Creating and Implementing Your Investment Strategy – Part 3 – Determine Your Specific Mix of Fixed Income Investments

• ______ % of my portfolio will be in fixed income investments and the remaining _____ % (1- fixed income %) will be in equity investments. The total should be 100%.
• For simplicity, throughout the rest of this post, we will assume that the asset split you choose is 30% fixed income and 70% equity.

So, you know that 30% of your investments should be placed in fixed-income vehicles. However, which ones should you choose to make up this 30%?

• Maturity
• No matter what the time horizon is for when your specific cash needs will occur, academic research has shown that short-term fixed income investment instruments have 1) less interest rate risk, and 2) higher returns.
• Because of these two factors, short-term (1-3 maturities) fixed income investments are considered superior to long-term ones.
• Fund Management
• As with equity investments, the fixed income security markets are extremely efficient, and therefore, active management is a loser’s game.
• Because of this, we will only want to seek out indexed/passively managed fixed income instruments for our investments.

• In my opinion, there are really four different options available to you as an individual investor for the fixed income portion of your portfolio:
• Cash / cash equivalents
• This category would include extremely liquid investment account types.
• Examples include money market accounts, savings accounts, and checking accounts.
• See following link to read my previous posting on these types of accounts – My Money Blog – Cash Equivalent Savings Accounts.
• Short-Term Indexed Bond Funds
• Offered by Vanguard and Fidelity. Vanguard fund I use is the Short-Term Bond Index, Ticker symbol – VBISX. Vanguard Bond Index Funds
• Feature low cost, passive management and expense ratios.
• Inflation Protected Bond Funds
• Also offered by Vanguard and Fidelity. Vanguard fund I use is the Inflation-Protected Securities fund, Ticker symbol – VIPSX.
• This type of investment instrument provides a hedge against changes in inflation.
• The interest rate associated with the bond fund changes with fluctuations in inflation.
• US Treasury Securities
• Can be used in place of Short Term Indexed Bond Funds. Personally, I prefer to use indexed bond funds due to the fact that they are offerred by Vanguard, and it therefore, keeps all of my investments in one place.
• Bought directly from the US government/treasury.
• Backed by the full faith and credit of the US goverment, and are therefore, very safe investments.
• Still have interest rate risk associated with them, however.

For the 30% fixed income / 70% equity asset allocation example above (assuming the investor is below 60+ years old) –

• 5% of your overall portfolio would cash
• 5% would be inflation protected securities
• 20% (30%-5%-5%) would be index short term bond funds.

Note: The data is this table is taken from pgs. 350-351 of Malkiel’s famous book,
A Random Walk Down Wall Street. If you haven’t read it, click on the link to the left to pick up a cheap used copy from Amazon.com.

In Part 4 of this series, I take everyone through how to figure out your specific mix of index funds for the equity portion of your portfolio.

Keep on learning!

Jacob

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