Updated on 09.15.14

Portfolio Theory, 7 Investments You Need, & My Own Plans

Trent Hamm

The most recent issue of Money Magazine had a blaring cover story: “The Only 7 Investments You Need Now.” Those were some tall words, and I was intrigued about what they had to say. Their seven investments:

1. A blue-chip U.S. stock fund
2. A blue-chip foreign stock fund
3. A small-company fund
4. A value fund
5. A high-quality bond fund
6. An inflation-protected bond fund
7. A money market fund

For each one of these, Money offers some specific fund suggestions and came in quite heavy on Vanguard recommendations.

What I found most compelling, actually, is that this lines up at least reasonably well with the basics of portfolio theory and also with my preferred reference on portfolios, Paul Farrell’s excellent The Lazy Person’s Guide to Investing. As a result of the advice of the article and the book, I’m coming ever closer to figuring out my exact plan for investing my money as per our family’s financial plan. Let’s walk through the logic.

Portfolio Theory 101
A lot of sites like to talk about “portfolio theory” and treat it as some sort of arcane science, spoken about in hushed tones by very smart people sitting upon their thrones made out of money.

Nonsense. It’s actually pretty simple.

A portfolio is just a collection of different investments. Those investments each have a certain expected return and a certain expected risk. For example, you might have a portfolio made up of 50% stocks in one company and 50% cash. The individual stocks have a fairly high expected return but a substantially large expected risk, while the cash has a low expected return but very low risk.

Those individual investments in your portfolio will sometimes go up, sometimes hold steady, and sometimes go down, but not all at the same time. For example, one sector in the stock market might be going up like crazy (like tech) while another one is holding steady (like processed foods).

Sometimes those different investments will go up and down at the same time. Sometimes, they’ll do the opposite of each other. Sometimes one will go up, then go down, while the first one remains unchanged. The more similar two investments behave, the more correlation they have.

You can minimize the risk in your portfolio by minimizing the correlation between pieces of your portfolio. So, for example, that above portfolio with just stocks and cash actually has very low correlation and is actually not to bad.

Obviously, you also want diversity. You want a bunch of different investments so that your entire portfolio isn’t at risk when one sector or one stock crashes.

So, your portfolio should consist of several investments that have a low correlation with each other. One quick way to do that is to just buy stocks in different sized companies in different sectors, and also mix in bonds and cash holdings, too. In simplest terms, modern portfolio theory just means “you should be invested in several things that are fairly diverse.”

The portfolio above from Money Magazine is pretty diverse – four stock funds with fairly little overlap, two bond funds with little overlap, and a cash element, too. Thus, as a portfolio, it’s not too bad according to the tenets of portfolio theory.

What Lazy Person Suggests
lazy personAfter reading the piece in Money Magazine, I turned to my preferred handbook on investment portfolios, Paul Farrell’s The Lazy Person’s Guide to Investing. If you haven’t read it, it’s worthwhile. Farrell takes simple investing portfolios from a ton of different sources and analyzes them with a big sense of humor all the way through. I tracked a few of the portfolios for a while and not only are they simple, they’re pretty solid. Farrell focuses on the “lazy” aspect by composing funds that are almost entirely made up of index funds, mostly from Vanguard. You just buy based on that formula, rebalance every once in a while, then use the money when you need to.

The Money Magazine portfolio reminded me immediately of a portfolio from this book, so I opened up my copy and found the Kiplinger’s “lazy portfolio” on page 32:

25% large cap stock funds
25% small cap stock funds
25% foreign stock funds
25% domestic bond funds

It’s even simpler than the Money Magazine suggested portfolio and nearly as diverse. Money’s portfolio has a cash element as well, but aside from that, the portfolios are very similar.

In other words, not only do these two basic portfolios match each other, but they both fall in line with basic portfolio theory. My additional readings point the same way: a simple, diversified portfolio like this is the way to go.

Defining My Own Plan In Detail
For this article, I’m going to focus entirely on my taxable portfolio, which I’m going to start soon in order to build towards my family’s dream home in the country. In order to achieve this, I want a portfolio that earns well, but earns at least somewhat predictably, which means I need to minimize risk while still keeping some high-earning returns.

