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Amy Chain
Amy Chain
Amy Chain: Hello, I’m Amy Chain. Welcome to tonight’s live webcast on “Keys to Building a Successful Investment Portfolio.” Over the next hour or so, we’ll discuss the key considerations for portfolio construction, tips for constructing a tax-efficient portfolio, and why asset allocation is so critical. And with us today to discuss this important topic are Scott Donaldson of Vanguard Investment Strategy Group and Bryan Lewis of Vanguard Personal Advisor Services®. Gentlemen, thank you both for being here tonight.

Bryan Lewis: Thanks for having us.

Scott Donaldson: It’s a pleasure, Amy.

Amy Chain: We’ll spend most of our evening tonight answering questions from you, but there’s two items I’d like to point out before we get started. First, there’s a widget at the bottom of your screen for accessing technical help. It’s the blue widget on the left. And if you’d like to read some of Vanguard’s thought leadership material that relates to tonight’s topic, click on the green resource list widget, which is on the far right side of the player. And before we really get into our discussion, we’d like to ask our audience a question. And so on your question now, you’ll see our first poll question, which is to help us get to know you a little bit better. That question is, “Which of the following best describes your situation? Are you retired, retiring in about five years or less, more than five years from retirement, or just getting started?” So go ahead and weigh in now, and we’ll look back and reflect on your answers in just a few minutes. And, Bryan, while we’re waiting for our audience to weigh in on this first polling question, I’d love to send a question to you that came in to us ahead of today’s webcast. This question is from Patricia in California, and Patricia asks, “Can you help me understand what I need to do to get started? I truly don’t know how to invest or make it work. Can you help me with that?”

Bryan Lewis
Bryan Lewis
Bryan Lewis: It’s such a great question. It’s a question that I’m asked quite frequently, and when you start thinking about how to build a plan and a strategy and really where to get started, you really want to start with defining your goals, right? You need to know what you’re investing for. You really need to define whether it’s for retirement, am I saving for college, paying off or buying a home? And once you’re able to clearly define those goals, you can start shifting towards thinking about the portfolio. How do you start building the portfolio? And once you start looking at this, Vanguard follows what we call a top-down approach. What that means is you first want to start with your overall mix of stocks and bonds, so you want to define your asset allocation. And then when you start doing that, and there’s tools on the Vanguard website if you need help along the way, and once you’re able to start defining that, you can start looking at the suballocations. You can start looking at, all right, if I’m on the stock side looking at U.S. versus international, and then start looking at my large-, mid-, and small-cap value versus growth, and then more importantly as you look to build this portfolio, you want to use very low-cost investments, particularly mutual funds, to build this portfolio around. And by using these low-cost investments, you’re just increasing the likelihood through low-cost investing that, again, you’re keeping more of the returns, which we’ll talk more about this evening. And as you build the portfolio, really the last component to it is selecting the underlying investments. And a lot of clients come to me, and I have this conversation quite frequently, is they do what we call a bottom-up approach, and that’s where they begin to start selecting the investments, whether it be on a performance basis or if you start looking at how highly rated they are. And when you start building that portfolio from the ground up, you start to have a portfolio that’s complex, it can be very eclectic as far as the holdings, and you could be less diversified than you actually believe you are. And when you start looking at the portfolio, that’s when I help my clients clearly define what their goals are, build the portfolio, take into account the tax efficiency of it, and, more importantly, when you build the plan, you still have to remain very disciplined once you execute and start the plan. And really this goes to all investors, right, whether you’re starting off at a young age or you might be later in your career and you’re just beginning the process to start saving towards retirement, as an example. You really need to be able to be disciplined with that and execute. For example, when you think of rebalancing, you need to be able and stay committed to looking at the portfolio maybe once or twice a year and be active in the sense of save as much as you can and just resist the urge to or the temptation to get out of the investments, as an example, when the market’s down. You know, if you follow these types of principles, the four founding principles for Vanguard, you’re just going to increase the likelihood that the portfolio is, and you’re going to be able to really meet some of these longer-term objectives that we have established.

Amy Chain: So if I could summarize, it sounds like you’re saying start with your goals. Figure out where you’re going before you get going anywhere. Decide what your proper asset allocation should be based on those goals. Only then do you decide what investments should comprise that portfolio and make sure you’re taking costs into consideration along the way.

Bryan Lewis: Exactly.

Amy Chain: And then once you have a plan, stick with it.

Bryan Lewis: Exactly, and just keep it simple. If you keep it simple, it just, again, makes it something that it’s easier to manage, and, obviously, you can stay on track.

Amy Chain: That’s great. Now our results from our first poll are in, and about half of our audience this evening is retired. From there we’ve got about 20% retiring in five years, 20% about five years out, and 20% just getting started. Or, I’m sorry, about 7% just getting started. So knowing that we now know that the majority of our audience is in the retired camp, does that change at all how we would suggest they think about their portfolio?

Bryan Lewis: In my view from a financial advisor position, no. This is something that all investors, whether you’re starting off as an accumulator, you’re within five years of retirement as a pre-retiree, or for somebody who’s retired, this is something that you stick with the strategy, and it’s been proven to work.

Amy Chain: That framework works for everyone.

Bryan Lewis: Exactly.

Amy Chain: Okay.

Scott Donaldson: The outcome may be slightly different for each investor in different points along their lifecycle and where they are.

