by Archie M. Richards, Jr., CFP^®
June 4, 2001

I have recommended in these columns that you place half your money in a broad index fund of domestic stocks, say, the Vanguard Total Stock Market Index Fund, and the other half in a broad index fund of foreign stocks, say, the Vanguard Total International Stock Index Fund. (Look, I'm not married to Vanguard, but in terms of low cost and low turnover, sorry, they're the best.)

Domestic stocks and foreign stocks don't rise and fall together. As explained by Roger Gibson, author of Asset Allocation, they're in different asset classes. The timings of their fluctuations differ. As one class falls, another may rise.

Over the long term, regular U.S. stocks have had the best record of any asset class, but they're roller coasters. When you diversify appropriately to several asset classes, the overall performance is about the same, but the diversification cuts the portfolio's volatility.

Small stocks count as an asset class. But separate diversification here is unnecessary, because the Vanguard Total Stock Market Index Fund, which tracks the Wilshire 5000, owns many small stocks in suitable proportions.

The stocks of developing countries are another asset class. But again, separate diversification is unnecessary, because the portfolio of the Total International Stock Index Fund includes them.

To make room for investment groups that should be owned separately, I suggest reducing the proportions of the Total Stock Index Fund and the Total International Stock Index Funds from 50 percent to 30 percent each. This leaves 40 percent to go.

Place 20 percent in the Vanguard Long-Term Bond Index Fund. (Put this one in your IRA, if you can, to render the income non-taxable.) Bonds fluctuate differently from stocks, and they perform especially well during periods when inflation is declining. Interest rates fall when inflation lessens, causing bond prices to go up. I expect government policies to continue improving in the next twenty years, as they have been doing in the last twenty. I therefore look for inflation to fall below zero, becoming benign deflation. Yes, I know, government policies improve in fits and starts. Senator Jefford's departure from the Republican Party is a fit. But for the first time in sixteen years, the Vermont House of Representatives recently went Republican; that's a start.

Except for modest reserve funds, avoid short-term debt like Treasury bills and money market funds. As inflation declines, the interest they generate will fall, as has generally been occurring for two decades.

For the final segment, turn to real estate. If you already hold sufficient real estate for investment purposes, add no more. Otherwise, apportion 20 percent of your portfolio to the Vanguard REIT Index Fund. Real estate investment trusts (REITs) trade as stocks, each one holding a portfolio of real estate. The REIT Index Fund owns shares of almost all REITs, providing interests in houses, apartments, industrial properties, hotels, office buildings, and even undeveloped land.

Over time, the proportions of these four mutual funds will change. Let's say that international stocks perform especially well, rising from 30 percent to 40 percent of the portfolio. Without rebalancing, you would hold too much at the beginning of the subsequent decline. Alternatively, assume that the internationals fall to only 20 percent of the portfolio. Without rebalancing, you would hold too little at the beginning of the subsequent advance.

Allow the funds to fluctuate within ranges, say, 23-to-37 percent for the domestic and internationals stocks, and 15-to-25 percent for the bonds and REITs. When a fund exceeds its range, sell a portion and add to one or more of the others. If you withdraw cash, do so from the fund that's on the high side. If you add cash, put it in the fund that's on the low side.

Multiple-asset-class investing works. Strangely enough, this can cause a problem. When one of the investment groups performs particularly well, many investors, including your friends, will pile on board, using insufficient diversification. Their money will grow faster than yours for a while, maybe even for years, making you feel behind the eight ball. When you rebalance your portfolio, you'll be selling a portion of investments that temporarily are unusually profitable for the others.

It's tough to buck the crowd, but continue using and rebalancing multiple-asset classes anyway. Tell your friends you have no investments. Maybe they'll feel sorry for you and give you money.

With multiple-asset classes, you're likely to come out ahead. The roller coaster ride will certainly prove less scary.