IN MY 1993 BOOK Bogle on Mutual Funds, after discussing the large number of asset allocation strategies available to investors, I raised the possibility that “less is more”—that a simple mainstream (i.e., index) balanced fund, 60 percent in U.S. stocks, 40 percent in U.S. bonds, one that provides extraordinary diversification and operates at rock-bottom cost, would offer the functional equivalent of having your entire portfolio overseen by an investment advisory firm.

It was in 1992 that I decided to form just such a 60/40 stock/bond balanced index fund at Vanguard. Viewed through the lens of the quarter-century that followed, the fund has been an extraordinary success (Exhibit 19.1).

Let’s look at the remarkable record of that balanced index fund. During its 25-year lifetime, the fund has earned an annual return of 8.0 percent, as compared to 6.3 percent for its peers, an advantage of 1.7 percentage points per year. That margin resulted in a compound advantage in cumulative return of 202 percentage points.

The balanced index fund’s advantage has largely been the result of its low costs—an expense ratio of 0.14 percent versus 1.34 percent for its balanced mutual fund peer group. That expense ratio advantage and the remarkable 0.98 correlation of its annual returns with those of its peers (1.00 is perfect correlation) give us every reason to expect the balanced index fund to outperform its peers in the years ahead.

Yes, an investor would have been better off by holding a low-cost S&P 500 Index fund, with an annual return of 9.3 percent during this period versus the balanced index fund’s return of 8.1 percent. With its lower volatility (balanced index 8.9 percent, 500 index 14.3 percent), its advantage in risk-adjusted return would be even higher. But when there was trouble, the balanced index fund offered exceptional protection. During 2000–2002, when the S&P 500 declined by 38 percent, the balanced index fund fell just 14 percent. In 2008, with the S&P 500 off 37 percent, the fund was off just 22 percent.

For investors who have a very long time horizon, and considerable grit and guts—investors who have the courage to be unintimidated by periodic market crashes—clearly an allocation of 100 percent to the S&P 500 Index fund would nearly always be the better choice. (Its margin was unusually close over the past 25 years; I expect the spread to be wider going forward.)

But what if you have a limited time horizon, or are cowed by stock market volatility and tempted to liquidate your stock portion when the seas are rough? Then the hands-off, set-the-allocation-and-stay-the-course strategy of the fixed 60/40 stock/bond asset allocation of the balanced index fund represents an option worthy of your serious consideration.

The wisdom of Benjamin Graham, again.

I see no reason for the retired investor to depart far from the advice that Benjamin Graham offered to all investors those many years ago, as reported in the previous chapter—a basic allocation of 50 percent stocks and 50 percent bonds, with a range of between 75/25 and 25/75. The higher equity portion for more risk-tolerant investors, perhaps seeking greater wealth for themselves and their heirs; the lower ratio for risk-averse investors, willing to sacrifice the potential for greater returns for some extra peace of mind.

I’ve often been cited as an advocate for a similar simple and seemingly rigid asset allocation: your bond position should equal your age, with the remainder in stocks. That asset allocation strategy can serve the needs of many—if not most—investors quite well, but it was never intended to be more than a rule of thumb, a place to begin your thought process. It is (or was!) based on the idea that when we are younger, have limited assets to invest, don’t need investment income, have a higher tolerance for risk, and believe that equities will provide higher returns than bonds over the long term, we should own more stocks than bonds.

But when we grow older and ultimately retire, most of us will have accumulated a significant investment portfolio. Then, we are apt to be more risk averse, more willing to sacrifice maximum capital appreciation and to rely more heavily on the higher income yields that bonds have provided over the past 60 years. Under these circumstances, we should own more bonds than stocks.

The need for flexibility.

I hardly intended such an age-based rule of thumb to be rigidly applied. For example, surely many young investors beginning their first full-time jobs might as well regularly invest not 75 percent, but 100 percent of their savings in equities during those early years of investing.

And zero percent in equities is likely a dubious goal for a new centenarian. (We will have lots more centenarians as time goes on.) Continually selling equities by such an investor to reduce the stock allocation might not make much sense, especially if you consider the potential for large taxes on capital gains that are realized when stocks with substantial appreciation are sold.

A flexible age-based plan comports with our common sense. But the many studies that have been done to validate the wide variety of similar (but more precise and more complex) allocation strategies have a common flaw: they are based on past returns on bonds and on stocks, neither of which seem likely to be repeated in the coming decade. (See Chapter 9.)

“The checks are in the mail.”

Which brings me to an even more important point. As we age, we begin to rely less on the human capital that has largely got us to where we are today, and more on our investment capital. Finally, what’s most important when we retire is the stream of income we need to support our needs—the dividend checks we receive from our mutual fund investments and the monthly checks we receive from our Social Security payments.

