What is the optimal asset allocation? Of course the answer to this question depends on where you are in life and your tolerance for risk. A retired person who is 70 years old likely should have a higher percentage of their assets invested in money market funds and bonds than a 35 year old with most of their career ahead of them.
For those with a relatively long time horizon, I recommend investing heavily in equity and bond index funds. Why index funds? Eugene Fama, one of the intellectual father’s of the efficient market hypothesis, said “I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information.” From Wikipedia:
The [efficient market] hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.
Paul Merriman’s Fund Advice website is an excellent resource for those who are interested in investing in index funds (that’s a tongue twister). His article on the “Ultimate Buy and Hold Strategy” is particularly enlightening. Mr. Merriman also gives some model portfolios for various fund groups. I prefer the Vanguard funds due to their relative low expense ratios. While the Fund Advice website recommends 40% bonds, I believe that this is pretty conservative for young investors (disclaimer, I am 27 years old). Thus, a 20% bond allocation should be sufficient. As I noted before, you should put some cash put into a money market fund for emergencies and to plan for large expenditures which you expect to occur in the next year or two. The amount of money to put in the money market depends on your own personal situation. Also, I abstract from any mention of home purchasing as an investment, even though for many people a large portion of their savings is tied up in the equity of their house.
My model portfolio is show below. All funds are from the Vanguard group, but you can create a similar portfolio with funds from other mutual fund groups.
| Name of Fund | Symbol | Allocation |
| 500 Index | (VFINX) | 11.0% |
| Value Index | (VIVAX) | 11.0% |
| Small Cap Index | (NAESX) | 11.0% |
| Small Cap Value Index | (VISVX) | 11.0% |
| Developed Markets Index | (VDMIX) | 14.4% |
| International Value | (VTRIX) | 14.4% |
| Emerging Market Index | (VEIEX) | 7.2% |
| Intermediate Term Bond Index | (VBIIX) | 10.0% |
| Short Term Bond Index | (VBISX) | 10.0% |
| 100% | ||
In this allocation, we have 20% bonds and 80% stocks. Half of the bonds are in short term and the other portion is in intermediate term bonds. For the equity portion of the portfolio, 55% is invested domestically and 45% is invested internationally.
You can see that the portfolio is more heavily weighted towards small-cap and value funds since over the long term these funds have outperformed the simple S&P index. While the small cap funds are more volatile than the S&P, the value funds will be less volatile and more likely to lose less value when the market is declining (thus giving you a slight hedge).
The Fund Advice website notes:
From 1927 through 2006, an index of large U.S. growth stocks produced an annualized return of 9.3 percent; large U.S. value stocks, by contrast, had a comparable return of 11.5 percent. Among small-cap stocks over the same period, growth stocks returned 9.3 percent, and value stocks returned 14.5 percent.
A disclaimer: I am not a financial adviser, but this is basically how I invest my own savings.