Simple portfolios for complex times

By Morningstar

It has been about a year since subprime contagion swept the nation, and what a year it's been. We've seen a gold rally, fast and deep interest-rate cuts, and oil prices at all-time highs.

All that uncertainty has taken its toll on stock markets: From May 2007 through April 2008, the S&P 500 Index ($INX) lost about 4.7%. Much of the pain came in this year's first quarter, the index's worst in more than five years.

The return of heightened volatility in both stock and bond markets has prompted a lot of worried questions from our readers about what kind of overhaul might be appropriate for their portfolios. But making big adjustments to your portfolio based on short-term market news is rarely a good idea.

Instead, investors attempting to get their sea legs amid all the volatility should focus on building simple portfolios that can withstand market ebbs and flows.

2 assumptions

I made two assumptions as I went about suggesting simple portfolios:

• That investors have fairly long time horizons -- 10 years or more -- and are comfortable weathering the periodic ups and downs of equity investing. The portfolios therefore have fairly aggressive asset allocations: 50% to 60% in U.S. equities, 30% to 40% in international equities and 10% to 20% in bonds.

• That investors are holding these portfolios in tax-deferred accounts such as individual retirement accounts or 401(k)s (for the sake of picking bond funds, etc.).

Option 1: The simplest portfolios around

The easiest way to a good-looking portfolio is to invest in an aptly titled target-date fund. These funds are hassle-free. Once you buy one, the fund company directs assets to underlying funds that it also manages across various asset classes (think large caps, small caps, international stocks, bonds, etc.), in weightings appropriate to your time horizon.

As different asset classes go through hot or cold streaks, the managers rebalance these funds. Also, the managers gradually adjust asset allocation over time to become more conservative as the retirement year approaches.

These funds work even for investors who are nearing retirement or are already in it; they can opt for a fund with a target year of 2005 or 2010. Such funds already have assets tilted more heavily toward bonds and cash equivalents.

Fund companies small and large provide target-date offerings, and some of them are better than others. We recommend seeking one with these characteristics:

• Low fees (including expenses from underlying funds).

• Ample diversification.

• A dose of equities even in funds whose retirement year is has passed.

Click here (registration required) to learn more about target-date funds, including our favorites.

Option 2: A trio of Vanguard funds

Index-fund providers continue to slice up markets into ever-narrower pieces, but some of the best indexes are the broadest.

As for the best index funds, they are the ones that offer ultralow fees and, by their very nature, eschew active management. These funds' low fees are part of the strong case for using them versus actively managed funds, and low fees have helped index funds beat the majority of actively managed rivals over long periods.

An easy way to build an all-index portfolio is to buy just three funds: one that invests in the whole U.S. bond market, a second that invests in the whole U.S. stock market and a third that invests in international stocks.

(Vanguard will soon roll out a global stock index fund, combining U.S. and foreign stocks, that will further simplify equity exposure for index fans.)

A few large fund families offer extremely low-cost index funds, with Fidelity and Vanguard continuously competing for "cheapest index fund" rights.

Continued: A sample all-Vanguard portfolio

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