by elmads

Introduction

Investing in FTSE Global All Cap Index fund and even on other funds that invests on businesses (equities) posses risks, and one of which is the fluctuations of its prices. If market price goes down so as your invested money, this is where first time investors usually lose money as they panic sell when they see their portfolio turns negative.

For example, if you’ve invested £10,000 on the FTSE Global All Cap Index Fund, then it went down to £7,000 due to a recession. Most first time investors would panic and sell their holdings because they are afraid that it might go further down. That’s a grave mistake, instead first time investors should see it as an opportunity to buy more as the markets are lower. Think of it as a price sale of your most beloved item. Accumulate more when the market is down as this will turn out as a golden opportunity in the very long-term horizon.

Nevertheless, not everyone will be able to handle such immediate decline in their invested money and also create their own portfolio to cushion such declines. This is why Vanguard created their “Ready-Made-Portfolios” to mitigate those large price declines, but there is a trade off, it also hampers price increases. There is this saying in investing regarding risks “The higher the risk, the higher the return, but the more volatile it will be (price fluctuations)”, and the opposite is also true.

So, how does Vanguard’s Ready-Made-Portfolio do it? it’s through allocating our capital to both Equities and Bonds.

Bonds & Equities

Before I show you the ready made portfolio of Vanguard, we must tackle quickly two asset classes namely Bonds & Equities. There are a lot of Asset Classes in our world, I’ve discussed each and one of these in my blog titled “The 5 Basic Asset Classes”.

For this blog, I’ll summarize the difference of the two.

• Bonds – These are called securitized debt assets. When we buy bonds, we actually give our hard-earned money as a loan to either the government or corporations. Basically, Governments and Corporations borrow money from investors, these are called bonds. It is an asset for investors who own the bonds, while it’s a liability for the government and corporations who borrowed the money from these investors. They are mandated to repay their investors interests every quarter, or every 6 months, then they return the whole amount of the money they borrowed after the end of the contract, which is always stated in the Bond.
  
  I’ve also discussed this deeper in my blog titled “The Bonds Asset Class”

• Equities – This is where we buy shares of a company and become a part owner of it. If the company grows and expands, then our invested capital will be able to grow as well.
  
  I’ve also discussed this deeper in my blog titled “How Shares are Made and How the Stock Market Works”

In terms of price fluctuations, Bonds are conservative meaning it doesn’t quickly change in prices, unlike equities. To mitigate the erratic price movement of equity prices, investors add bonds on their investment portfolio to reduce the price volatility.

Bonds also give certainty of income and cash flow, because it has a specified amount of money that needs to be paid by the debtors to its investors. Unlike equities, where income and cash flows are not certain because of several factors that could also affect the underlying business, such as the management, macroeconomic factors, their competitive advantage compared to their competitors and their capital allocation capabilities.

How do Bonds x Equities portfolio actually reduce the changes in one’s portfolio performance? It’s through diversification’s capital weighting. I’ve discussed this in my blog titled “Diversification”.

Remember this, as this is where the core principles of Vanguard’s Ready-Made-Portfolios are based.

Ready-made portfolios

If you’re nervous about building your own portfolio allocation, and do not know how to balance between equity and bond funds to cushion price volatility, then you might want to look into Vanguard’s Ready Made Portfolios. There are two categories that you will be seeing here, the Target Date Retirement Funds & LifeStrategy Funds. Let’s talk first about the Former Fund type.

Target Date Retirement Funds

We’ve talked already that bonds act as a cushion for the price volatility of equities. But, we haven’t discussed yet about the supposed percentage of bonds allocation depending on our age.

There is this portfolio allocation principle in the investment world where, some investors point out that our supposed to be % investment in equities should be equal to (100 minus our current age).

For instance, I’m currently 31-years-old, (100 – 31 = 69). This translates as, I should invest 69% of my total money on equities, while the remaining 31% on bonds. That’s the gist of it.

The reason behind this principle is that we can take and handle more risk when we are younger. If we ever commit any mistakes early on, we could still be financially fine, as we have the luxury of the time to rectify our investment mistake before we reach our retirement age.

Also, having capital allocated in equities helps our portfolio to have faster growth than in bonds.