My goal is to contribute $15,000 a year minimum for eight years to that portfolio, then use that portfolio to buy the land and begin building the house that we want. I would rather have a reliable 7-8% growth than a likely 10% growth with a chance of a complete bust, so I’m going for a diverse portfolio.

In the past, I’ve noted why I’m partial to Vanguard and also why I’m partial to index funds, so I’ve decided to basically take Money’s suggested portfolio and use that for my house investment portfolio. I plan to own the following seven funds:

Vanguard 500
Vanguard Total International Stock Index
Vanguard Small-Cap Index
Vanguard Value Index
Vanguard Total Bond Market Index
Vanguard Inflation Protected Securities Fund
Vanguard Prime Money Market

However, I would like a proportional split like the following, as we saw in the Lazy Person model portfolio:

75% stocks
25% bonds and cash

That means I’m going to have the percentages roughly allocated like this:

15% Vanguard 500
25% Vanguard Total International Stock Index
15% Vanguard Small-Cap Index
20% Vanguard Value Index
5% Vanguard Total Bond Market Index
10% Vanguard Inflation Protected Securities Fund
10% Vanguard Prime Money Market

I have the highest percentage in the Total International Stock Index because it doesn’t overlap with the other elements at all, and I have a fairly high percentage in the Vanguard Value Index because it pays strong dividends and only slightly overlaps with the other two domestic indexes.

How will I buy? My plan, as mentioned earlier, is to pay off all of my non-mortgage debts before beginning to invest. When I start, I’ll buy the minimum amount of each fund ($3,000), then contribute an amount each month ($500-$1,000, depending on our financial situation then) that moves the portfolio closer to the target percentages above. Then I just contribute steadily, sit, and wait.

Aren’t you changing plans a lot? Of course they are. I’m attempting to do as much research and learning as possible before I commit to a plan, but once the cash starts going in, I’m going to stick firmly to the plan. This period of time, as I continue to pay off debts, gives me time to learn and plan and revise that plan, and I think it’s interesting and illustrative to discuss those plans as they grow and evolve as I learn more.

As I study and learn, however, and spend more time discussing our plans with my wife, my actual investing plans become more clear and falls more in line with my actual goals. If I were to start today, this would be my plan – it matches up with everything I’ve learned up to this point.

How does this affect me? There are two big lessons that anyone can take from this.

First, it’s worthwhile to do the research and plan things. Don’t just start investing – plan ahead. My family’s financial plan gives us some breathing room before we start dumping in cash, but I’m not waiting until the day to start investing to plan. I’m thinking about it, figuring out how to minimize my risk and what kind of returns I want, and talking to my wife about things, too. I’m also reading a lot of sources on investing, too, and incorporating various pieces into my overall picture.

Second, don’t accept just one person’s ideas. My plan is coming together as a result of not just my own thoughts, but the input of a lot of reading and research. Before you make a major financial move on your own, make sure you know what you’re doing and make sure you’ve read up on your choices from multiple sources. Don’t just jump into the pool because someone made one suggestion – think it out and find more than one person’s perspective.

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  1. My.cold.dead.hands says:

    I’m going through the same thing with my allocation questions, as a matter of fact I asked this same thing on another forum.

    I’ve been doing lots of research on this topic and still don’t feel comfortable with what I am finding.

    Like you, I am investing in index funds for the cost. I have a 85%/15% equity/bond mix with a 25 – 30 year time horizon.

    Here is my specific question:

    How do you decide on the exact percentages? I can understand the general concept of staying diversified across asset classes and having exposure to different areas of the market, but why 25% in the S&P as opposed to evening it out all around (still keeping the same in bonds)?

    Maybe I’m overthinking things.

  2. Aristotle says:

    The idea of investing in a diverse portfolio seems right to me, but I have trouble wrapping my mind on the underlying rationale for it. People say that doing so makes it so that your entire portfolio isn’t put at risk, that a low in investment X will be balanced out by a high in investment Y. But doesn’t that also work the other way–so that a high in Y is negated by a low in X? It seems to me like you could read it either way, and on that second reading, it doesn’t sound so attractive–after all, I don’t want my investment highs to be counteracted at all! I’m sure there’s something flawed with my logic here, so if someone can explain it to me in an understandable way, I’d greatly appreciate it.