Amy Chain: Good, good. I’m going to toss another question out to our audience and then, Scott, I’m going to come back to you. The question for our audience is, “What percentage of your portfolio is comprised of international investments: 75% or more, 50 to 75%, 25 to 50%, or less than a quarter?” Please respond now and we’ll get to your answers in a few minutes. But in the meantime, Scott, I’d like to ask you to answer a question that came in from Ervindra from Tennessee who asks, “How does Vanguard define success in an investment portfolio? Is there a widely accepted definition or are there different versions of success, depending on the portfolio?”

Scott Donaldson
Scott Donaldson
Scott Donaldson: Sure, sure. It’s something, and Bryan hit on a lot of issues in evaluating your portfolio, creating a plan is all vitally important. I think I’d probably start by saying making sure from defining investment success. You don’t want it to have to be relied upon achieving some level of outsize returns. You also don’t want the success of your investment plan to be determined or contingent upon what I would say are unrealistic savings or spending goals. And kind of a great example of that, I think, would be you have an investor who decides they feel they need a million dollars on the day they retire. They’re 30 years old, and part of their plan to achieve that million dollars is saving $2,000 a year. Again, unrealistic. There’s not an investment portfolio in the world that’s going to be able to solve that or make that strategy successful. Significant outsize returns would be needed considering that you need to be a little more realistic, define clear goals in order to be able to measure exactly what you’re striving for.

Amy Chain: And when you say goals, what I think you mean is “I’d like to have enough money to replace X percent of my income in retirement” as opposed to “I’d like to have X percent returns in my portfolio.” Set a specific goal, talk about what you want to do with the money, and then create a plan that will help you accomplish that. Is that fair?

Scott Donaldson: Yes, absolutely. I think it could be as different as, somebody could have a goal that you’re going to measure as far as focused on risk. I’d like to have a portfolio that doesn’t lose money over the course of a one-year basis. It could be return-based. It could be more focused on a 1 or 2% return above the rate of inflation over a three-year period. It’s something that you can measure on an ongoing basis and decide. But I think it’s probably most important that most investors don’t think about in this context is think about it in the case of determining what’s a required return versus a desired return.

Amy Chain: Let’s define that. We talk about that quite a bit, but I don’t know that our audience maybe knows what we mean. Define required return for us.

Scott Donaldson: Sure, I can probably explain it in a simple example. So let’s say an investor decides that they need a certain amount of income a year once they retire. They’ve got a certain size of a portfolio or assets that’re able to help them achieve that income. And the return determination to achieve that annual income, let’s say, is calculated at about 4% a year. So when they’re evaluating their required return of 4% a year, if that’s what they’re achieving, but they then look at—I mean everybody wants to achieve the greatest amount of return absolutely possible. But if you look at your portfolio over history or the last year and you’ve gotten 4 or maybe even 5 or 6, but then you then look at the broad stock market and see that it was up 12. There’s no reason you should be upset about that or determine that your investment strategy is a failure because it did exactly what you were trying to do, and you didn’t have your portfolio set up or established to achieve the 12. That’s more of a desired return. The required is something people need to focus on more so, not just outperforming their neighbor or outperforming the market necessarily, is to set the portfolio up to meet their specific goals.

Amy Chain: Bryan, how can we help them determine what their required return is?

Bryan Lewis: It’s a question I’m asked quite frequently, and really the goal, when you think about it, is, especially around this goals-based approach, is we want to get you from point A to point B. And to Scott’s point about managing the returns and your expectations, when you start thinking about how much risk should you be taking to get from point A to point B, if we can get you, for example, say, to retirement with less risk, you know, it’s important, and you need to look at it that way versus, say, somebody who’s looking for 8, 9, 10% on a consistent basis. Not only are they likely going to be disappointed, they’re likely going to be taking on more risk than they truly should be.

Amy Chain: That’s a good point. Now the results from our poll question are in, and it looks like about 80% of our viewers have less than a quarter of their investments in international investing. So knowing that about half of our viewers are retired and most of them are about a quarter in international equities, what do we think about that? Or international investments; I guess we didn’t specify.

Bryan Lewis: When you start breaking down the holdings and you look at the international markets, it’s no surprise when you start seeing it, and especially for international that hasn’t done that well really over the last six or seven years, it’s no surprise that a lot of people don’t have as high an exposure to the international markets. But when I have this conversation with my clients and you start talking through, alright, let’s take a step back, times when you think of the U.S. market, the U.S. stocks, for example, aren’t always going to do better than the international stocks. And we have to take a step back and really look at the risk and try to manage that and really manage the volatility of the portfolio, again, really to get you to a smoother return, more consistent return over time to meet these long-term objectives. So on the international side, it’s not overly surprising, and I’m sure we’ll get into a little bit more in the international questions.

Amy Chain: Great. Anything to add before we jump into some questions from our viewers?

Scott Donaldson: No, I think I’ll just kind of add to what Bryan said. I think it’s important to realize, one, having 25% as part of your overall portfolio, that’s a lot higher than it used to be ten years ago. So that’s, actually, fairly positive that investors are finally realizing that international equities, as well as bonds potentially on the international side, can be a very valuable diversifier. So that’s actually a fairly positive trend that I would envision there with that high of an international allocation. And we think generally, depending on your portfolio, level of equity, and to how heavy on fixed income that it is, is somewhere having an exposure that could be up to as high as 40% of an equity portfolio. We’re on our way there by the sounds of that.

