3-fund portfolio rebalancing

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fire2031
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3-fund portfolio rebalancing

Post by fire2031 »

I'm in the process of setting up a taxable account for my wife and I (for possible early retirement) as well as a few 529 accounts for our children. All accounts will be with Vanguard, and I want to be managing them more or less passively. I'm looking for some guidance on selecting investments.

Specifically, I'm looking into setting up 3-fund portfolios for each account. I'm not sure if I should select a static 3-fund portfolio, or an auto-balancing 3-fund portfolio (like a Vanguard Target Retirement Fund or Target Enrollment Fund). A static strategy seems to have lower fees and higher return rates, but it will not rebalance.

Is anyone using static 3-fund portfolios? If yes, do you periodically re-balance them at all yourself?

Is re-balancing a 3-fund portfolio really necessary, since it's already so diversified? Meaning, given that the risk level of a 3-fund portfolio is already low, is the expense and effort involved in rebalancing it worth it? I know the answers to these questions will vary depending on the risk tolerance someone has, but I'm looking for general best practices and personal experiences you might want to share.

Thanks a lot.
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Re: 3-fund portfolio rebalancing

Post by samsoes »

I may be weird, but I enjoy rebalancing my 3-fund portfolio. My rebalance bands are 3% absolute, or 20% relative, whichever comes first. In other words, if my target allocation is 40%, I'll rebalance below 37% and above 43%. If my target allocation is 10%, then I'll rebalance at +/- 2%, since 20% of 10% = 2%.

Most importantly: follow the rebalance rules strictly. Don't panic-sell in a down market. And don't tinker with it before hitting a rebalance boundary, because a stock portfolio is like a wet bar of soap: the more you touch it, the less of it you have.
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livesoft
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Re: 3-fund portfolio rebalancing

Post by livesoft »

Do you care about paying income taxes on your taxable investments? I think one should care about that and invest in a way that does not add too much to one's income taxes. What is your marginal income tax bracket for both federal and state income taxes?

The risk of a 3-fund portfolio is not low. Where did that come from?
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fire2031
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Re: 3-fund portfolio rebalancing

Post by fire2031 »

livesoft wrote: Sat Jul 31, 2021 9:26 am Do you care about paying income taxes on your taxable investments? I think one should care about that and invest in a way that does not add too much to one's income taxes. What is your marginal income tax bracket for both federal and state income taxes?

The risk of a 3-fund portfolio is not low. Where did that come from?
Of course I care about taxes. I'll be buying and holding these investments, so I expect the tax implications to be minimal until I withdraw, these being Vanguard funds. No idea at the moment where my tax bracket will be when I withdraw. How does tax depend on rebalancing?

My research has turned up 8+% return rate for a 50/30/20 Vanguard 3-fund portfolio, historically. As far as stock investments go, the risk in a 3-fund portfolio should be at the low end, given the diversification, shouldn't it?
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Re: 3-fund portfolio rebalancing

Post by livesoft »

fijoy wrote: Sat Jul 31, 2021 9:40 amOf course I care about taxes. I'll be buying and holding these investments, so I expect the tax implications to be minimal until I withdraw, these being Vanguard funds. No idea at the moment where my tax bracket will be when I withdraw. How does tax depend on rebalancing?
Dividends are income that shows up on your Form 1040 tax return. Rebalancing could create capital gains that will show up as income on your Form 1040 Schedule D. Dividends could be non-qualified, qualified, and/or tax-exempt interest dividends which are all generally taxed different ways.

A 50/30/20 3-fund portfolio might lose 40% of its value. I would call that risky.

