Investment Portfolio For 30-Year Old

Reader Question

Hi LTR, Great blog! I was wondering if you could weigh in on a couple of questions that have been bugging me about my asset mix and investment selections.

-What is the best thing I could do with money sitting inside a Vanguard ROTH or a Schwab 401k (with unrestricted investment options) for the bond/cash allocation of my retirement accounts given the dismal outlook for bonds in general in the coming years? For instance if this money wasn’t locked in these accounts I would probably seek out CD’s at individual banks which could equal (or almost equal) current bond yields but with principal protection if/when interest rates rise. I would also buy I-bonds. I’ve already done this somewhat with my foray into Mango, EE Savings bonds and lending club (which I know is risky) but I can’t really go further without investing to much of my “non retirement” money in long term vehicles.

-In my “non retirement” taxable money I’ve got a bunch of highly appreciated Apple stock (via employer RSU’s) that I'll take a big cap gains hit on, but I know it’s really to much of my non retirement money at this point. What would you do with it? I’m not sure I really want this locked up for the long term just yet. I don’t have any specific plans to spend it , other than I would like to eventually acquire a rental property.

-Thoughts on my stock allocations? About me: Single, Male, 30, living in San Francisco renting, no debt Balances in $K by account type
401k @ Schwab 51.4
Roth @ Vanguard 134
Taxable @ Vanguard 3
Lending Club @20+% (for now) 2.6
High Yield @5% (Mango..) 10
1980's EE Bonds @ 4% 4.8
TOTAL RETIREMENT 205.8
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Cash at ~ 1% (Ally, Alliant) 53
AAPL Stock 58
TOTAL NON RETIREMENT 111
Net worth 317K

This is my current stock allocation and is 100% invested within my Schwab 401K or my Vanguard Roth using the lowest cost Vanguard or Schwab ETF’s in each category, so my weighted expense ratio is somewhere around ~%0.07. Stock / Bond split 70 / 30

Stocks US / World split 55 /45
Total Stock Market  38.0%
Small Cap Value 7.0%
REIT 10.0%
International Large Cap 30.0%
International Small Cap 7.5%
Emerging Market 7.5%

Bonds right now I have a rough breakdown as seen below... but I’ve never been particularly happy with this, everything but the last two line items are in tax sheltered accounts.
Short Term / intermediate (BSV,SCHR) 25%
Long Term (VCLT) 20%
TIPS (VTIP, SCHP) 25%
Alternate (Lending club) 5%
Cash, Mango, EE savings bonds 25%

I don't follow my allocations with laser focus (since I have to do it all by hand).. but I try to rebalance and stay within 2 or 3% in most cases. I've had a little style drift over the years but not much and have been able to hold on in bad times. Thanks!

My Reply

Thanks for writing and for giving a very detailed breakdown of your finances. From what you listed you are doing everything just about right. Your stock and bond investments are very well diversified and are held at lowest possible costs, which is by far the most important thing in investing. You hold a good chunk in bonds which is a great idea even if bonds are priced for just so-so returns. Not rebalancing too often is fine, especially for ETFs since you're paying the bid-ask spread on each purchase (I assume you don't pay commissions since you're with Vanguard and Schwab brokerages inveting in Vanguard and Schwab ETFs -- but if you do pay commissions that's another reason to not go too crazy on re-balancing). Style drift isn't the best but you say it's slight. The fact that you've been able to hold on through the years is a good sign as well. So overall you are in very good shape. I'll give you my input on some small tweaks you could do and on a more general re-arranging of your portfolio for greater simplicity and tax-friendliness. A lot of my advice will be based on using today's I and EE Savings Bonds available through TreasuryDirect.gov, so you should familiarize yourself with them. It's not that they are great bargains, but they're still better than just about all other fixed income choices.

