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Know what you own … and why you own it

August 23, 2013

Take a good look at your portfolio. Do you know what's in there?

Perhaps more important, do you know why it's there?

A lot of investors—including some who consider themselves pretty good at managing their assets—have a tough time explaining what they own and why. Ask a friend to explain his or her investment strategy and how it's being implemented, and you may be greeted with a blank stare and an awkward silence.

Fortunately, there's no reason to be caught off guard when someone asks about your portfolio. Here's a simple guide to answering those questions.

"What do I own?"

The internet makes it easier than ever to put your investments under a microscope. When you log on to vanguard.com, you can see a list of all your Vanguard holdings in one spot. But that's just the first step.

We can also show you how your portfolio is allocated among the major asset classes—stocks, bonds, and short-term reserves such as money market funds—and then break down each of these groups even further. For example, we'll show you how much of your money is invested overseas (and where), the credit quality of the bonds you own, the tax efficiency of your portfolio, and how your Vanguard investment costs stack up against industry averages. We'll even offer useful food for thought on how you might better align your asset mix with your goals, time frame, and tolerance for risk. (More on this topic below.)

Principles for investing success

Know your goals. Invest with balance. Minimize cost. Maintain discipline.

Learn more about Vanguard's core principles

Of course, being a mutual fund investor means you indirectly hold shares in hundreds or even thousands of different companies or bond issues through the funds you own. Here too, vanguard.com makes it easy to figure out what's in your portfolio with just a few clicks.

For example, say you own shares in Vanguard Total Stock Market Index Fund. As of June 30, 2013, this fund had more than 3,550 separate holdings. A look at its Portfolio & Management page shows you the fund's ten largest holdings as of the most recent month-end, or you can go deeper and view a complete list of everything in the fund, ranked by the shares' market value. With a few quick calculations, you can roughly gauge your exposure to a particular security. This is especially useful if you're trying to avoid the needless "overlap" that comes from owning shares of the same stock or bond in several different mutual funds.

"Why do I own it?"

The reason people invest is pretty straightforward: They have important goals, and they want their money to grow in order to reach those goals.

But look beneath the surface and you'll find that people invest in various asset types for different reasons. And those reasons have a lot to do with how those asset types have performed over stretches of time—what you'll often hear described as "past performance."

Stocks and stock mutual funds, for example, have track records of significant long-term growth. Bonds and bond funds, on the other hand, are by nature more conservative, and have a history of slower, more modest growth. Cash, meanwhile, has little opportunity to grow in value, and it gets eroded by inflation over time.

So, based on historical performance, you should just put every penny you've got into stocks and forget that bonds and cash even exist, right?

Well, no.

For one thing, past performance is not a guarantee of future performance. For another, stocks are subject to significant risks, and Vanguard believes the best way to mitigate those risks is through asset diversification, as we'll explain below.

Stocks: A success story . . . with plenty of setbacks along the way

Despite boasting an enviable long-term performance history, stocks have been prone to periods of dramatic and painful volatility.

Consider the chart below, which follows the performance of a $10,000 investment in the broad U.S. stock market starting in 1960. After 40 years, that initial investment would have been worth more than $180,000. But look at all the unnerving ups and downs that would follow in the next several years. Think about the trauma investors experienced during the bear markets of 2000–2001 and 2008–2009—and imagine having to retire and live off of your earnings just as the market hit one of those rough patches.

The bottom line: Stocks have proven their ability to build wealth over the long term, making them particularly useful for far-off goals like retirement, but they're not without significant risks.

Growth of $10,000 in a 100% stock portfolio:

100% stock portfolio

Returns are represented by the Standard & Poor's 500 Index (1960–1970), the Dow Jones Wilshire 5000 Index (1971–April 22, 2005), and the MSCI US Broad Market Index thereafter. Returns are adjusted for inflation. The data do not represent any particular portfolio or recommended asset mix. Source: Vanguard.

