Survive the Market: Your Two-Fund Solution

investing

This week, I'm going to keep it simple.

I'm going to suggest a simple way to invest that provides broad diversification, an opportunity to participate in market upswings and a buffer against downturns at a minimal cost.

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Sound too good to be true? Of course, it is. But the strategy I have in mind is a sensible way to get started with a long-term plan for investing after the most brutal period any of us could have imagined.

It's what I'll call the Two-Fund Solution, a simple yet elegant way to construct a portfolio that can overcome the forces of procrastination and indecision. It is not intended to be a finished product but rather a solid building block for the future.

As the name implies, the Two-Fund Solution involves the purchase of two broadly based mutual funds. The intent is to make it as easy as possible to implement.

The first is an index fund designed to track the overall U.S. stock market. Such funds usually are called total stock market funds. My favorite is the Vanguard Total Stock Market Index Fund, but there are similar funds available from Fidelity, Charles Schwab and T. Rowe Price among others.

A total stock market fund will allow you to capture the long-term rewards of stocks in a low-cost, tax-efficient manner that provides broad diversification across all segments of the market from large caps to small caps.

The second fund is one that tracks the overall U.S. bond market. Again, these kinds of funds are usually called total bond market funds. I like the Vanguard Total Bond Market Index Fund, but other mutual fund families offer good choices, as well.

Again, a total bond market fund exposes you to all segments of the bond market and eliminates the need to guess when is the best time to invest in particular portions of the bond market.

Together, the total bond and total stock funds allow you to establish a solid foundation that either you can build upon or allow to stand on their own for years to come.

Making Up for Missing the Stock Market Rally

If all you ever did in life was to invest in a total stock market fund and a total bond market fund along with some cash, you'd still be doing pretty well compared to many who view investing as an all-or-nothing activity, buying high and selling low as they chase last year's top performers.

I won't pretend this is the most finely-tuned portfolio out there, but it's also one that won't get you into a whole lot of trouble.

The audience I have in mind for the Two-Fund Solution is those who missed out on the recent stock-market rally as they sat on a pile of cash.

Either they knew they wanted to invest but recent events made them nervous and indecisive. Or they panicked during one of the past year's free falls and liquidated everything in favor of cash. In both cases, they are just unsure how to move forward

The key question these investors face is what portion of their assets they should allocate to each of these funds.

My recommendation for those who remain skittish is that they move slowly at a pace they're comfortable with. The Two-Fund Solution can be implemented all at once or in a series of steps.

For the nervous investor, a logical first step might be to dedicate half of your savings to the Two-Fund Solution and keep the remaining assets in cash. Then, evenly divide the noncash half between the total stock market fund and the total bond market fund.

If you're a little more aggressive, you might keep a quarter of your savings in cash and then split the rest between the total stock market and total bond market funds.

In either case, you can move more cash into each fund as you become more comfortable with this strategy.

Going Global: The Three-Fund Solution

You might also consider a move to a Three-Fund Solution, adding to the mix a total international stock market fund. For a conservative investor, an appropriate mix might be 50 percent total bond market, 35 percent total U.S. stock market and 15 percent total international stock market.

The international fund can be added at the beginning, or somewhere along the line, depending on how easy you want to make it.

Keep in mind, the Two-Fund Solution (and the Three-Fund version) is not without risk. In the past year, just about any portfolio other than one invested entirely in cash lost money. But a heavy allocation to a total bond market fund would have mitigated losses.

For instance, suppose you invested $50,000 each in the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Fund at the beginning of 2008. At the end of last week, such a portfolio would have been worth $86,143, assuming your reinvested your dividends, according to Morningstar.com.

That amounts to a 14-percent decline in your initial $100,000 investment. But such a loss pales in comparison to a 37-percent drop in the Standard & Poor's 500 Index, a benchmark for U.S. large cap stocks.

On the flip side, a large allocation to a total bond market fund will also dampen returns when the stock market rises as it has done since mid-March. My 50-50 Two-Fund Solution rose about 4 percent in April compared to the S&P 500's 10-percent gain.

That's why each investor has to decide for themselves the appropriate potential risk-versus-reward balance. Whatever the right mix for you, the Two-Fund Solution can be a simple way to get started on a sound path toward long-term investing.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.

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