Just as you may need a new suit if you lose or gain weight, sometimes you need to tailor your portfolio in response to changes in your life. Rebalancing your portfolio, making tactical adjustments, and harvesting losses for tax purposes aren't the only times it may make sense to trade exchange-traded funds (ETFs).
The prime consideration in portfolio construction is whether you can and should take risks in the hope of garnering high returns or whether you must limit your risk with the understanding that your returns will likely be modest. (Diversification can certainly help to reduce investment risk, but it can't eliminate it.) Certain events may occur in your life that warrant a reassessment of where you belong on the risk/return continuum.
Marriage, divorce, and the arrival of babies are major life changes and need to be weighed heavily in any investment decisions. So, too, are the death of a spouse or parent (especially if that parent has left a hefty portfolio to the adult child); a child's decision to attend college; any major career changes; or the imminent purchase of a new house, new car, or Fabergé egg.
Betsy and Mark: A fairly typical engaged couple
Betsy and Mark are engaged to be married. They don't have a lot of money. But both are young (early 30s), in good health, gainfully employed, and without debt. They plan to merge their savings of roughly $37,500 and invest it for the long haul.
The first thing they do is to decide how much money to take out to cover emergencies. Given their monthly expenses of roughly $3,500, they need to earmark five months' of living expenses — $17,500 — and plunk that into an online savings account. That leaves them with $20,000 to invest.
Normally, you wouldn't consider an ETF portfolio for $20,000, but this is money they aren't going to touch until retirement. They both need to open a Roth IRA. (Any money you put into a Roth IRA grows tax-free for as long as you wish, and withdrawals are likewise tax-free.) They divide the $20,000 between the two accounts. Since each of them can contribute $5,000 per year, they both make double contributions — one for the past year (for example, you can make your 2015 contribution until April 15, 2016), and one for the current year.
To save on transaction costs and keep things simple for now, limit the number of investments giving each partner a "partial" portfolio. Neither account alone is well-diversified, but together, they are.
Betsy's Roth IRA:
| Vanguard Mega Cap 300 ETF (MGC) | $4,000 |
| Vanguard FTSE All-World ex-US Small Cap Index ETF (VSS) | $3,000 |
| Vanguard Total Bond Market ETF (BND) | $3,000 |
Mark's Roth IRA:
| Vanguard FTSE All-World ex-US ETF (VEU) | $4,000 |
| Vanguard Small Cap ETF (VB) | $3,000 |
| Vanguard Total Bond Market ETF (BND) | $3,000 |
As Betsy and Mark's portfolio grows, they should plan to add other asset classes (real estate investment trusts, natural resource stocks, inflation-protected securities, and so on) and other accounts.
One year later — how pregnancy and buying a home affect their portfolio
Betsy is pregnant with twins! The couple is saving up for their first home, with a goal of making that purchase within 18 months. Although IRAs are normally not to be touched (without stiff penalty) before age 59-1/2, an exception is made for first-time home purchases. Betsy and Mark could take out as much as $10,000 without penalty.
They would prefer to leave their Roth IRA money untouched, but the couple think the money may need to be tapped. At this point, the money in the Roth IRA has grown from $20,000 to $22,000 (for illustration purposes, say that each investment grew by an equal amount), and Betsy and Mark can each contribute another $5,000 in fresh money, bringing the total of both accounts to $32,000. Since there is a possibility that $10,000 will need to be yanked in one year, earmark any fresh money to a fairly nonvolatile short-term bond ETF.
Betsy's Roth IRA:
| Vanguard Mega Cap 300 ETF (MGC) | $4,400 |
| Vanguard FTSE All-World ex-US Small Cap Index ETF (VSS) | $3,300 |
| Vanguard Total Bond Market ETF (BND) | $3,300 |
| Vanguard Short-Term Bond ETF (BSV) | $5,000 |
Mark's Roth IRA:
| Vanguard FTSE All-World ex-US ETF (VEU) | $4,400 |
| Vanguard Small Cap ETF (VB) | $3,300 |
| Vanguard Total Bond Market ETF (BND) | $3,300 |
| Vanguard Short-Term Bond ETF (BSV) | $5,000 |
Yet one year later — continuing to adjust the portfolio to major changes
The twins (Aiden and Ella) have arrived! Much to their surprise, Betsy's parents have gifted the couple $10,000 for the purchase of the home. The Roth IRA money needn't be touched. At this point, they should sell the short-term bond fund and add to their other positions. Also, provided the couple had another $5,000 each to contribute, they should begin adding asset classes to the mix, perhaps starting with the iShares Barclays TIPS Bond Fund (TIP), the SPDR S&P Global Natural Resources ETF (GNR), the Vanguard REIT ETF (VNQ), and the Vanguard Global ex-US Real Estate ETF (VNQI).
Hopefully, Betsy and Mark (and Aiden and Ella) will have many happy years together. And with each major life event, they need to adjust their portfolio appropriately.