Amy Chain: Can we talk a little bit more about why we think international exposure is important? I think when we do webcasts, we talk about international exposure, and then we hear from our viewers afterwards. Could you spend a little bit more time talking about what role it’s supposed to play, and here you are talking about minimizing risk. I always thought it added risk. Let’s pause and talk about the role that an international component of a portfolio can play.

Bryan Lewis: Yes, so on the international equity side, the goal Vanguard wants our clients to have, 40% of your stock allocation to international. Typically we don’t want any less than 30%, no more than 50%. But ideally 40% of the stock allocation should be in international. If we could bring up the international chart, I think it would be nice for the viewers to see really the reason behind that. And when you start looking at a portfolio of just pure domestic stocks as an example, you start to see that there’s potentially more volatility within the portfolio. But as you can see on this chart, if you look and you compare say 100% stock allocation versus an 80% stock/20% bond mix or even a 60% stock/40% bond mix, regardless of the type of allocation overall to stocks and bonds that you have, if you just focus here on this chart, it’s focusing only on the stocks. And the starting point on the left-hand side is if you start with 100% of your stock allocation to U.S. stocks, and if you start to shift towards international, again, this is on the stock side, 10% of your stocks in international, 20% of your stocks in international and so on, you can start to see that these lines start to dip down. And what this is measuring is volatility. And when you start to look towards that 40% line, again of the stocks for international as the target, you can see that it’s taking full advantage of that volatility. We want to reduce this, and I always joke with my clients that this is probably one of the few times you want to see a negative number. And what this is really implying is that the overall volatility of the portfolio is coming down. So, again, it just creates for more of a smooth ride within the portfolio versus a lot of the jagged ups and downs of the stock market.

Amy Chain: That’s great, thank you. Let’s take a live question that we got from Franz. Franz, thank you so much for sending this question in. Franz says, “I am retired. It’s important that I generate income with my portfolio without risking losing on the principle. What sort of investments do you recommend, and how can I best generate this income that I so need?” Bryan, you want to get us started?

Bryan Lewis: Yes. So typically, especially for investors who are looking for income, typically what you want to start looking at is likely the bond investments. Particularly bond mutual funds serve two purposes. One, they generate income. Granted, the yields are lower than they’ve been for a while. However, what they do when you start focusing on bonds as well is they provide some layer of a stability to the overall portfolio, to the stock market. And we’ve seen that this year alone. When you start looking at January and February for the stock market, we saw some declines in the market pretty quickly, a lot of volatility this year. And if you look at some of the bond investments, even with the prospect of rising interest rates, they’re still providing the income component to it as well as, in this case, year to date. They have some positive returns as well. But the overall volatility of the bond investments when you compared them to the stocks, I joke with my clients, when you think about driving a car, you’re far away from retirement, your foot’s on the accelerator, you know, the accelerator in this case is the equity portion of the portfolio. And as you get closer to retirement, you need to start tapping the brakes, which, again, implies that you start to really begin to add more of the bond portfolio. And then for somebody who’s in retirement that needs a lot of income, again, the bonds are really going to add that layer of stability.

Scott Donaldson: Right.

Amy Chain: This leads us into some more questions about sort of asset allocation and when to change and when not. We got a few questions ahead of today’s webcast, one from Cynthia in Illinois, one from Bob in Indiana. Cynthia is asking about “Once you’ve established your portfolio,” so let’s say you’re speeding down that highway toward retirement, you have your established portfolio, “at what points does it make sense to pause and reflect on your allocation and check to see if it’s still right?”

Bryan Lewis: And this is a question I’m asked quite frequently from my clients as well that I help them with. And when you start thinking about the different techniques some institutions will apply or even advisors, and there’s this idea of a time-only approach, meaning you can look at it monthly, you can look at it quarterly, and, you know, if you’re targeting 50% stock, whatever the allocation is at that time, you would rebalance. Then there’s this idea of threshold only, and it’s using percentages. This notion of 1%, 2%, 3%. If you’re outside, for example, if you go with a 5% threshold and your portfolio is in excess of 5% off of its target, an example would be say 50% stock is your target, you look at the portfolio and it’s at 56% in stocks, you would rebalance back to your target allocation. And then when you think of what Vanguard recommends, and this is what I help my clients with as well, is we actually use a combination of the two. We recommend that our clients at least look at the portfolio once if not twice a year and use a 5% threshold. So when you start to look at a portfolio, for example, every six months you look at it, and you’re within that 5%, plus or minus of your target. So, again, an example would be if you go with 50%, you look at it and it’s at 52% in stock, you may not have to rebalance. But as you start to go along and the markets continue to be volatile, and the prospect when you look at stocks, there’s the growth potential, so there’s going to be a point in time when stocks go up. They’ll, obviously, go down. You’re going to need to rebalance. And if you use it once or twice a year and you look at that 5%, that’ll just be manageable, and it’ll keep you on track.

Amy Chain: And this actually leads into another great question that we got ahead of today’s webcast from Arthur in Maryland. Scott, I’d love for you to chime in on this one. Arthur, this is a little long, so I’m going to read it because I think it’s important. Arthur says, “My portfolio allocations are 60% stocks and 40% bonds. A run in the market on the equity portion increases the bond port— A run in the equity market increases the— We know what we’re trying to say. When stocks go up, so does the equity portion in a portfolio. When stocks go down, up goes the bond portion.” What’s our recommended strategy for that? Is it okay to let the market sort of self-correct the allocations in a portfolio or do you wait and let the market do it for you or do you actually step in and make proactive reallocations within your portfolio?

