. However, this week I shifted my allocation to be 25% short-term Treasury bonds and 75% Treasury inflation-protected bonds (TIPS).

Comparing Yields to Find Expected Inflation
You can compare the nominal yield of the Treasury bonds and the real yield of TIPS and find the implicit expected inflation. For example, if a 20-year Treasury bond yields 5%, and TIPS yield 2% real, then the expected inflation is the difference, or 3%. (If inflation is 3%, then the nominal yield of TIPS becomes 2% + 3% = 5%.)

This week, the expected inflation over the next 10 years has been hovering around 1%, some of the lowest in a long time. On Monday, the 10-year Treasury yield was 4.08% and the TIPS real yield was 3.05% (source: US Treasury), for an expected inflation of 1.03%. As of Friday, the gap was 1.02%. For the 20-year bonds, the gap predicted inflation of a about 1.6-1.8%. If the actual inflation rate turns out to be greater than these values, then holding TIPS will result in a higher yield over time.

Here is a chart of annual CPI-U changes over time (source: BLS.gov). The red line is the 10-year moving average:

Yes, there are deflation worries in the near future, but you can see the only decade that inflation has averaged below 1% was during the Great Depression. Not only that, but our currency was still on the gold standard then.

Currently High Real Yields
As mentioned earlier, the current real yields offered by TIPS of around 3% are also the highest in many years:

Since real yields are rising, the value of existing TIPS have actually dropped. So I’m buying low. 🙂 If real yields rise any higher, I’d buy even more.

Making The Change
There are many things to consider out out there, like global demand and the infamous $700 Billion bailout package (where do you think this money comes from?), but I only see more spending and borrowing down the road. With the printing presses available to go full blast, and lots of future promises made, I just can’t see inflation being this low for a decade.

Combine this with the fact that TIPS have a historically high real yield, it would seem like the market is overreacting. Although I usually don’t make such changes, I decided to go for it. So far, I have chosen not to go with 100% TIPS because I wanted to maintain some of the benefits of short-term treasuries, like lower volatility and low correlations with other assets. It’s kind of tough though, as the yields are horribly low right now due to the flight-to-quality.

I haven’t increased the target amount of total bonds in my portfolio, although due to the current drift and limitations due to juggling separate accounts, they are now 18% instead of 15%. I still believe in stocks as well due to their low valuations, and have also made equities purchases this week to re-balance that side of my portfolio. I am expecting to invest another $10,000+ before the year ends.