The most obvious thing that jumps out at me is that you hold $53K in 1% savings accounts but have no I-bonds. I-bonds are very clearly preferable to 1% cash and if I were you I would do my best to open an account with TreasuryDirect.gov and buy the $10,000 allowance in I-bonds for 2012 (it will take several days to process, so do not delay). Then soon thereafter you'd buy another $10,000 in I-Bonds for 2013. After a year those I-bonds become as good as emergency cash (redeemable at very slight penalty) except they yield more and are tax-deferred. As I've been writing over and over I-Bonds are the biggest no-brainer in taxable fixed income today.

I would go easy on Lending Club. I am very skeptical of peer-to-peer investing in the US. Simple reason is that US retail banking industry is very well developed and is very good at gauging risk of lending to individuals and businesses (yes, even after the housing bubble, I'm still sticking to this opinion). The fact that banks are only willing to lend to these individuals at rates much higher than those available on Lending Club is a big red flag. Yes, banks have internal costs and are out to make profit, but there is just too big a difference between 27% charged by credit cards and, say, 13% available on Lending Club. It's fun and even educational to put a bit of money into peer-to-peer lending as you have but I would not make it a major part of the portfolio. And I would look at it more as high-risk equity-level investment than as low-risk, bond-style one.

I'm less enthused with small cap investing than most investors. I firmly believe that all those data series going back to 1920s that show superior returns from small caps are presenting a picture that fails to account for extremely low liquidity of small cap investments in the past. I am guesstimating that the liquidity premium for small caps was in the range of 2% annually in the 1970s and maybe even 1980s and even higher before that. That's why those small cap investments look so good in hindsight. Nothing like this exists now. What we call "small caps" are just as liquid as the largest of large caps. Where liquidity premium still exists today is in OTC stocks and the lowest decile or two by market cap of exchange-traded stocks. These are not captured at all in conventional small cap investments. There are micro-cap funds but the evidence is far from clear that they enable you to capture that premium. On top of the liquidity premium argument small caps have outperformed large caps for the past decade which in my opinion does not bode well for their outperformance in the next decade. The subject of small cap investing really deserves its own post or two but bottom line is that I don't think investors are well advised to make significant bets on small cap in general, and, especially, now. Your bet on small caps isn't excessive, so I don't think you necessarily have to abandon it but I definitely would not increase it.

As far as your Apple stock, I would bite the bullet and sell, pay taxes, and use the proceeds to diversify into your usual mix of stock/bond investments. It's very painful to take the tax hit but no great company is immune from a change in fortunes. Apple stock is very reasonably valued and I have little doubt that Apple will continue to be a great business for years to come, but I just would not want to take my chances on it when I can diversify instead. Maybe you can sell a chunk in 2012 and another early in 2013 to keep yourself from being bumped into even higher tax bracket by the gains. You would then take post-tax proceeds from the Apple stock sale and channel it into the same portfolio mix as you do within your 401k and Roth IRA. More specifically, you could use AAPL proceeds to max out I-Bonds and EE-Bonds for 2012 and 2013 and then sell your IRA/Roth bond holdings in order to buy more equities there.

Also, you mentioned rental property... Do make sure to do plenty of research before going that route. Residential real estate is very reasonably priced in much of the country today, but landlording is very different from passive investing in stocks and bonds. You will never be able to be completely hands-off as a landlord. You might hire a management company but that will eat up much if not all of your profit margin. Do a whole lot of research before jumping in. Here's my post on the subject: http://www.longtermreturns.com/2012/03/how-to-value-real-estate.html

Last of the specific issues is that you said you weren't happy with your bond allocation. I don't actually see anything very wrong with what you have. You avoid longer-term nominal treasuries entirely which I think is perfectly fine since you have VCLT instead. VCLT, while no bargain in absolute terms, is superior to long-term nominal treasuries on expected returns and may well end up superior to short-term ones as well (though it's an apples-and-oranges comparison). The fact that you hold TIPS is another reason to go with I-Bonds, by the way. I-Bonds are clearly superior to any TIPS you can buy and investing into I-Bonds in taxable would let you sell your appreciated TIPS in tax-sheltered accounts and use the space for, say, more corporate bonds or equities. The choice of BSV/SCHR is fine. You're not getting much return out of them, but they are safe from losses in value should interest rates rise. You could exchange them for short-term corporate bond fund (VCSH) to squeeze a little more yield at the cost of a little more risk. The difference will not be dramatic, however. VCLT is your one bid for more yield and I think it's a reasonable holding as well -- at just 30 years old you are young enough that even if interest rates do rise you can afford to ride out the losses in VCLT value and eventually benefit from higher yields. However I would argue that today's EE-Bonds are very close to VCLT in expected returns while being much safer and while allowing you to use tax-sheltered space for other investments.