Yes, the market value of our capital is important. But frequent peeking at the value of our investments is not only unproductive, but counterproductive. What we really seek is retirement income that is steady and, if possible, grows with inflation.

Social Security fits those criteria perfectly. And, with moderate risk, a balanced mutual fund portfolio can effectively supplement (or be supplemented by) Social Security payments. About half of the balanced portfolio’s income comes from interest on bonds, and the other half from dividends, mostly from large-cap stocks. With only three significant exceptions, the dividends on the S&P 500 Index have increased every year since the Index began 90 years ago, in 1926. (See Exhibit 6.2 in Chapter 6.)

Social Security payments plus index fund dividends—a sound basis for steady and growing income.

A combination of Social Security payments and dividends from index funds¹ (supplemented as necessary with withdrawals of capital) are likely to be an effective means of enjoying regular monthly income from your retirement assets. (Although few equity mutual funds pay dividends monthly, most have programs for providing regularly scheduled monthly payments.)

The income yields on stocks and bonds are near historical lows (stocks 2 percent, bonds 3 percent), and because of the pernicious impact of mutual fund expenses, the yields on actively managed mutual funds are much lower, as we saw in Chapter 6. Such low yields are unlikely to adequately satisfy the retirement income needs of many investors. So investors will be better served to consider generating retirement income through a total return approach—using a combination of fund dividends and regular withdrawals from accumulated capital to generate a steady stream of monthly checks during retirement.

Non-U.S. stocks—a new paradigm for allocation?

During the past decade, acceptance of the traditional two-fund model portfolio (U.S. bonds and stocks) has largely been superseded by a three-fund model portfolio: 33 percent in a bond index fund, 33 percent in a U.S. stock index fund, and 33 percent in a non-U.S. stock index fund.

Such a three-fund portfolio allocation simply reflects the broad acceptance of a global portfolio by many advisers and investors. Such a portfolio is essentially based on the market capitalizations of the stocks of nearly all of the world’s nations.

In my 1993 book Bogle on Mutual Funds, I advised investors that they did not need to hold non-U.S. stocks in their portfolios, and in any event should not allocate more than 20 percent of their stock portion to non-U.S. stocks.

My view that a U.S.-only equity portfolio will serve the needs of most investors was (and still is) challenged by, well, everyone. As the argument goes, “Isn’t omitting non-U.S. stocks from a diversified portfolio just as arbitrary as, say, omitting the technology sector from the S&P 500?”

I argued the contra side. We Americans earn our money in dollars, spend it in dollars, save it in dollars, and invest it in dollars, so why take currency risk? Haven’t U.S. institutions been generally stronger than those of other nations? Don’t half of the revenues and profits of U.S. corporations already come from outside the United States? Isn’t U.S. gross domestic product (GDP) likely to grow at least as fast as the GDP of the rest of the developed world, perhaps at an even higher rate?

The advice in my 1993 book has worked out well.

For whatever reason, my advice has worked out well. Since 1993, the U.S. S&P 500 Index has earned an average annual return of 9.4 percent (cumulative +707 percent). The non-U.S. portfolio—I refer here to the MSCI Europe, Australasia, and Far East Index (EAFE)—has had an annual return of 5.1 percent (+216 percent).

That said, perhaps the relative advantage achieved in the U.S. stock market over the past quarter-century has now been arbitraged away, and that long period of relative underperformance by non-U.S. stocks has led to more attractive valuations abroad. Who really knows? So you will have to consider the probabilities and make your own judgment.

A fixed stock/bond ratio? Or a ratio that changes with investor goals, or with time?

The goal of the balanced index fund with a fixed stock/bond ratio was to relieve investors of the challenges of allocating assets as markets change. But I soon came to the (obvious!) conclusion that the arbitrary 60/40 balanced portfolio—perhaps the most sensible ratio for investors seeking to balance risk and return—might not be suitable for all investors. So why not offer funds with other allocations?

So in 1994, Vanguard began to offer four “LifeStrategy” Funds (Exhibit 19.2)—Growth (80 percent equities), Moderate Growth (60 percent), Conservative Growth (40 percent), and Income (20 percent). Each of these equity allocations now include 60 percent U.S. stocks and 40 percent non-U.S. stocks; each bond allocation includes 70 percent U.S. bonds and 30 percent non-U.S. bonds).

The rise of the target-date fund (TDF).

The LifeStrategy funds are by no means the only variation in the balanced fund concept. Over the past decade, there has been an explosion in investor demand for target-date funds (TDFs)—funds that hold diversified portfolios of stocks and bonds that gradually become more conservative as the fund approaches its target date, usually the year that the investor expects to retire.