Scott Donaldson: Right, well, actually Bryan just kind of outlined a couple different strategies to go about this. And generally one advantage of waiting or putting some sort of a threshold around a rebalancing strategy is to allow that general fluctuation. And so if you’re a 60/40 investor, the markets go up, you may go up as high as 65 or 66 and so forth. But if it’s not at a point where you’ve deemed it to be your rebalancing period, the markets may take it back down. So you come up with a strategy that you’re comfortable with, where that market fluctuation is accounted for. But markets go up a certain amount, and when they go back down, they may not go down the same amount or they may go down more. So you can’t just forget about it and assume the markets are going to do the rebalancing job for you. You need to be active and look at it and then decide, again, sticking to the plan, remaining with your risk tolerance that we haven’t talked a whole lot about yet. But you’ve determined that 60/40 is the right allocation, so if you’ve spent all that time and effort to determine that’s your right asset allocation, then rebalancing should be a very strong part of your ongoing plan that you’re maintaining that 60/40.

Bryan Lewis: And I’ll just add to that as well. It’s not about maximizing returns. It’s about managing the risk of the portfolio. If you wanted to maximize your returns, you would just be all equities. But when you look at managing the risk to, again, be able to match with your risk tolerance, and as you especially get close to retirement or even in retirement, again, it’s about managing the underlying risk of the portfolio, which a lot of people have chal— It is a challenge to do that, and it’s an emotional change as well. For example, if stocks are up and your allocation is off again in excess of that 5% threshold, who wants to sell a stock that’s doing well?

Amy Chain: That’s right. It feels counterintuitive—

Bryan Lewis: Exactly.

Amy Chain: —when the market’s up to be saying I should sell my stocks.

Bryan Lewis: Right, exactly. And that’s where a lot of people get, the emotions can kick in, and that’s something I do help my clients with as well. Alright, let’s get back to the target. Here’s why. Again, it’s about managing risk to meet these objectives.

Amy Chain: And that risk there is because when the equities inadvertently make up a greater portion of your portfolio, your portfolio is exposed to more risk than you intended with your target allocation.

Bryan Lewis: Exactly, and if you don’t rebalance eventually because of the prospect for stocks, the growth, eventually your allocation could be, if you’re targeting 60% stock, you can go up to 70, 80, and so on.

Scott Donaldson: Think about that old adage and the investment. What’s the “buy low, sell high,” right? A rebalancing strategy is a mechanism that actually implements that on a regular basis. So as markets are going higher and higher, you’re selling, right, and going back to your asset allocation. As the markets go down and you go below your normal stock allocation, you want to sell bonds to buy more stocks to bring it back up. So it’s an actual implementation of that old adage of buy low, sell high.

Amy Chain: It is but we’re not encouraging people to market-time.

Scott Donaldson: No.

Amy Chain: Rather, we’re back to where we started where we said set a goal, decide on the asset allocation that makes sense, and when you have an opportunity to buy low and sell high to get back to that allocation that you set at the beginning, you should be doing it.

Bryan Lewis: Right.

Scott Donaldson: And it shouldn’t be on just a whim. It should be according to an annual or semiannual or some threshold or some combination. The minute you start to try to say, “Oh, now’s a good time to rebalance because the market has moved” starts to enter in the emotional aspect of investing, which is not selling when you probably should be and buying maybe when you shouldn’t be because you’re letting your emotions take over.

Bryan Lewis: Yes.

Amy Chain: Let’s take another live question that we got, back to talking about international investing. This one comes from Charlie. Charlie, thank you so much for your question. Charlie asks, “Regarding international allocation, what about the statement that the U.S.-based stocks are already heavily invested in global areas like Coca-Cola that are available on a worldwide basis?”

Bryan Lewis: I get that question on a weekly basis. It’s the idea of multinationals, Coca-Cola, McDonald’s, Pepsi. They generate a lot of the revenue overseas, and when I create financial plans or I’m having a discussion with the client and talking through Vanguard’s allocation for international, we get into the details of this. You know, there’s a few things you have to account for. So in the international markets, you have to think of, there’s some currency benefits potentially to that. But, more importantly, the U.S. is very heavy in IT, biotech. When you start looking at some of these international markets, they are very old-world industry. As far as exposures, you think of automobile, consumer goods. So if you’re, in a sense, excluding the international markets, you’re giving up Nestle, you’re giving up Toyota. Automobile is a big exposure overseas as well, so you’re giving up pretty much half the world as far as the exposure, especially when you start looking at the global market cap, which is roughly half and half, half U.S., half international. So it’s something you need to consider.

Scott Donaldson: We’ve done a lot of research on this as well in my group, and the one thing that I think people forget about and a lot of the data shows the true. There are many, many huge multinationals that have huge exposures to foreign earnings that are driven from the different countries and so forth. So there certainly is exposure there. However, as far as the performance of the stocks, a lot of the data shows that the performance is driven more by where the stock trades, and it acts more like the market of where it’s trading versus everybody always looking through to where their earnings are coming from. And if, say, Brazil is up, their market’s up, and half of a company’s earnings come from Brazil, that stock, most likely, is not up if the U.S. market is down, if it’s trading on the U.S. market.