The 8+% return is probably before taxes. If you are paying 40% total tax rate on the dividends and realized capital gains each year, then you will be unlikely to achieve that 8+% return. Most people would not be paying a 40% total tax rate on investment earnings, but folks who live in places like NY and CA might be unless they pay attention and actively do things to make sure they do not.
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fire2031
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Re: 3-fund portfolio rebalancing

Post by fire2031 »

livesoft wrote: Sat Jul 31, 2021 9:50 am Dividends are income that shows up on your Form 1040 tax return. Rebalancing could create capital gains that will show up as income on your Form 1040 Schedule D. Dividends could be non-qualified, qualified, and/or tax-exempt interest dividends which are all generally taxed different ways.

A 50/30/20 3-fund portfolio might lose 40% of its value. I would call that risky.

The 8+% return is probably before taxes. If you are paying 40% total tax rate on the dividends and realized capital gains each year, then you will be unlikely to achieve that 8+% return. Most people would not be paying a 40% total tax rate on investment earnings, but folks who live in places like NY and CA might be unless they pay attention and actively do things to make sure they do not.
Thanks @livesoft. Agreed that rebalancing will have tax implications. Also agreed that a 50/30/20 fund is subject to risk short term.

My original question is really about the need for rebalancing in a buy and hold long-term strategy with Vanguard index funds, with benefits like the 8+% returns long term and tax-efficiency (due to their patented 0 capital gains method and low dividends) that go with them.

The options I have are:
1. Pick a static 3-fund strategy, like 50/30/20. Just buy and hold it. If the stock market is down when it comes time to withdraw, assume I'll have other stock-independent funds to rely on until the market is back up.
2. Pick an initial 3-fund strategy, like 50/30/20, and manually rebalance it, say every 3 years.
3. Pick an auto-rebalanced 3-fund investment, like VTIVX

Does an auto-rebalancing fund (option (3) above) in a taxable account create a a taxable event every time it rebalances?
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retired@50
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Re: 3-fund portfolio rebalancing

Post by retired@50 »

fijoy wrote: Sat Jul 31, 2021 10:32 am
3. Pick an auto-rebalanced 3-fund investment, like VTIVX

Does an auto-rebalancing fund (option (3) above) in a taxable account create a a taxable event every time it rebalances?
No.
The taxes you'll pay with a fund like VTIVX are just from bond interest and stock dividends. The fund gets to move stuff around without creating a taxable event for you, the shareholder.

ETA: Is there some reason you're not just holding 100% stock in taxable and using a tax-deferred retirement account to hold bonds and do rebalancing? Typically, that works out pretty well.


Regards,
Last edited by retired@50 on Sat Jul 31, 2021 10:39 am, edited 1 time in total.
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Re: 3-fund portfolio rebalancing

Post by pkcrafter »

fijoy wrote: Sat Jul 31, 2021 9:02 am I'm in the process of setting up a taxable account for my wife and I (for possible early retirement) as well as a few 529 accounts for our children. All accounts will be with Vanguard, and I want to be managing them more or less passively. I'm looking for some guidance on selecting investments.

You can hold some tax-efficient funds in taxable and non-tax efficient funds in in tax-advantaged accounts. It's the overall portfolio you have to maintain.

Tax-efficient fund placement

https://www.bogleheads.org/wiki/Tax-eff ... _placement


Specifically, I'm looking into setting up 3-fund portfolios for each account.

You don't have to do that, but you may have different allocations for different goals. it's the overall asset allocation for each goal that matters. For instance, it's better to not hold taxable bonds in a taxable account. You may also want to consider Vanguard's tax-managed balanced fund, VTMFX (50/50) for a taxable account.

I'm not sure if I should select a static 3-fund portfolio, or an auto-balancing 3-fund portfolio (like a Vanguard Target Retirement Fund or Target Enrollment Fund). A static strategy seems to have lower fees and higher return rates, but it will not rebalance.

The TR funds and Lifestrategy funds are auto-rebalancing, but they hold more foreign stock and taxable bonds. You can hold them in a tax-deferred account and then add more US stock somewhere else to reduce the foreign allocation. Also consider Vanguard's tax-managed balanced fund, VTMFX, (50/50)

Is anyone using static 3-fund portfolios? If yes, do you periodically re-balance them at all yourself?