Bonds: The modest yin to stocks' raging yang

Bonds have a reputation for being conservative—even boring. Allocating part of a portfolio to bonds has traditionally been seen as a smart way to guard against stock volatility.

In the next chart, the black line again represents a portfolio with a starting balance of $10,000. This time, however, the investor goes with a blend of assets: 70% stocks and 30% bonds. (For comparison, the original 100% stock portfolio is represented by the faint red line.)

Growth of $10,000 in a 70% stock/30% bond portfolio (black line):

70% stock/30% bond portfolio

Stock returns are represented by the Standard & Poor's 500 Index (1960–1970), the Dow Jones Wilshire 5000 Index (1971–April 22, 2005), and the MSCI US Broad Market Index thereafter. Bond returns are represented by the S&P High Grade Corporate Index (1960–1968), Citigroup High Grade Index (1969–1972), Lehman Brothers U.S. Long Credit AA Index (1973–1975), and Barclays Capital U.S. Aggregate Bond Index thereafter. Returns are adjusted for inflation. The data do not represent any particular portfolio or recommended asset mix. Source: Vanguard.

Although the investor's ending balance is noticeably lower this time around—a consequence of bonds' lesser long-term returns—what's also noticeable is the lower degree of volatility. Thanks to that 30% bond allocation, the distance between "peaks" and "valleys" is smaller. Fewer soaring highs, perhaps, but also fewer frightening plunges.

The bottom line: Bonds may not be exciting, but we believe they can help smooth out the rough edges in portfolio performance, and they're particularly suitable for investors seeking stability.

Cash: The pros and cons of ready money

We've mentioned cash in passing here, and before we move on we should acknowledge the role that it plays in our lives—and in our portfolios.

Strictly speaking, cash isn't much of an investment. Thanks to inflation and other market forces, the dollar (or pound, euro, or yen) that's in your pocket today probably won't buy quite as much a year from now. And if you have money tucked away in a money market fund, you've surely noticed that yields have been at rock-bottom levels in the last few years. But what cash lacks in growth potential, it makes up for with liquidity. Where it might take days or even weeks to tap into a stock or bond portfolio, accessing your cash is generally as easy as writing a check or visiting an ATM.

There's also the stability factor: Although your cash may not go as far this time next year, provided inflation is under control, the difference will be fairly minor. That makes a cash reserve (whether in a savings account, money market, or similar vehicle) a useful tool for meeting near-term obligations such as mortgage payments, tuition bills, and other day-to-day spending needs.

The bottom line: Cash is essential in our lives, and it can be a practical component of your overall portfolio. Just don't count on it to make you rich.

Asset allocation: The driving force behind performance

Research underscores Vanguard's belief that investment success (or failure) is largely determined not by individual investment selections but by the long-term mixture of assets in a portfolio.

As shown in the 2013 research paper Vanguard's framework for constructing diversified portfolios, asset allocation—again, your overall mix of stocks and bonds, as opposed to which particular stocks or bonds you own—was responsible for 88% of a diversified portfolio's return patterns over time, with security selection and market timing responsible for just 12%.*

One way to understand how changes in asset allocation might affect your performance is to look at the best, worst, and average annual returns for various hypothetical asset mixes over time, as in the following chart, which examines five different scenarios over a very long period—the nearly 90 years from 1926 through 2012.

As you can see in the bottom row, during this period U.S. stocks produced a 10.0% return on average each year, while U.S. bonds averaged 5.5%, and a balanced half-stock, half-bond portfolio would have averaged 8.3%.

  100% bonds 80% bonds /
20% stocks
50% bonds /
50% stocks
20% bonds /
80% stocks
100% stocks
Best one-year performance: +32.6% +29.8% +32.3% +45.4% +54.2%
Worst one-year performance: –8.1% –10.1% –22.5% –34.9% –43.1%
Average annual performance: +5.5% +6.7% +8.3% +9.4% +10.0%

Stocks are represented by the Standard & Poor's 90 Index from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Barclays U.S. Long Credit AA Index from 1973 to 1975; and the Barclays U.S. Aggregate Bond Index thereafter. Source: Vanguard.