Target-date funds for retirement are by far the most popular, now holding assets of nearly $1 trillion. And their concept—essentially, replacing stocks with bonds as the need to fund future liabilities draws closer—can be applied to other investment goals as well, such as children’s college expenses. One of the reasons for the popularity of target-date funds is their simplicity. All you need to do is estimate what year you plan to retire or your child will start college, and then invest in the fund closest to that target date. “Set it and forget it” is the idea.

TDFs can be an excellent choice, not only for investors who are just getting started with their investment programs, but also for investors who decide to adopt a simple strategy for funding their retirement. But as your assets accumulate and your personal balance sheet and investment goals become more complicated, it is worth considering the use of individual building blocks like low-cost stock and bond index funds to construct your portfolio.

If you choose to invest in TDFs, I encourage you to “look under the hood” first. (Always a good idea!) Compare the costs of TDFs, and pay attention to their underlying structures. Many TDFs hold actively managed funds as components, whereas others use low-cost index funds.

Make sure you know precisely what is in your TDF portfolio and how much you’re paying for it. The major actively managed TDFs have annual expense ratios that average 0.70 percent; index fund TDFs carry average expense ratios of 0.13 percent. It will not surprise you to know that I believe that low-cost, index-based target-date funds are likely to be your best option.

Don’t forget Social Security.

Whatever asset allocation strategy you decide is best for you, you absolutely must take into account the role of Social Security—a major source of income for most retirees—as you age. In fact, some 93 percent of retired Americans collect Social Security. When determining their asset allocations, most investors need to take Social Security into consideration as a bond-like asset.

The value of Social Security in your portfolio is significant. I’ll illustrate this with an example. The average remaining life expectancy for a 62-year-old American is about 20 years, so I’ll assume that at age 62, an investor will collect Social Security for 20 years. With a final salary of $60,000, an investor who claims Social Security right away would receive $1,174 per month. If we discount that benefit by the current rate on inflation-adjusted Treasury bonds, the investor’s Social Security would have a capitalized value of about $270,000. But since that value vanishes on the death of the retiree, let’s arbitrarily discount it by about one-fourth, to a revised value of $200,000. (Later, I’ll come back to the topic of when to claim Social Security.)

Now let’s assume our investor has a portfolio of mutual funds worth $1 million and uses Benjamin Graham’s classic 50/50 allocation. Ignoring Social Security, the investor would allocate $500,000 each into stocks and bonds. But we shouldn’t ignore Social Security.

Social Security and asset allocation.

When we add the $200,000 imputed value of Social Security to the investor’s portfolio, it would total $1,200,000. But with that extra Social Security investment, the bond-like portion of the portfolio rises to $700,000 or 58 percent, with 42 percent in stocks.

To achieve a true 50/50 allocation, the investor would allocate $600,000 in stocks and $600,000 in bonds ($400,000 in bond mutual funds, $200,000 in Social Security). Target-date funds generally ignore Social Security income, which leads to investors holding more conservative portfolios than they might realize. While TDFs may ignore Social Security as a bond-like asset, you should not.

Caution: Deferring Social Security payments substantially enhances the monthly payments you later receive, but at the expense of not receiving any Social Security payments at all during the interim years. Investors must balance the opportunity to increase their eventual monthly payments against the absence of those monthly payments over a full decade.

For example, our investor with annual earnings of $60,000 would receive about $1,174 per month if payments began at age 62. By deferring Social Security until age 72, the monthly payments would increase to $1,974—a remarkable increase of almost 70 percent. But by deferring payments for 10 years, that investor would have missed out on a total of $140,900 in Social Security payments. It would take 14 years of collecting the higher monthly benefits to break even on those deferred payments.

The need to draw down capital.

With the current interest rate on bonds at roughly 3 percent and the dividend yield on stocks at 2 percent (in both cases, before the high costs of actively managed funds), the income produced by your retirement portfolio is apt to fall well short of your retirement spending needs. A rule of thumb suggests that an annual withdrawal rate of 4 percent (including income and capital) of the year-end value of your initial retirement capital, adjusted annually for inflation, is likely—but by no means guaranteed—to be sustainable throughout your retirement years.

Do not adhere rigorously to spending rules such as 4 percent annually. Maintain a level of flexibility in your retirement spending plan. If the markets are particularly bad and your spending rule would take too large a bite out of your portfolio, tighten your belt and draw down a little less. If the markets are good and your spending rate provides larger payments than you need, reinvest the unexpected windfall for the ever-uncertain future. By so doing, you’ll reduce spending from the portfolio when the markets are depressed and have the opportunity to recoup your capital when the markets recover.

No guarantees.

Let me reiterate: Any asset allocation strategy is subject to numerous risks—stock market risk, payout risk, macroeconomic risk, and other risks in the fragile world in which we exist. All we can do is make informed judgments, and then be flexible in our allocation and payouts as conditions change.