Yes, that's a common strategy. I check in March and October to see if the allocations need adjusting.

Is re-balancing a 3-fund portfolio really necessary, since it's already so diversified? Meaning, given that the risk level of a 3-fund portfolio is already low, is the expense and effort involved in rebalancing it worth it?

The portfolio's risk level is dependent on the allocation to stocks. A portfolio of 80% stocks is risky, meaning the portfolio might experience a fall of about 30%. You can do all your rebalancing (adjusting) in tax-deferred accounts, so there is no cost. Keep taxable bond funds out of taxable accounts



https://investor.vanguard.com/investing ... allocation


Paul
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Wiggums
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Re: 3-fund portfolio rebalancing

Post by Wiggums »

retired@50 wrote: Sat Jul 31, 2021 10:37 am
fijoy wrote: Sat Jul 31, 2021 10:32 am
3. Pick an auto-rebalanced 3-fund investment, like VTIVX

Does an auto-rebalancing fund (option (3) above) in a taxable account create a a taxable event every time it rebalances?
No.
The taxes you'll pay with a fund like VTIVX are just from bond interest and stock dividends. The fund gets to move stuff around without creating a taxable event for you, the shareholder.

ETA: Is there some reason you're not just holding 100% stock in taxable and using a tax-deferred retirement account to hold bonds and do rebalancing? Typically, that works out pretty well.


Regards,
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Re: 3-fund portfolio rebalancing

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fijoy wrote: Sat Jul 31, 2021 10:32 am
livesoft wrote: Sat Jul 31, 2021 9:50 am Dividends are income that shows up on your Form 1040 tax return. Rebalancing could create capital gains that will show up as income on your Form 1040 Schedule D. Dividends could be non-qualified, qualified, and/or tax-exempt interest dividends which are all generally taxed different ways.

A 50/30/20 3-fund portfolio might lose 40% of its value. I would call that risky.

The 8+% return is probably before taxes. If you are paying 40% total tax rate on the dividends and realized capital gains each year, then you will be unlikely to achieve that 8+% return. Most people would not be paying a 40% total tax rate on investment earnings, but folks who live in places like NY and CA might be unless they pay attention and actively do things to make sure they do not.
Thanks @livesoft. Agreed that rebalancing will have tax implications. Also agreed that a 50/30/20 fund is subject to risk short term.

My original question is really about the need for rebalancing in a buy and hold long-term strategy with Vanguard index funds, with benefits like the 8+% returns long term and tax-efficiency (due to their patented 0 capital gains method and low dividends) that go with them.

The options I have are:
1. Pick a static 3-fund strategy, like 50/30/20. Just buy and hold it. If the stock market is down when it comes time to withdraw, assume I'll have other stock-independent funds to rely on until the market is back up.
2. Pick an initial 3-fund strategy, like 50/30/20, and manually rebalance it, say every 3 years.
3. Pick an auto-rebalanced 3-fund investment, like VTIVX

Does an auto-rebalancing fund (option (3) above) in a taxable account create a a taxable event every time it rebalances?
Certain platforms allow you to avoid the taxable event of rebalancing in a taxable account as the lowest performing (underperforming) asset receives all additional investments until it is back in balance. Works well for the accumulation years when set on automatic pilot.

M1 Finance does this, so you could have the three fund portfolio with an initial AA and every subsequent additional investment as well as dividend and income distributions would fill out the underperforming asset(s) first in an automatic fashion without you having to do any manual rebalancing. If using periodic investments of weekly, bi-weekly, or monthly - it does an excellent job of keeping things on target to your AA percentages.

Although having bonds in a taxable account at the moment is not producing enough income to worry that much about regarding annual taxes, think ahead to the future where that may not be the best place to be holding a larger position in an ordinary income producing (tax wise) investment. Depending on your tax situation, a Municipal Bond Fund(s) may be an alternative - again, it all depends on your tax situation and not crossing any thresholds that could have other financial implications.