Amy Chain: So what do we think investors should do knowing that information?

Scott Donaldson: They should be broadly diversified across U.S. equities as well as non-U.S. equities to the tune that Bryan highlighted, up to 40% of their portfolio on the equity side. And on the international bond side, which we haven’t talked about, should be as well up to say 30% of their bond portfolio, but the key difference there is on a hedged basis. So looking at portfolios that actually hedge the currency risk out because—

Amy Chain: Define it for us.

Scott Donaldson: Anytime you’re investing internationally, an investor in the U.S. buying say United Kingdom stock, the dollars have to be converted in the local currency in order to buy that. In order to spend that money, that currency has to be converted back to U.S. dollars. So there’s an exchange rate, okay.

Amy Chain: So if you’re buying an unhedged security, you’re betting not only on a security but also on the currency.

Scott Donaldson: You are, right. So hedging the returns and the exposures back to the U.S. dollar basically takes that currency play out of it and gives the pure exposure just to the underlying fixed income performance and actually getting to that broad diversification. And, actually, I think it’s a good time, I’d like to bring up a chart to kind of add to this. There’s a market cycle chart that we can show, and this is a very interesting chart. And as you first look at this chart, you’ll notice there’s a lot going on here. And don’t worry that you can’t read any of the particular words, but I do want everybody to focus on all of the different colors. And what this chart shows—

Amy Chain: It looks like a bowl of Skittles to me.

Scott Donaldson: Yes, what this chart shows is an annual ranking of best performing asset classes, both global as well as U.S., various sectors, ranked from best to worst in several years looking backward. What you will notice, or in this case maybe not notice, there are no particular trends that can be highlighted here. It’s all over the board, so one year you have international stocks doing well, the next year not. You might have large growth doing well one year, the very next year not doing particularly well. I’d like to call this, I’ve heard it, I’ve called it, heard it called the periodic table, right? I’ve heard it called the quilt chart. Now we’re going to refer to it as the bowl of Skittles. I like to call it the first to worst or the worst to first chart, and here’s an example of why I think that. Let’s pull up one more chart on emerging markets to give you a highlight of, this is why it’s important to diversify, okay, is on a regular basis the market leadership changes. And here’s an example that in any particular year you notice emerging market equities were the worst performing in some years and then very quickly changed to the outperforming or the best-performing asset class and then back to the worst again. So the key to being broadly diversified across both U.S. and international stocks, and that’s not just across those particulars, but within the U.S. and within international stocks, you should also really own all aspects of those particular markets. You should own large-cap, you should own small-cap, growth, value, and that’s because all of your portfolio then or a good chunk of your portfolio is never exposed to the worst-performing asset class, and you’re always going to have some exposure to the outperforming asset class. So by definition, that is diversification.

Amy Chain: That’s good. That’s great. We have spent a fair amount of time talking about the first half of our viewers tonight, the retirees. Let’s answer a question for the other half, those that are a little further out from the retirement date. Gotham, from California, sent in a question ahead of time; and he said, “I’d like to understand your perspective on asset allocation for someone with a longer-term view, maybe 20 or so years from retirement. How does that maybe change, or not, some of the things that we talked about earlier?”

Bryan Lewis: Yes, and I think when you start getting back to the points we made earlier, you have to have a strategy. You have to know, again, you’re defining your goals, and certainly if it’s retirement for someone who’s younger and starting off, it’s a very long period of time, and you likely can take on more stock risk within the portfolio for the growth potential. But it’s really dependent upon your overall tolerance for risk. You really need to be able to define that asset allocation. And when you start looking at building that portfolio, remaining disciplined and you think of the rebalancing component of that, it’s still, again, for somebody who’s an accumulator, very far away from retirement, or close to retirement or even in retirement, it’s very much the same thing. You have to be disciplined.

Amy Chain: Time makes a big, big difference. Scott, anything to add?

Scott Donaldson: Well, I think the person mentioned they were about, what, 20 years?

Amy Chain: Twenty years.

Scott Donaldson: So if you think about it just from a time horizon standpoint, you could easily make the case that that person, without knowing anything else about them, could easily be more heavily oriented towards stocks. And really the primary reason for that is stocks are more risky, they’re more volatile, they certainly have greater return potential. So sometimes that takes years and sometimes decades actually for those higher returns to actually be realized. Time horizon really is only one aspect really of the equation. Another very, very important, and I might argue probably much more important even than time horizon, is how much tolerance for risk or tolerance or propensity to accept loss is really an investor willing to withstand? Because a 20-year or 30-year time horizon actually makes no difference and is somewhat meaningless if that person at the first sign of a market correction or a huge loss decides to abandon that investment strategy and sells out at the wrong time. The long-term time horizon really didn’t matter. So really asset allocation, and Bryan mentioned this, I think it’s a balancing act between time horizon, risk tolerance, and then some return objective that you’re actually trying to seek. And it can be vastly different for different people at the same age.

Amy Chain: Now when the time horizon is smaller, when it’s something more like five years or so from retirement, such as Ron from Ohio suggests, does that change? How do you think differently when the time horizon is smaller?