On the other hand, as we near retirement age, we couldn’t afford to make risky bets anymore as we would eventually be needing the money sooner. No one would want to be needing the money during a market and economic downturn, which could put our portfolio substantially at risk when it is still purely invested in equities. A logical reasoning if you ask me.

The two principles of investing in both bonds and equities, while allocating it based on our age, or the date when we plan to retire, are where the Vanguard Target Retirement Funds are based.

Let’s take 2 Target Date Retirement Funds as an example. One retirement date fund that will be coming soon, while the other is not until the 4 decades have passed. These are the Target Date Retirement Fund 2025 and Target Date Retirement Fund 2065.

Investors who place their hard-earned money on the Target Date Retirement Fund 2025 are expected to retire approximately in 2025, while for investors investing on the later fund are expected to retire around 2065. This is generally how we will think and frame our minds when we want to invest in Target Date Retirement Funds, and again this is a personal choice. What we’ll do here is to just invest our hard-earned money on our chosen fund regularly and just let it run.

If you choose to invest in the Target Retirement Fund 2025, the Fund manager will allocate your money as indicated in the photograph above. 57% on equities and 43% on bonds. This allocation will be adjusted by the Fund manager depending on their own research. The % allocation will change and would most likely be more on bonds than in equities once it reaches 2025 and beyond.

The next one is the Target Date Retirement Fund 2065. We can see already the substantial difference of this fund’s investment allocation when compared to the Target Date Retirement Fund 2025, where 80% of our money will be invested on equities while 20% on bonds.

The longer the time before we retire, and the longer our time horizon to invest, the greater the percentage investment allocation should be on equities.

Below is a statement from Vanguard Group about their Target Date Retirement Funds.

“We'll automatically keep it to the right balance of shares and bonds, depending on how far you are from retirement. At the start we invest your money mostly in shares rather than bonds. Why? Because although shares are riskier, they offer higher potential returns. And because you have time on your side, you'll be better able to ride out any ups and downs in the stock market. Then as you get closer to retirement, we'll gradually start moving your money into bonds. These are more stable but offer lower potential returns. Why do we do this? The idea is that as you get closer to your goal, you'll be more interested in preserving what you've got with bonds, rather than making big potential gains with shares. After all, you don't want a stock market slump to reduce your savings just before you intend to start using them as you won't have time to regain any losses.”

LifeStrategy Funds

This is another ready-made-portfolio from Vanguard. Unlike, Target Date Retirement Funds where the fund manager will change the allocation of equity and bond investment as your date of retirement comes close. In here, the fund’s allocation will be steadily the same all through out your investment journey, not unless you sell your fund holdings and use the proceeds to buy another fund, this is called reallocating your investments.

For example, let’s say you’ve chosen to invest in LifeStrategy 80% Equity Fund today. This means that your money will be invested in 80% equity then 20% on bonds. Even if you reach retirement age or even past that age, your investment allocation will be the same as long as your hard-earned money is still invested in this fund.

Which one is better?

Investment decisions are personal endeavours, meaning it should be based on our own personality, risk appetite, financial goals and time horizon. If you want a process where your capital grows faster, with still decades away from your planned retirement, and you subsequently want a slow transition into a more safe investment once you’re nearing your planned retirement age. Then you might want to look deeper into the Target Date Retirement Funds.

On the other hand, if you want a consistent portfolio allocation of Equities and Bonds all through out your investment journey, regardless of your age. Then you might want to look into the LifeStrategy Funds.

The answer here will be based on your own personal choice, on how much price fluctuation you can take in your portfolio.

Below is a graph of the Risk Reward graph of the LifeStrategy Fund taken from Vanguard, which could help you make a decision if you’ll ever want to invest in this type of fund.

On the Fees side. Target Date Retirement Funds have higher Ongoing Charge Fees (OCF) of 0.24% compared to the 0.22% (OCF) of LifeStrategy Funds. That being said, both of the funds fees are still considerably lower when compared to other funds that are not handled by Vanguard.

To sum it up

Your fund of choice is up to you, you could invest in purely equities, or bonds, or both of them or through ready made funds by vanguard, or just do it yourself.

What’s important is that you make the investment choices that will give you peace of mind whatever happens. That even if the market goes down, you’ll still be able to sleep well at night. Peace of mind and simplicity of our investment portfolio are two of the most important aspects of investing. Making money work for us without stressing ourselves in the process.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.