The question is, since you are setting the account up for your wife to be for an early retirement situation, will there be periodic additions to your investments for rebalancing without tax consequences for a period of time, or is the early retirement happening soon? I am assuming you are setting it up early to give it time to grow and make additional investments before entering decumulation.

CyclingDuo
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Re: 3-fund portfolio rebalancing

Post by tashnewbie »

Agree with others that it’s generally best to use stock index funds like VTSAX and VTIAX in taxable. Depending on your tax brackets it might make sense to use a tax exempt muni bond fund in taxable. You haven’t disclosed enough details to help us advise you about your options.

Then you can hold taxable bonds in your tax-deferred accounts.

View your portfolio as one big portfolio across all of your accounts. You don’t have to hold the components of the 3 fund portfolio in every account.

Use age appropriate funds in the 529s.

Definitely check out the tax efficient fund placement wiki that’s linked in another user’s response.
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Re: 3-fund portfolio rebalancing

Post by fire2031 »

CyclingDuo wrote: Sat Jul 31, 2021 11:02 am The question is, since you are setting the account up for your wife to be for an early retirement situation, will there be periodic additions to your investments for rebalancing without tax consequences for a period of time, or is the early retirement happening soon? I am assuming you are setting it up early to give it time to grow and make additional investments before entering decumulation.

CyclingDuo
Thank you @CyclingDuo. I expect to be investing into the taxable account at least for the next 10 years.

Just so I understand your this right, rebalancing by moving money from one fund to another in a taxable account will create a taxable event, correct? This is true even if I choose an auto-rebalancing fund, like the Vanguard Target Retirement fund in a taxable account, right?

On the other hand, if I intend to keep adding to the taxable account for several years, I have time to rebalance just by changing the amount of money I invest into each individual fund in the account over the years?
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Re: 3-fund portfolio rebalancing

Post by CyclingDuo »

fijoy wrote: Sun Aug 01, 2021 9:16 am
CyclingDuo wrote: Sat Jul 31, 2021 11:02 am The question is, since you are setting the account up for your wife to be for an early retirement situation, will there be periodic additions to your investments for rebalancing without tax consequences for a period of time, or is the early retirement happening soon? I am assuming you are setting it up early to give it time to grow and make additional investments before entering decumulation.

CyclingDuo
Thank you @CyclingDuo. I expect to be investing into the taxable account at least for the next 10 years.

Just so I understand your this right, rebalancing by moving money from one fund to another in a taxable account will create a taxable event, correct? This is true even if I choose an auto-rebalancing fund, like the Vanguard Target Retirement fund in a taxable account, right?

On the other hand, if I intend to keep adding to the taxable account for several years, I have time to rebalance just by changing the amount of money I invest into each individual fund in the account over the years?
Correct - trying to avoid creating a taxable event in a taxable account by rebalancing would be key. Whether one uses something like Acorns or M1 where additional investments go into the underperforming assets first to avoid rebalancing tax issues, or you DIY by altering which fund or ETF to put the money into that is underperforming in your Vanguard, Schwab, Fidelity, etc... account on your own would be a non taxable rebalancing event that I would advise to pursue.

CyclingDuo
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fire2031
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Re: 3-fund portfolio rebalancing

Post by fire2031 »

retired@50 wrote: Sat Jul 31, 2021 10:37 am No.
The taxes you'll pay with a fund like VTIVX are just from bond interest and stock dividends. The fund gets to move stuff around without creating a taxable event for you, the shareholder.

ETA: Is there some reason you're not just holding 100% stock in taxable and using a tax-deferred retirement account to hold bonds and do rebalancing? Typically, that works out pretty well.

Regards,
Thanks for the reference to balancing across taxable and tax-deferred accounts. Will definitely look into that.