Bryan Lewis: It’s something that you definitely need to be on top of, right? So when you think of, you know, as you plan to step into retirement, you’re going from this focus of accumulating your assets to a point where now you’re shifting your mindset to maybe protecting more of what you’ve accumulated. And when you start thinking about what a lot of investors do and the conversations that I have with clients is they tend to, especially when interest rates are low, they tend to have a much heavier stock allocation. And I ask the question, “How would it feel if you had to continue to work? Say you’re a year from retirement and you had to continue to work for another five or six years, how would you feel?” And I usually get a chuckle and we talk through this, but it’s important, especially as you plan to step into this what I call pre-retiree status, you need to start planning ahead. And you really need to start shifting potentially from a very aggressive portfolio to maybe something that’s a little bit more balanced. And not to mention, I’m sure, there’s questions around can you retire and other aspects of retirement that you need to account for, and this is a big component of it.

Amy Chain: Those goals that were way off in the horizon as we were speeding down the highway are starting to come into view.

Bryan Lewis: Correct.

Amy Chain: So you have to start thinking about them a little bit more practically perhaps than before.

Scott Donaldson: Yes, and I think you should also keep in mind, though, because you’ve hit retirement and now you’re out of the workforce, you have a portfolio and you have income sources that are coming in, and based on your evaluation of your financial situation and what are those income sources, it may be totally appropriate for a person who is retired at 65 or they’re at 70 years old and have a stock-heavy allocation. Because they don’t need to access that, they may have a growth objective in the sense that they’ve got enough income coming in and a particular portfolio is really designed, in their mind to, say, provide for their heirs. I mean, we haven’t even talked about the impacts of investment decisions on tax and estate planning.

Amy Chain: And we will get there, but I think you bring up an important point. In fact, Donald asked us this question ahead of today. And Donald says that he’s 72 so his time horizon isn’t perhaps as long as some others. But I think, Donald, you do have a long time horizon, and that is something that you have to think about, right? So we often talk about how life expectancy goes a long way these days. And how should investors that are in retirement be thinking about making sure they have enough assets to last them for a long, long time?

Scott Donaldson: Right. Definitely they need to look at their situation and determine if still some growth, inflation still is a risk. A 72-year-old still could have easily another 15- to 20-year investment horizon ahead of them. And I think another way to kind of think about this long-term investment is not necessarily think about it in years as much as sometimes it could be a person with a five-year horizon. Think about it in a mindset or an emotional aspect, meaning if you’ve set a plan, it could be a very conservative plan of 30% stocks, 70% bonds because you have a short horizon. However, the long-term view could be in your tuning out the noise of daily, weekly, monthly, or even annual market moves that does not tempt an investor to move off their plan that nothing officially has changed in their lifestyle or their life circumstances that would warrant some move. But long term is more in a philosophy of you don’t need to do something every day just because the market or some news has come across the news wire.

Amy Chain: Now, Bryan, what would you say to someone like Sue from California who says that she has a pension that’s going to cover a large chunk of her income needs in retirement? How should Sue be thinking about her investment needs?

Bryan Lewis: Yes. The answer to that I don’t think, especially when I think of clients that I manage and continue to look at and you think of pensions and you think of Social Security and various sources of income, particularly on the pension side, a lot of people look at that as more of a fixed asset more than it’s just a stream of income. The points we’ve been making about asset allocation should not change based off that, and it’s very dependent upon your tolerance for risk. And that doesn’t change whether you have the source of income or not. What it could change is your overall goals for the portfolio. So, for example—

Amy Chain: And potentially the required rate of return that we talked about, right?

Bryan Lewis: Exactly. So if you start thinking about, “Alright, this is covering what I need,” you can start, shift your mindset to maybe legacy planning or whatever it might be that your goals can change. But it doesn’t mean that you should necessarily, because you have the stream of income, start shifting say to a more aggressive portfolio, which I believe is the tendency of a lot of investors that have this steady stream of income is to take more risk with the portfolio. And what you can find in a down market that it might be too aggressive.

Amy Chain: Now, Bryan, I’m going to stick with you. We’ve got lots of folks writing and asking you to talk to us more about your clients. Maybe talk to us a little bit about the way that you serve clients and how maybe some of our viewers that want to learn more can learn more.

Bryan Lewis: Yes. So I am part of what’s called Vanguard Personal Advisor Services. And what that is, is basically for clients that you think of all the things we’ve been talking about—defining your goals, building a balanced plan, using low-cost investments, and staying disciplined—a lot of the clients that I work with, they could do that well or they, you know, when I partner with them, I actually help to manage the portfolio. And the way I describe it is a lot of investors, you’re in the driver’s seat. Maybe periodically you pull the car over and ask for some GPS support from Vanguard. In the world that I live in, the idea is I’m in the driver’s seat, and I’m giving my clients more time to, whether it be work, they can spend more time traveling, family, or if they just are very uncomfortable about the management component of it, that’s when Vanguard can help. And what we do is we manage the clients’ accounts. We help you define your goals and build the portfolio. And we’re very proactive with our clients. So a lot of the clients that come to Vanguard are very self-directed, and there’s certainly nothing wrong with that. In Personal Advisor Services, the financial advisor is being proactive in reaching out to you basically every quarter to update you on the portfolio. And that’s something I, I build that relationship with my client. They have an advisor they can turn to; it’s the same person. And there’s other things to this that we haven’t really talked about as we’ve been focusing on the portfolio management. Well, there’s other wealth management components. You think of estate planning, when to take Social Security. These are all things that I help my clients do. And at a very low cost, we can probably increase the likelihood that we get you, as I say, from point A to point B, which is to get you through and meet these goals.