  3. Michael says:

    You ought to read up on Post-MPT.

  4. Joe says:

    Aristotle – the reason people advocate a balanced portfolio is for the same reason that the phrase – “don’t put all your eggs in one basket” exists – if things go south, you are protected if you have diversified.

  5. Oliver says:

    So much for majoring in finance at uni! I could’ve just come and read that! Nice article.

  6. Jules says:

    Stock markets, as I understand them, are substantially more risky than other types of investments, and I would question the wisdom of putting a larger percentage of my investments in them, ESPECIALLY as Goldman-Sachs recently predicted that oil will reach $200/barrel soon (they said 24 months, I say 36-48).

    Is there a good investment dictionary out there? I get the feeling that I’d be good at this if a) I had any money to invest and b) if I knew what any of the words meant. I’m working on the former, so that one day I may be able to do the latter.

    And I have to wonder–if you diversify too much, and leave your money in too many places, wouldn’t that make it harder to earn more, since it’s the interest that earns you the moeny in a lot of these (except of course, for the stock market)?

  7. KC says:

    You know there are fees for being below $10k in each fund. This is directly from their site.

    For nonretirement accounts, traditional IRAs, Roth IRAs, UGMAs/UTMAs, SEP–IRAs, and education savings accounts (ESAs):

    Vanguard charges a $20 annual account service fee for each Vanguard fund with a balance of less than $10,000 in an account. This fee does not apply if you sign up for account access on Vanguard.com and choose electronic delivery of statements, confirmations, fund reports, and prospectuses. This fee also does not apply to members of our enhanced services, which require a minimum of $100,000 in total eligible household assets held at Vanguard by you and your immediate family members who reside at the same address.

    You either need to sign up for the electronic delivery or you need to consider Vanguard’s ETFs that can be bought through a broker. In fact, you should consider their ETFs anyway. Some of them have lower expense ratios than their index funds. For instance VTSMX has an expense ratio of 0.15% and a yield of 1.78% and the ETF VTI has an expense ratio of 0.07% and a yield of 1.86%. Both index the Total Stock MArket.

  8. Klaus says:

    I was also wondering about the per-fund maintenance cost, as well as the lack of diversification while implementing this.

    Could start with the Vanguard STAR fund or one of the Target Retirement funds until have enough saved to diversify into individual funds / ETFs.

  9. Dan says:

    Since this is a taxable account, you should take a look at VFWIX instead of VGTSX due to its tax advantages.

    It’s also important to note that in general, you should be planning your asset allocation in terms of your TOTAL portfolio, including non-taxable/retirement accounts for both you and your wife. In doing so, you’d want to minimize your tax consequences by putting tax inefficient investments such as bonds, TIPS, and small-value/cap stocks into tax deferred accounts.

    You may also want to look at REITs, as they have a low correlation with the other assets in your portfolio.

    Since you have some specific goals that you’re investing for this may not apply to you, but it is something you should at least take into consideration.

  10. Lauren says:

    What’s the major benefit of guessing at percentages rather than just buying in a Total Stock Market Index Fund for the US and then an international fund as well? Doesn’t buying the former automatically diversify your portfolio among large-cap, small-cap, etc?

  11. Baker says:

    I’m going to assume that if he writes a blog he’ll probably manage his portfolio online and get e-delivery….

  12. Frugal Dad says:

    I wish Vanguard would lower their minimum investment criteria – $3k is a lot to come up with to open a fund. I know I could save it in a targeted savings account, but it just doesn’t have the same appeal and I’m likely to need it for something else before I can save up $3000.

  13. Dave says:


    Be careful investing in stocks with an 8 year time horizon. In 3 years or so, you’re going to want the (vast) majority or all of that in bonds, shifting towards cash over the 2 years following that.

  14. Lurker Carl says:

    Any money you intend to use within a 10 year time frame should not be invested in stocks. Too much chance of the money not being there when you want it. Municipal bonds, cash, etc, but never in stocks.

  15. Whitney says:

    I am also looking into investing with a taxable account. One thing you might want to look up is the difference between Vanguard Total International Stock Index vs Vanguard FTSE All World ex US Index Fund. This is a link to a comparison between the two http://www.bogleheads.org/wiki/index.php/FAQ_on_Vanguard_International_Funds. Most people tend to put Vanguard FTSE All World ex US in their taxable account because it is more tax efficient than Total International Stock Index.