What I suspect might be a source of your unhappiness with your portfolio is that it simply seems a bit untidy. You have a half-dozen stock holdings and as many bond holdings. Each one of those holdings is perfectly fine on its own and they make sense as a group but overall it's still a messy picture. Here is my suggestion on how to simplify it:
1) Contribute to allowed max to Roth IRA ($5,500 in 2013)
2) Contribute to 401k at least up to max employer match, and, ideally to max allowed contribution ($17,500 in 2013). You are probably in high tax bracket now, so I would contribute to regular 401k, not Roth 401k (assuming that's even a choice).
3) If you are eligible to participate in favorable term ESPP you should continue to do so. Favorable terms would, roughly, be a discount of at least 10% with eligibility to sell within a year or discount of 20% and selling within 2 years, or ability to purchase at lower of two prices (e.g. start and end of quarter). Deciding on whether specific terms are favorable is not an exact science. But if all you get is, say, a 5% discount and having to hang on to the stock for a year I would probably pass it.
4) Until and unless interest rates change significantly from current levels, put the rest of your savings into I-Bonds and EE-Bonds.

The above would let you stash away up to $43,000 in various tax-advantaged vehicles per year plus ESPP plan. I don't know how much you save, but for most people that's already far more than they can save annually.

Then I would organize the accounts as follows: 401k, Roth, and ESPP would be primarily equity holdings while I- and EE-Bonds would be fixed income holdings. With up to $20K annual room for I- and EE-Bonds that lets you to max out 401k and Roth with stocks  and still stash away up to $24K in ESPP and still preserving the 70/30 stock/bond split in annual contributions. You probably won't even need that much room since that implies total savings/investments of almost $70K annually.

If you are happy with your stock funds, that's fine. If you wish to simplify then you could go with 55% VTI + 45% VXUS in Vanguard or 55% SCHB + 35% SCHF + 10% SCHE in Schwab.

With your bond funds, again, the idea is that unless and until interest rates change significantly I- and EE-Bonds are easily the superior choices (with I-Bonds doubling as emergency cash reserve). So you would do well to max out your annual purchases of I- and EE-Bonds and as you do so sell off your bond holdings in 401k/Roth to maintain the overall 70/30 stock/bond split.

Here is what your overall portfolio might look like, roughly of course, in five years assuming you simplify, assuming no major changes in interest rates, assuming annual contributions of $20,000 to 401k (including employer match), $5,500 to Roth, $10,000 annually to I- and EE-Bonds, no ESPP, and assuming near-zero market returns (for simplicity only) for these five years:

• Schwab 401k: $100K in SCHB, $65K in SCHF, $20K in SCHE
• Vanguard Roth IRA: $90K in VTI and $75K in VXUS
• Sell all AAPL stock and use proceeds along with current and future savings to have about $55K in I-Bonds and $55K in EE-Bonds (buying $10K of each kind annually)
• ~$50K in cash, CDs, Lending Club, etc.

This would put you at about $350K in equities (55/45 US/foreign in both 401k and Roth IRA) and $110K in I- and EE-Bonds with another $50K or thereabouts of cash/CDs/Lending Club left over in other taxable accounts (which could also be used for your investment property or whatever else). This would give you about 70/30 stock/bond split overall.

Again, don't take all my advice as a sign that you are doing something terribly wrong now. Your portfolio is fine the way it is and you are way ahead of your peers in both the amount of savings and investments and understanding of how to invest successfully for the long term. I am just giving you my input on how I would change things since you asked for it. Hope that answers your questions and gives you some ideas on how to proceed.