Amy Chain: This is important that we talk about how it helps. How does having an advisor help? And we often talk about the behavior coach aspect of it. Talk to me about how you can help investors as their behavioral coach when it comes to their investments.

Bryan Lewis: Yes. An example, January and February of this year, stocks are down. The tendency is who wants to lose money? And the reaction is I want to get out what’s not making money. And a lot of people want to try and deviate from that. And to my point earlier about when we analyze what a typical or an average investor does, one single transaction could be detrimental to the portfolio. And when you think of paying for this and the type of service, the methodology that we follow and really taking the emotion out of it, is going to pay off in the long run. When you start thinking about how do you build the portfolio, which investments do you hold in certain accounts to increase your after-tax return? Those are all important components that you need to think about. And then you think of particularly investors who are saving towards retirement, what investments do you buy? Or somebody who’s in retirement, they need to generate income, how do you create a stream of income? And those are all things that we help you with, and we do it tax efficiently. And, again, in the long run, you’re likely going to net out to have a better after-tax return.

Amy Chain: Tax efficiency, Scott, is something that you alluded to a little earlier in the conversation. Let’s talk about that for a minute. Talk about what we mean by tax efficiency, where investors should start with building a tax-efficient portfolio.

Scott Donaldson: Sure. It’s interesting; tax efficiency actually could be a topic in and of itself, I think, in one of these opportunities to talk to clients. But thinking about the various facets, I think, and Bryan hit on one, but if you think about it from starting, generally there’s several ways to gain tax efficiency. Tax efficiency to me is not necessarily minimizing taxes. So you could actually go out and buy an investment that loses money, okay, has no income distribution, you sell it at a loss, and you have no tax consequence of that. I don’t think anybody would be happy with that strategy necessarily, but it’s more about maximizing the after-tax return or maximizing what you keep from your investments. And there’s various strategies to do that. It can certainly start at the product level. There are products specifically designed to be tax-efficient. And an example would be say a tax-managed fund, that their mandate or their goals are to make trades or not make trades specifically to not incur taxes. Municipal bonds is a great example, a product or an investment category that actually is tax-exempt. And then once you move from the product level, you move to strategy or implementations. And there’s just different strategies that by nature are more tax-efficient. And a great example is the index-active debate. Generally speaking, a broad stock market index fund, something like a total stock market index, is much more tax-efficient generally than an actively managed fund. And it’s just by nature of the philosophies. Broad-market indexing being more of a buy and hold. Not a lot of transactions or turnover of names out of the portfolio, where an actively managed portfolio, say on the stock side, has certain price targets. And once a stock hits a price target, boom, they’re out of that stock and they’re into another one. Tax efficiency is not part of their goals because they’re managing assets for taxable investors as well as tax-exempt investors. So, generally the more active a strategy is, potentially the less tax-efficient that it can be. And then, finally, you move to an area of implementation at the portfolio level, something that Bryan mentioned, a strategy called asset location. Right, we’ve talked a lot about asset allocation, but asset location is purchasing your tax-efficient investments, like a broad stock market index, in your taxable accounts and then sheltering less tax-efficient investments such as taxable bond funds that literally every dollar that they return in interest and coupon is taxable. Sheltering those within a tax-advantaged account like an IRA, actively managed equity funds, sheltering them in an IRA to kind of overall manage that portfolio. And I think a strategy people don’t think about a lot is when they rebalance. How about rebalancing your portfolio or your stocks have went up? It’s time to sell stocks and move them back down to bonds. Do that in your IRA. Don’t do it outside of your IRA, right, is some things that certainly Personal Advisory Service and working with an advisor like Bryan can absolutely help you think through all of those various applications of being tax-efficient.

Amy Chain: And I’ll put in a plug now. If anyone would like to learn more about how our behavioral coaches can help you, you can check out the green resource widget that’s listed on your screen. And there’s more information on Personal Advisor Services there. Let’s stick with this sort of asset allocation discussion and answer a question that came from Jennifer in Minnesota. Jennifer is asking whether or not it’s appropriate to change your asset allocation, depending on the financial environment. When there’s a bull market in place for longer than average, should either looking back or projections about the future affect what you’re doing with your portfolio?

Scott Donaldson: Yes. I mean, we’ve talked a lot about, again, the asset allocation and making sure that it’s right for your particular goals. If you’ve determined an asset allocation is right for you, the market continues on and continues to grow, and a prolonged bull market occurs. The plan that you set up, or should, and hopefully includes some sort of a rebalancing strategy back to that asset allocation is certainly going to be a mechanism that’s actually going to help. And it’s not from a, oh, it’s time to get out because the bull market’s longer than history. It’s more about the process that you’ve set up ahead of time that on a one-year basis if we’re more than X percent out of whack on our asset allocation, it’s time to sell some stocks. So it’s an automatic rebalancing that should handle that. But, again, I think importantly what also I’m hearing in this question a little bit is also don’t let the market noise on a day-to-day basis take you off of that plan. Generally speaking, and maybe Bryan, you can add to this, is it’s not that you never change your asset allocation. There are certainly times to change your asset allocation, but it’s more in line with life events that occur. I’m retiring now, right? We just had a new child. Different reasons to change your portfolio. Not because the market is either way up or way down, unless those market moves have gotten you to rethink your true risk tolerance. And we have these conversations all the time. When you ask somebody, “Would you be comfortable if the stock market went down 20% if you knew that the long term you had a chance to get a much higher return?” Usually people say, “Oh, yes, yes. I would hang on to that.” However, in reality, from all the clients that I’ve worked with, when you’re living it and the market is actually down and your balances or your retirement balances are actually down 20 or 30%, it’s a very, very emotional time. And that’s when the true test of what risk tolerance is, so you really need to be reflective of that when setting up your plan. So if the market’s down 20 and you’re an 80% equity investor, you just go on about your business because you’ve already expected that that should be part of what’s going to happen at some point in the future.

