New-Year Ideas for Vanguard Investors

Now that 2005 is in the rearview mirror, it's a good time to give your portfolio the once over and make sure it's in good shape for the new year. While there's no reason to alter a long-term investment plan, I think there are some adjustments Vanguard investors can make around the edges of their portfolios to position themselves for 2006.

Worth the Chance?
Let's talk bonds first. In the current environment, fixed-income investors aren't getting paid much for taking on more risk. For instance, the yield on the two-year Treasury bond is about the same as the yield on the 10-year Treasury note. So even though the 10-year bond ties your money up for eight additional years, you won't receive any additional compensation for that risk. Similarly, the spread between high-yield bonds and relatively risk-free Treasuries are at their lowest level in years. There's not much sense in taking chances if you aren't getting paid for it. So as you rebalance your portfolio, I think it's not unreasonable for long-term investors to keep their fixed-income allocation slightly lighter than they ordinarily would. I'm not talking about a major tilt, but if your equity allocation has grown 5% or 10% above your target, I'd hesitate to rebalance that amount into fixed income at least until the bond market provides some clearer signals.

For your long-term asset allocation, I still think a cheap, high-quality intermediate bond fund is the way to go. My favorites are  Vanguard Total Bond Market Index (VBMFX) and  Vanguard GNMA (VFIIX) for tax-sheltered accounts, and  Vanguard Intermediate-Term Tax-Exempt (VWITX) for taxable accounts. But there's good reason to temper your expectations for these funds in 2006. With yields at these low levels and with rising rates eroding returns, I wouldn't be surprised to see intermediate-bond funds return around 3% to 4% next year.

That starts to make cash look a lot more attractive, particularly for investors with investment horizons of fewer than two years. With a yield of 4.0%, Vanguard Prime Money Market Account is a viable option. Indeed, in this climate, even CDs hold more appeal. As of this writing, one-year CDs available via Vanguard Brokerage pay 4.6%.

Shift Your Profits
What about your intraequity allocation? It makes sense to look at those areas that have performed well and grown beyond your targeted allocation, then rebalance with a contrarian eye. Small- and mid-cap equities have had a nice long bull run, as have value stocks. Consequently, funds that invest in these areas probably take up more space in your portfolio than they used to. Look to take some profits in those areas and redeploy them in funds that invest in larger stocks and in growth equities--areas of your portfolio that have likely been shrinking.

I have called for a revival in large-growth stocks before, and though there have been stirrings from that market segment recently, a full-fledged comeback has yet to materialize. But I'm sticking to my guns. Many fund managers I talk to have found attractive opportunities among the market's largest names. Many have viewed this as an opportunity to upgrade the quality of their portfolios at bargain prices. Similarly, growth stock multiples are now a fraction of the nose-bleed levels they reached in 1999. Indeed, their prices have come down enough to catch the eye of some noted value hounds. To me, that's a sign that growth stocks are poised for a recovery.

I'm a fan of  Vanguard Morgan Growth , but those looking for an index fund also have a good choice in  Vanguard Growth Index (VIGRX). Furthermore, although it lands in the blend section of the style box,  Vanguard Primecap Core (VPCCX) has a notable growth bias, which could give it an extra edge over its peers over the next few years.

I also think there's a case to be made for funds that focus on dividend paying stocks. Corporations are awash in cash, and I look for them to grow dividends. Plus, in this low-return environment, a healthy dividend yield becomes all the more valuable. To that end, I recommend  Vanguard Equity-Income (VEIPX), which is one of the highest-yielding funds in the large-value category. While some investors might be tempted by the yields garnered by Vanguard's fine stable of balanced funds, I tread cautiously for now. The bond sleeves on  Vanguard Wellington (VWELX),  Vanguard Wellesley Income (VWINX), and  Vanguard Tax-Managed Balanced (VTMFX) are all more sensitive to rising interest rates than competing funds.

This article is from a recent issue of The Vanguard Fund Family Report, our monthly newsletter dedicated to helping Vanguard investors find superior long-term return investment opportunities. To review a risk-free trial issue of The Vanguard Fund Family Reports, click here. Fund Family Reports for Fidelity and American Funds are also available.