  16. Karen says:

    I’d question the wisdom of basing my investment research on books given how fast the market changes.

  17. David Hunter says:

    Aristotle you are exactly right. Basically in a perfect market (unlike the one we are in) the market prices in risk vs return. The net result is the greater the expected return, the greater the risk. Despite being in an imperfect market this is generally true in the real world.

    In other words to make substantial money one either has to earn money (via wages or production) or take substantial risks to get those substantial returns.

    Diversification reduces risks and thus reduces returns making it a suitable strategy to hold money but not to (substantially) grow it.


  18. Robert says:

    Jules: I happen to think that while high oil costs have a lot of short-term negative impacts upon the economy, they also have some long-term pluses. For one they are finally getting people to do more than pay lip-service to the notion of cutting back on their overconsumption, particularly when it comes to fuel (I love the fact that GM is considering closing out the Hummer consumer brand, the entire brand was one of the prime examples of wasteful excess).

    But the one impact that high oil has that has me very interested is in terms of investing. While the oil prices will drag upon the price of many traditional stocks, at least until those companies/industries adapt, they will also serve to spur development of alternatives. There’s no shortage of ideas for alternative energy sources, such as solar, geothermal, wind turbines, wave turbines, bio-fuels (even ones that aren’t produced from our food crops), etc.

    All of these ideas have their good and bad elements, and will need quite a bit of research to fully develop them into an economically viable alternative. But thanks to those high oil prices, the money is (finally) being put forward to further their development and when some of these prove to be ready for wide-scale use it will spur a LOT of new investment opportunities.

    Another way to look at it is this: We’ve known about oil and how to acquire it in various forms (such as naturally occuring raw asphalt mined and sold by several ancient towns in the Meditteranean) from the ground for Millenia, yet it wasn’t until the last 150 or so years that we had any reason to want to use very much of it. Prior to the twin developments of the Internal Combustion Engine, and the chemical knowledge to make a wide variety of synthetic products such as plastics and dyes, petroleum was considered a “worthless” substance. Today it drives our economy, it is the raw material for most of our consumer products, and it is even critical for producing the fertilier needed to support our overly large world population.

    As oil becomes more scarce (and thus expensive) there are a number of alternatives that will take it’s place, and the companies that bring them to the market will reap a huge reward for those wise enough to invest in them early… The trick is to figure out which alternatives will work, and which of these companies will be a success. But that’s always the issue when it comes to succesful investing, isn’t it?

  19. Shanel Yang says:

    Thanks for sharing your financial plan and the results of all your research to date. I’ll definitely keep coming back because everything you say seems to make sense! Of course, I’ll do my own research, too; but, it certainly helps to start from a knowledgeable, yet sincere, source.

  20. Steve says:

    Frankly, I find the stock market very frightening. Of course, I invested in Enron at 45 dollars and sold it for a nickel.

  21. Trent Hamm Trent says:

    Karen: “I’d question the wisdom of basing my investment research on books given how fast the market changes.”

    I agree wholeheartedly with that if you’re talking about individual stock picks. But this isn’t about individual stock picks. It’s about owning as diverse of a slice of the stock market as I possibly can. I don’t want to own a bunch of one stock, I want to own a bit of a ton of stocks.

    That strategy is timeless. It doesn’t rely on sector shifts or market timing or anything like that.

  22. Christopher says:

    Steve: In some sense it’s entirely reasonable to find the stock market frightening. If you’re speculating then the risk you’re taking can be astronomical, as it no doubt was with Enron. (Though the return can be pretty good, too. What was the high on Enron while you held it?)

    Ramsey frequently says you should never buy anything you don’t understand. I agree with that whole heartedly, and that’s why I ignore his advice on buying managed mutual funds. The best I could hope to do with those is compare past performance (as he says you should do), but that falls far short of understanding the fund. Most index funds I understand. If the average company in the US goes up then a total markets fund goes up too. I think it’s a pretty safe bet in the long term that US companies will go up. Similar statements exist for other stock market index funds. Bonds are more complicated and I’m just beginning to understand them. With single stocks you need to be able to make an objective judgment about whether the share in the company you’re buying is worth more than you’re paying for it. I don’t have time to do the research to make that call, so I don’t buy single stocks.