Granted, 1926–2012 is an unrealistically long time frame for most (but not all!) investors. Even so, a look at shorter spans shows how variations in asset allocation can produce very different outcomes. For example, from 1980 through 2012, U.S. stocks returned an average of 11.1% a year, while bonds returned 8.5%. A portfolio split evenly between the two asset classes and rebalanced periodically would have generated an average annual return of 10.2%. That means a 50/50 portfolio could have earned nearly 2 percentage points more per year during this particular period than it would have over the longer stretch from 1926 through 2012.**

Now, zero in on the volatile years from 2000 through 2012, and the picture changes dramatically: Against a backdrop of economic uncertainty, U.S. stocks returned just 2.3% a year on average, while U.S. bonds averaged 6.3%. The hypothetical 50/50 balanced portfolio would have averaged 4.9% a year—not spectacular by long-term historical standards, true, but considerably better than the 2.3% return of a 100% stock portfolio.**

If you're able to predict which way the markets are headed today, tomorrow, next week, and next year, congratulations. That miraculous foresight means you'll be able to adjust your asset allocation to take advantage of Wall Street's zigs and zags before they happen. But if you're a mere mortal like the rest of us—and if you understand that trying to time the markets is generally a fool's errand—you'll maintain a diversified portfolio with an allocation to both stocks and bonds that's appropriate to your personal risk tolerance, time frame, and financial goals.

Asset allocation made simpler

Now that you understand that how you allocate your money may be the most important factor in determining your volatility exposure and long-term returns, you may be wondering how to decide on the best allocation for your portfolio.

There's no right answer for every investor, but as a general rule Vanguard believes your investing style should become more conservative as you get closer to your goal. That's because as the years go by you'll have less time to ride out the markets' ups and downs—and because you'll need to pay more attention to preserving your assets, as opposed to growing them.

Investments in Target Retirement Funds are subject to the risks of their underlying funds. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.

A target-date fund, such as one of Vanguard's Target Retirement Funds, can help with asset allocation decisions. Each fund invests in an underlying mix of low-cost Vanguard index funds and has an asset mix that's appropriate for someone planning to retire in the target year. You simply pick the fund with the date closest to your expected retirement date and you'll get a stock/bond allocation that's aligned with your needs. As time goes on, your Target Retirement Fund gradually invests more conservatively, helping you maintain a sensible asset mix all the way through retirement. You never have to wonder when or how to adjust your asset allocation—the fund does it automatically.

For example, Target Retirement 2045 Fund is designed for investors who expect to retire in about 30 years. As of July 31, 2013, almost 90% of its portfolio was in stocks, which makes sense when retirement is decades away. In contrast, Target Retirement 2010 Fund is for investors who have already retired or are just about there. As of July 31, 2013, almost 60% of its portfolio was in bonds.

Each Target Retirement Fund holds a mix of stocks, bonds, and cash, letting you focus on your portfolio's return as a whole. This big-picture perspective of performance can help you avoid being tempted to make changes based on the periodic ups and downs of individual investments.

By sticking with your strategy—and by understanding both what's in your portfolio and why it's there—we believe you'll improve your chances of investing successfully over the long run.

 

* Calculations are based on monthly returns for 518 U.S. balanced funds from January 1962 through December 2011. For details of the methodology, see the Vanguard research paper The Global Case for Strategic Asset Allocation (Wallick et al., 2012). Sources: Vanguard calculations, using data from Morningstar.

** For these comparisons, stocks are represented by the Wilshire 5000 Index from 1980 through April 22, 2005, and the MSCI US Broad Market Index thereafter. Bonds are represented by the Barclays U.S. Aggregate Bond Index. Source: Vanguard.

Notes:

  • All investments are subject to risk, including the possible loss of the money you invest.
  • Past performance is not a guarantee of future results.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.
  • An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
  • The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index.
  • In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
  • For more information about Vanguard funds, visit Funds, Stocks & ETFs or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
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