A Sleep-Well Portfolio

The equity fund should use those assets that can remain invested for the long haul.  The T-note ladder should also be treated as a long term investment, though it can serve as a source of emergency funds.  However your liquidity needs should be kept in a good money market fund. 

Index Funds

For the equity index fund, I recommend the Vanguard Index 500, although the Vanguard Index Total Market fund is also a good choice.  They are both very low cost funds that closely track the S&P500 index and the broad market Wilshire 5000 index, respectively.  Both offer excellent diversification in the U.S. equities market. 

An index fund will never be among the top-rated equity funds, yet if it is low cost it can be counted on to do better than about two-thirds of the managed equity funds, on average.  If you are concerned about accumulating too much of your savings at one fund company, there are other broad market index funds available, although most are not as good as the Vanguard funds. 

Why not buy the best performing funds?  You have only to look at the record to see that the top-rated funds are constantly changing. Managers come and go, and even the best ones have off years when they produce below market-average returns.  With an index fund you never need worry about the manager losing his touch or leaving.  He makes no judgement calls, but simply keeps the fund’s assets allocated in proportion to the market capitalization of its component stocks.  For this reason index funds have a low turnover in stocks, which means low realized (taxable) capital gains compared to most managed funds. 

Asset Allocation

Equities should be the core investment because that is where the long term growth potential lies. Over the years, the annualized total return on the S&P500 index has averaged about twice as much as the return on long-term bonds.  That can make a huge difference for the buy-and-hold investor.

As a rough guide, equities should comprise about (100 minus your age) percent of your portfolio. But this really depends on your tolerance for the short term volatility of equity prices. Even though only paper losses are involved when the market value of your index fund drops, as it surely will from time to time, it makes no sense to lose sleep over it. This is where the T-note ladder comes in. It will reduce the variability in the total value of your portfolio, albeit at the expense of lower long term gains. 

Ladder of Treasury Notes

A T-note ladder is simply a set of Treasury notes that will mature at roughly equal intervals.  It can be kept going by rolling over each note as it matures.  The notes can be bought for as little as $1000.  The average maturity of the ladder could range from 1 to 2.5 years, depending on whether you are rolling over 2-year or 5-year notes. The latter will produce somewhat greater income, but its market value will be more sensitive to changes in interest rates. 

T-Note Ladder vs Bond Fund

Why not use a medium term bond fund instead of a T-note ladder?  There are two good reasons. One is that the T-note ladder is expense-free if you buy through the Treasury Direct plan, while bond funds typically have expenses that can consume 10 percent or more of the earnings. The other is that a bond fund has no date-certain market value.  Its value is constantly fluctuating with interest rates.  Thus it may not provide the counterbalance for the volatility in your equity fund that you were seeking. 

While it is true that a bond fund is easier to manage, the Treasury Direct program is very easy to use.  You can now buy any new Treasury security over the Internet after you have set up an account.  A link to the Treasury Direct website is given in "How to Buy Treasury Securities" under Background Information.

Diversification

This two-component portfolio will not maximize your reward/risk ratio.  Further diversification, for example into international funds, might improve the performance.  There are many international regional index funds that attempt to track benchmarks for their regions, much like the S&P500 index funds track the stock prices of major companies in the U.S.  However adding such diversification does require more effort in terms of monitoring international developments.  In my opinion the potential rewards are likely to be small and not worth the effort for many investors.

No Middle Men

The one real problem with the “sleep well portfolio” is that it’s boring. There is no need for an investment adviser, no brokers to deal with, no mutual fund load charges, and no sales commissions. It is virtually expense-free. You can safely ignore your portfolio between quarterly statements and have confidence that in the long run your assets will grow very nicely. 

For those who want to learn more about this kind of investing, I recommend the following two books: Bogle on Mutual Funds by John Bogle, and The Bond Book by Annette Thau.  Both are available in any good bookstore.