[My alternative title for this article could be, “My Kids Roth IRAs’ Asset Allocation.” However, you don’t have to have a kid Roth IRA or a kid to take advantage of some of the ideas here.]
I’ve written about my kids’ Roth IRAs before. One of the benefits of dog sitting is that they can help, get paid, and legally save money for retirement that they’ll never have to pay taxes on. It’s not a lot of money, but a minimum of 50+ years of compounding is very powerful.
One thing we recently learned from Peter Thiel’s Roth IRA is that high-growth assets can make huge gains over time. Their dog money will never be compared to early shares of Paypal at a fraction of a penny, but it will still give them a tremendous leg-up in retiring early. Every dollar that they put in now will grow to $11.50 if it compounds at 5% – a reasonable number after inflation.
To get that 5% after inflation they’ll have to invest aggressively. They’ll have to take some risks, but with a balanced portfolio and 50-years to recover from the inevitable crashes, it shouldn’t be a problem.
It’s with this thought in mind that I decided it was time for me to formally create:
My Kids Roth IRAs’ Investments
The challenge is looking for high-growth investments for a long time in the future. However, I also want to be highly diversified as my crystal ball has been in the repair shop. This means that I’m going with a 100% stock portfolio. I’m not going to have any bonds, cash, or anything that I don’t think can reasonably return 8-10% over the long term.
For a number of years, I’ve read that small capital stocks perform a little better than large stocks. This makes sense since small capital stocks can double a lot easier than a very, very big company. The United States has had a great run, but I think international stocks have more growth potential over the next 50 years. They have better valuations if you use traditional methods like Shiller P/E.
For those two reasons, this portfolio will be weighted a little more towards those areas than many experts would typically suggest.
With that in mind, I focused on a set of six ETF that I believe get me to my goal. I specifically chose Vanguard (with one exception) because I know their expense ratios are going to be very, very low. I want my money working in the markets, not in managers. Those ETF are:
- Vanguard Total Stock Market (Ticker: VTI)
VTI is a staple for almost any investment portfolio. It is one-stop shopping for the United States stocks. Unfortuately, it has a lot of technology controling it, so remove that tech risk by diversifying with other US-based ETFs. Return Since inception 05/24/2001: 8.80%
- iShares Core High Dividend ETF (Ticker: HDV) – The one non-Vanguard fund is a high-dividend ETF from iShares. Vanguard has a high-dividend ETF too, but a while back, for reasons I no longer remember, I like HDV more. In my view, this is a great way to remove tech risk from your portfolio. It’s got boring companies that simply make money and return it to shareholders. You won’t find Google in it, but you will find consumer staples, energy, health care, and utlities stocks. Return Since inception 03/29/2011: 10.34%
- Vanguard Small-Cap ETF (Ticker: VB) – Remember my focus on the returns of small-cap stocks? This is a great way to “fix” the unbalanced nature of VTI. VTI weighs holdings by market cap, so the biggest companies dominate it. This gives me more small companies that hopefully can be more nimble and score big wins over 50 years. The index will cycle out companies appropriately over that time. Return Since inception 01/26/2004: 10.35%
- Vanguard FTSE All-World ex-US ETF (Ticker: VEU) – This ETF invests in stocks outside the United States. Like VTI, it’s a good core holding. However, I’ve found that it mostly focuses on developed countries and stocks. That’s not bad if that’s your goal, but I think emerging markets have real growth potential especially over the long haul. For that reason, I added the next ETF. Return Since inception 03/02/2007: 4.32%
- Vanguard FTSE Emerging Markets ETF (Ticker: VWO) – This is a pure emerging markets play. Just like how HDV helped balance VTI, this helps balance my overall international exposure. Return Since inception 03/04/2005 – 6.99%
- Vanguard FTSE All-World ex-US Small-Cap ETF (Ticker: VSS) – This ETF is a mouthful, right? It’s a combination of VEU and VB… a mix of international small companies. One could reasonably leave this out of the portfolio, but I loved how it honed on the two things that I was looking to weigh more: small companies and international. I think this will have many companies that aren’t represented in VEU or VWO. Return Since inception 04/02/2009: 11.11%
It doesn’t seem like the VEU and VWO historical return is going to improve our gains. However, because they have better valuations, I feel more confident that they’ll perform better in the future while US stocks will trend back to historic norms.
