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The Short Answer

How to Build a Simple, Low-Stress Portfolio

Time-tested strategies again prove their relevance in uncertain markets.

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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 that remain stubbornly near all-time highs. The uncertainty has taken its toll on stock markets: From May 2007 through April 2008, the S&P 500 lost about 4.7%. Much of the pain came in this year's first quarter, the index's worst in more than five years.

This return of heightened volatility in both stock and bond markets has prompted a lot of worried questions from our readers regarding 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.

Two Assumptions
I made a few assumptions as I went about suggesting simple portfolios. The first is that investors have fairly long time horizons of 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.

The second assumption I made is that investors are holding these portfolios in tax-deferred accounts such as IRAs or 401(k)s (for the sake of picking bond funds, etc.).

Option One: The Simplest Portfolios Around
The simplest 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 post 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 even work 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 tilted assets more heavily toward bonds and cash equivalents.

Fund companies small and large offer target-date offerings, and some of them are better than others. We recommend seeking one with the following characteristics: Low fees (including expenses from underlying funds), ample diversification, and a dose of equities even in funds whose retirement year is has passed. Click  here to learn more about target-date funds, including our favorites.

Option Two: Join the Bogleheads
Index providers continue to slice up markets into ever-narrower pieces, but some of the best indexes remain the broadest ones. As for the best index funds, they are the ones that offer ultralow fees and, of course, 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 time periods.

An easy way to build an all-index portfolio is to buy just three or four funds: One that invests in the whole U.S. bond market, another one 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. For the sake of single-fund-family investing, here's how I'd build an all-index portfolio of Vanguard funds. (Investors could easily build a similar portfolio of all Fidelity funds, but with the caveat that  Fidelity Spartan International Index (FSIIX) doesn't include emerging-markets stocks).

Two notes here: Although we recommend dollar-cost averaging--buying in little by little over time--investors who want to build a portfolio all at once should consider Vanguard's exchange-traded funds for the domestic index,  Total Stock Market Index ETF (VTI), and the bond index,  Total Bond Market Index (BND). They're less expensive.

Option Three: Index Funds Complemented By Specialty Funds
All-index portfolios can be highly effective, but if you'd like a chance to juice returns a bit, building a portfolio to do that is still simple. Use index funds as core holdings for the majority of assets, but then pick a few actively managed funds for the fringes of your portfolio. Here's an example of how to do that within the 55%/35%/10% broad asset-class weightings.

  • U.S. stocks:
    • 40% to 45%: A total stock-market index fund such as the one mentioned above.
    • 10% to 15%: Add a dedicated small-cap fund, as small caps have historically generated higher returns over time, and in this more-inefficient market corner, actively managed funds can add greater value. Our Analyst Picks are good place to start, and one that is still open to new shareholders and invests in both growth and value stocks is  Masters' Select Smaller Companies (MSSFX).
  •  International stocks:
    • 25% to 30%: An EAFE index fund will get you exposure to developed-market large caps, or you can stick with a total-market index fund from Fidelity or Vanguard, for example.
    • 5% to 10%: This is the highest-risk, highest-reward part of your portfolio. A foreign small-value fund (click to see our foreign small/mid-value  Analyst Picks) or foreign small-growth fund (click to see our foreign small/mid-growth  Analyst Picks) goes well here, or pair one of these funds up with a diversified emerging-markets fund (click to see our diversified emerging-markets  Analyst Picks) to get the farthest-reaching global exposure around.
  • Bonds:
    • A core investment-grade bond fund such as Vanguard Total Bond Market Index or  Harbor Bond (HABDX) gets the job done, but you can better diversify your bond holdings with a reliable multisector bond fund whose manager shifts assets among government bonds, overseas bonds, and high-yield bonds depending on where he or she spots the best values. Consider putting 10% of your bond holdings (so, a low-single-digits allocation in your overall portfolio) into a great multisector fund such as  Loomis Sayles Bond (LSBRX).

Andrew Gunter does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.