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After opening an account, put your first $100 in a broadly diversified ETF that represents the entire stock market, such as the Vanguard Total Stock Market VIPER. Every month after that, continue investing as much as you can. Put 100% of each month's contribution into one of the following ETFs, each of which invests broadly in one of five major asset classes:
- Vanguard Total Stock Market VIPER (VTI, news, msgs), which tracks the Wilshire 5000, an index of approximately 6,500 U.S-based stocks. It's like buying virtually the entire stock market.
- iShares MSCI-EAFE (EFA, news, msgs), which corresponds to the Morgan Stanley index of stocks trading in Europe, Australia and the Far East.
- iShares Lehman Aggregate Bond (AGG, news, msgs), which attempts to track the price and yield performance of the total U.S. investment grade bond market.
- iShares Dow Jones US Real Estate (IYR, news, msgs), which holds a basket of 75 real estate investment trusts (REITs) that represent that sector of the U.S. economy.
- iShares Dow Jones US Basic Materials (IYM, news, msgs), which includes stocks in the energy, basic materials and precious metals sectors.*
*(Once your portfolio reaches a total value of at least $25,000 -- and it will! -- you'll want to switch your commodity allocation to the PIMCO Commodity Real Return Strategy fund (PCRDX), which more accurately captures the returns of the commodity futures market than a collection of stocks can. The fund has a minimum initial investment of $2,500, which makes it impractical for smaller accounts.)
As you invest in subsequent months, rotate your purchases among the five ETFs until you reach your target percentage for each one. Concentrating your purchase in a single ETF each month minimizes your commission costs.
An easy, real-world portfolio
This real-world portfolio, unlike the equal-weight example, puts a little extra in U.S. and foreign stocks. That's where most of your growth is likely to come. It also adds a fixed-income asset class, bonds, to give your portfolio extra stability in rough markets.After a year has passed, you will have invested $1,200, and your portfolio would look something like this:
| End of Year 1 -- Target Allocation | ||
|---|---|---|
Security | Amount | Percentage |
$400 | 33% | |
$300 | 25% | |
$200 | 17% | |
$200 | 17% | |
$100 | 8% | |
Total value | $1,200 | 100% |
Congratulations! You've built a portfolio that will ride out the market's ups and downs a lot more smoothly than most.
In actual practice, however, you'll find that some of your investments have grown in value while others have lost money or stayed about the same. Also, about 4% of your investment will have gone to pay commissions.
But for this simplified example, let's suppose that your U.S. stock holdings increase 50% in value, while your foreign stocks decline 33%. We'll also magically erase the cost of commissions. There on the bottom line is a $100 profit! Your portfolio is now worth $1,300 and looks about like this:
| End of Year 1 with Gains / Losses | ||
|---|---|---|
Security | Amount | Percentage |
$600 | 46% | |
$200 | 15% | |
$200 | 15% | |
$200 | 15% | |
$100 | 8% | |
Total value | $1,300 | 100% |
But now you have too much money in U.S. stocks and not enough in foreign stocks. To restore your portfolio to its target percentages, you'll need to invest more of your new money in the assets that have done poorly. (This isn't as dumb as it seems at first blush: It disciplines you to buy more when prices for an asset class are low.)
Rebalance with new money
The basic idea is to keep your allocations close to the target by adding new money, rather than selling your winning funds, which will generate a taxable profit. This is called rebalancing and should be done at least once a year to bring your portfolio back in line with your target allocation.| End of Year 2 -- Target Allocation | ||
|---|---|---|
Security | Amount | Percentage |
$825 | 33% | |
$625 | 25% | |
$425 | 17% | |
$425 | 17% | |
$192 | 8% | |
Total value | $2,500 | 100% |
The easiest way to rebalance is to add each month's $100 investment to whatever asset class is farthest below your target allocation for it. If they're all about equally in line, then start rotating through each of the five as you did in the beginning.
Once you've established your target allocation, stick to it. Succumbing to the temptation to guess what the next hot asset class will be your surest ticket to mediocre returns. The key to success is discipline.
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