In Part 2 of this series (can be accessed using the link below), we were able to finalize the calculation of the appropriate fixed income asset allocation target you should put in place when determining the
best investments for 2011.
Now, you should be able to fill in the following statement:
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%?
Considerations
- 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.
Options
- 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.
-
- 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.
Selecting Your Fixed Income Investment Options
Given all of the considerations and options discussed above, I apply the guidance shown below of how to divide my funds within the fixed income portion of my portfolio.
- Select the cash % allocation of your total portfolio, according to the first row of the table.
- Assume that you will allocate 5% of your total portfolio to inflation protected securities.
- Subtract the cash % and 5% inflation protected securities allocations from the overall fixed income allocation you calculated (in previous posts) to obtain the % of your portfolio that will be made up with a short term index bond fund.
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
To receive updates on topics such as this one as soon as they are published, click on the link below to subscribe to My Money Blog:
Subscribe to My Money Blog via Email