  23. Tony says:

    Better to get started with small amounts now than waiting till later. Don’t forget about compound interest!

  24. Dave says:


    Along these lines, check out the new book “Spend ‘Till the End” by Laurence J. Kotlikoff and Scott Burns. I think it would make an excellent book to review on the Simple Dollar! Very heady stuff but written for us liberal arts majors!

  25. Dough Roller says:

    Trent, that’s a really nice description of modern portfolio theory and investing. Your suggested allocation is not far from mine, although I add REITS, emerging markets, and small cap foreign. I would echo what others have said, though, and suggest a significant shift away from equities given your 8-year time horizon. It’s not at all unprecedented for the market to decline over an eight year period.

    David, I did note with interest your statement that “Diversification reduces risks and thus reduces returns making it a suitable strategy to hold money but not to (substantially) grow it.” Diversification has allowed me to substantially grow money over the past 15+ years. After college I was $55k in the hole. Today I’ve got a six figure investment portfolio that’s heading to seven figures (I hope). All through a very simple investment plan not unlike what Trent has described. It does work!

  26. Kirk says:

    I agree with some of the comments that some asset classes are missing here. REITs and commodities are great portfolio diversifiers and have provided returns similar to US equities over the past 30 years.

    Also, I would add more international to the mix (with some foreign small and emerging). If you weight too much to the US, you are ignoring more than 50% of the world’s market capitalization or investing opportunities. Plus, if we were to ever endure a slump like Japan, your portfolio would suffer.

    For those who say we could never follow Japan’s slump, we are doing it so far. They experienced massive housing and stock market gains. When things fell apart, their national bank lowered rates to zero and the government refused to let anyone fail. Sound familiar?

  27. felix says:

    Hi Trent, looks to me that you are spreading your investment too thin here. Diversification is good only up to a certain extent – dividing into 7 areas is way too many, IMHO.

  28. Zook says:

    There isn’t a thing as the perfect portfolio and as you can see Trent, everyone has something to say about your AA.

    One thing…REIT’s are a part of the VTSMX at around 2-3%, so that isn’t all that high to make a diversifying difference, but it is tucked in there already. Personally, I have a REIT fund in my portfolio, but if you are already working on 7-8 funds, managing to add a few more will make re-balancing a pain, if it isn’t already.

    I would highly recommend going the small-cap value route for your position. And I know that isn’t the greatest tax-advantaged fund, but think about the Vanguard 2015 fund as an all-in-one fund. I wish these were a little more tax-friendly, but they really aren’t as bad as other funds out there. I think more folks should look into the target funds for 5-15 year time frames for their money/goals. Think about it: Vanguard optimally adjusts a single fund to a target date. Doesn’t need to be used strictly for “retiring”.

    I think the great thing here isn’t about discussing if the portfolio should be 75-25 or 65-35, which is fine discussion, but I think what needs to be rewarded here is your drive, desire to save and taking control of your finances.

    So what if you are 5% of of something, or don’t have enough ‘Gold’ in your portfolio, you have selected solid Vanguard funds and you are off and running! Instead of buying a 19th iPod or buying that 54th PS3 game, you are saving for something huge that means everything to you. I am sure you will be in a solid place in 8-10 years. If you save $15,000 a year for 8-years, you are already ahead of many in the game if you only make a few percent a year if we hit hard times.

  29. Roger says:

    Good article, and fairly decent investment portfolio. Only (possible) problem I can see is, as has already been touched on, with such a short time frame, investing so heavily in stocks leaves you in a position to be hit with a market lull exactly when you are planning to cash out your funds. (Which could be doubly problematic, as your stated goal is to use the results of these investments in order to for a lump sum property purchase in a few years.)

    The best work around I can see is to review your portfolio every year or two and slowly shift your assets more towards the bond/money market investments as you get close to your desired purchase date. Essentially, you’d be doing the same thing as a target date fund, but over a shorter time frame and with more flexibility over what assets to sell and which to retain.

    Just a thought based on what I would in your situation.

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