Amy Chain: Talking about expectations, let’s talk about the bond market for a minute. This question is coming from Jeffrey in Ohio. “What long-term total return assumption should be made for the fixed income portion of my portfolio?” Scott, maybe you can get us started on this one.

Scott Donaldson: Sure, sure. I mean, we, obviously, and everybody knows and we’re aware that we’ve been in this low-return, low-interest-rate environment now for roughly a decade. And it’s been a challenge for savers and investors in heavy fixed income portfolios because the yields on bonds have been so low. But bonds are a different animal than equities and part of the reason that they generally have lower returns and lower volatility is because of their structure, right? Contractual obligations to pay back a certain principle balance on a certain date. Okay, so it’s a structural, mechanical aspect to bonds. So much easier, not perfectly able to do so, but to forecast or acknowledge what future returns on bonds are, are a little bit easier to do or expect the range to be much narrower than equities is because of that. And a good way to do it is to look at the current yield. Right, so if you look at, I think the ten-year Treasury bond today closed somewhere around 1.75%. That’s a good indication that your return expectation on a bond today yielding 1.75, your return over the next ten years is going to be 1.75 a year. Give or take there certainly can be appreciation and depreciation a little bit on the values, depending on when you sell the bond, but current yield is a very good return assumption. So you’re looking at bond expectations today over the next ten years anywhere from 2 to 3%.

Amy Chain: Bryan, what are you telling your clients?

Bryan Lewis: Yes, and that’s, especially for somebody who’s very focused on generating income, it’s difficult. Right, when you especially look at the historical average return of bonds, they’re anywhere from 5 to 5.4% in that range.* And then you’re looking at, to Scott’s point, about potentially getting half of that, it’s difficult. And what the mindset is, let me try to look for other investments that potentially could give me more yield. And that’s when you start to drift from the plan, the target asset allocation. You start maybe considering dividend-paying stocks versus the bonds or even junk bonds or high-yielding bonds, and you’re really starting to increase the risk of the portfolio. And as I talk through these kinds of discussions, you start talking about well, what are your thoughts of instead of maybe losing 20%, now you’re buying more stocks. What are your thoughts about even losing 30%? And you look at this and to the point of yields, I mean, it’s challenging when interest rates are this low. However when you start looking at, for retirees, as an example, I was talking to a few people earlier today, where you start to look at, all right, what’s a reasonable spending strategy? And you can’t just look at the yield anymore. You need to look at what we call total return spending, and you look at managing not only the capital appreciation of an investment but also the income. And the combination of the two you get what’s called this total return aspect of it. So there’s other ways to manage the risk, but when you start looking at where yields are and you start shifting the portfolio, that’s again when you’re starting to drift from your strategy and you’re increasing the risk.

Amy Chain: Okay, and we’re going to have to wrap on that note. Any final thoughts for our viewers before we close this evening?

Scott Donaldson: Just to support the idea of stick with your strategy, define those goals that you have, look at sticking with the overall allocation, revisit this on a semiannual to annual basis, make sure you remain disciplined. And if you do find that this is something or anything that we’ve talked about or just the fact that it might be overwhelming, Vanguard’s here to help. Whether we’re managing it for you or not, you just need to pick up the phone and give us a call and we’re happy to help. And we really want to increase the likelihood of success for you.

Amy Chain: I couldn’t have said it better myself. So I’ll say to all of you that in a few weeks we’ll send you an email that’ll have a link to view some highlights from today’s webcast along with some transcripts for your convenience. And if we could have just a few more seconds of your time, please select the red survey widget. It’s the second one from the right at the bottom of your screen, and respond to a quick survey. We really appreciate your feedback, and we welcome any suggestions you have about topics you’d like us to cover in the future. And be sure to watch your email for an invitation for our next webcast. On May 19 at 7 p.m., we’ll be talking about “Extending Your Life,” “Extending the Life”—we’d love to extend your life, but we’ll be “Extending the Life of Your Retirement Savings Portfolio.” So we hope you’ll join us then. But for now from all of us here at Vanguard to you, we want to say thank you for being with us this evening.

*Source: Vanguard. Data as of December 31, 2015.

Important information For more information about Vanguard funds, visit or call 877-662-7447 to obtain a Prospectus or, if available, a Summary Prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the Prospectus. Read and consider it carefully before investing. All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your minimum investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Currency hedging risk is the chance that currency hedging transactions may not perfectly offset a security’s foreign currency exposures and may eliminate any chance for a securtity to benefit from favorable fluctuations in relevant currency exchange rates. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Investments in Target Retirement 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 the Target Retirement Fund is not guaranteed at any time, including on or after the target date. This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation. Advisory services are provided by Vanguard Advisers, Inc. (VAI), a registered investment advisor. © 2016 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.