My Kids Roth IRAs’ Asset Allocation
So I’ve got my six ETFs. The problem is solved, right? Nope, not exactly. I still have to figure what percentage of each to buy. I can’t just buy the same amount of shares of each. They have different prices. I don’t want to get into fractional shares. I also don’t want to leave too much cash uninvested.
I opened up my spreadsheet program and put the tickers in one column. Then I put the share prices in the next column. In the third column, I guessed the number of shares for each. Then I multiplied it across to get a total investment for each ETF. Then I added up all the totals and made sure that my kids would have enough to buy the ETFs. If I had too much money left over, I switched up my guesses on the number of shares to buy. However, I always tried to keep the ratios around where I wanted them to be.
Finally, I got some numbers that looked like they’d work. Was I ready to buy? Nope, not yet. I had to check my work.
I asked my friend if there was a tool that analyzed a group of ETFs and told you how diversified your portfolio was. She pointed me to a TD Ameritrade version of Morningstar’s X-Ray tool. I felt like an idiot, because I had written about Morningstar’s Instant X-Ray tool back in October of 2006. It’s the perfect tool for the job.
So I put the numbers in and found that I had too many large caps and more developed Europe stocks than I intended. I adjusted my guesses trading some VEU and VTI for small-cap stocks and got this result:
I think that result is beautiful. Information Technology is still the highest sector, but it’s only 16.5% of the portfolio. No single industry dominates the portfolio, so it is well-diversified from that perspective. Sixty percent of stocks in North America are more than I had originally wanted, but it’s not bad. Perhaps I could tweak it by changing my guess to add more to VSS and less to VB.
Finally, the stock-style box at the bottom looks good. It still has a little more large-cap stocks than small caps, but it is much more balanced than what most people have with a core holding of VTI. That holds so many large companies that the small companies can’t move the index. It’s also worth noting that the expense ratio is a low 0.07%. I’m not giving very much money to the managers at all.
How did the percentages work out to make this X-Ray? Because the kids have different amounts in their Roth IRAs, I don’t have the same exact percentage for each of them. If I did, I would be stuck buying fractional shares or not putting all the cash to work. It roughly turned out to be:
VTI – 17.5%
HDV – 5.3%
VB – 33%
VEU – 24%
VWO – 14.5%
VSS – 5.32%
Due to rounding, this doesn’t add up exactly to 100%, but it is close. So now, you can replicate something close to this with your own portfolio if you choose to do so.
Next Year’s Plan
The plan for next year would be to add REITs into the mix. I originally didn’t think REITs performed well enough to be included in a long-term high-growth plan, but they definitely can be included. So I’ll buy some VNQ (Vanguard’s main REIT ETF) next year. Also, I can work on the above point about including more small foreign companies instead of domestic ones.
You might have read all this and thought, “That’s great, but I don’t have kids” or maybe, “That’s great, but my kids don’t have Roth IRAs because I don’t have a dog sitting business.” You can come up with a hundred reasons why this specific circumstance doesn’t apply to you. However, I would argue that the process that I used can be useful for you and your asset allocation. You might have to add more bonds or change your objective, but the concept can work in any investment scenario.
I do have to leave you with one more final, final thought. I have a lot of fun with this stuff. I’m weird. You are likely not as weird as I am. I’m (attempting) to optimize this to an extreme level and it makes everything a little more complicated. Investing doesn’t have to be complicated though. Most people could put 65% of their money in VTI and 35% in BND (a Vanguard bond fund) and spend more time doing something they love. I never want to scare anyone away from investing, even if this article might be for more advanced investors.