About the tax implications of auto-rebalancing target retirement funds in taxable accounts, I'm getting conflicting info. This webpage:

https://mutualfunds.com/retirement-chan ... ate-funds/

states that target date funds "... sell stocks and purchase bonds periodically. This has the potential of generating a taxable capital gain distribution."

Looking at the page for VTIVX here:

https://investor.vanguard.com/mutual-fu ... ions/vtivx

I'm seeing that it does have taxable distributions. Am I reading these pages right? Are you saying these distributions are too small to be considered significant, tax-wise?
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Re: 3-fund portfolio rebalancing

Post by retired@50 »

fijoy wrote: Sun Aug 01, 2021 9:31 am
retired@50 wrote: Sat Jul 31, 2021 10:37 am No.
The taxes you'll pay with a fund like VTIVX are just from bond interest and stock dividends. The fund gets to move stuff around without creating a taxable event for you, the shareholder.

ETA: Is there some reason you're not just holding 100% stock in taxable and using a tax-deferred retirement account to hold bonds and do rebalancing? Typically, that works out pretty well.

Regards,
Thanks for the reference to balancing across taxable and tax-deferred accounts. Will definitely look into that.

About the tax implications of auto-rebalancing target retirement funds in taxable accounts, I'm getting conflicting info. This webpage:

https://mutualfunds.com/retirement-chan ... ate-funds/

states that target date funds "... sell stocks and purchase bonds periodically. This has the potential of generating a taxable capital gain distribution."

Looking at the page for VTIVX here:

https://investor.vanguard.com/mutual-fu ... ions/vtivx

I'm seeing that it does have taxable distributions. Am I reading these pages right? Are you saying these distributions are too small to be considered significant, tax-wise?
You raise an important point. I failed to research the ST and LT capital gains that come from the target date fund. Since they are small in size, relative to the much larger dividend, I suspect that those ST and LT capital gains are actually coming from the bond portion of the fund. Even the Vanguard Total Bond Market Fund (VBTLX) generates capital gains of this nature from time to time.

Since bond funds tend to do this, without you selling anything, it's a solid reason to not hold bond funds in a taxable account, if at all possible. Which is why the Boglehead wiki page that discusses tax efficient fund placement recommends holding bond funds in a tax-deferred account.

If you value simplicity over tax efficiency, then you can stick with a target date fund or a LifeStrategy fund that suits your desired asset allocation. You can consider the additional income taxes as the "price" of simplicity.

So, the general Boglehead method would just use tax-efficient stock index funds in taxable, and bond funds in tax-deferred. If this complicates things for your wife, you can either teach her about these tax-related issues (very boring stuff) or you can say "To heck with it" and just use an all-in-one fund in your taxable account and deal with any additional income taxes.

See link: https://www.bogleheads.org/wiki/Tax-eff ... _placement

Regards,
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Re: 3-fund portfolio rebalancing

Post by etfan »

Isn't it true that this "tax inefficiency" is just a matter of deferring taxes? The "bright side" of having to pay taxes on bond funds in taxable accounts today, is that I won't have to pay those taxes later. Am I describing that correctly?

It's true that I may be in different tax brackets, but it also means that this is not a dollar-to-dollar comparison. I may be paying one dollar in taxes today instead of paying 75 cents in taxes in the future, but I may also be paying one dollar today to avoid paying $1.75 in the future. The "advantage" is therefore neither absolute nor guaranteed.
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fire2031
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Re: 3-fund portfolio rebalancing

Post by fire2031 »

etfan wrote: Sun Aug 01, 2021 12:32 pm Isn't it true that this "tax inefficiency" is just a matter of deferring taxes? The "bright side" of having to pay taxes on bond funds in taxable accounts today, is that I won't have to pay those taxes later. Am I describing that correctly?

It's true that I may be in different tax brackets, but it also means that this is not a dollar-to-dollar comparison. I may be paying one dollar in taxes today instead of paying 75 cents in taxes in the future, but I may also be paying one dollar today to avoid paying $1.75 in the future. The "advantage" is therefore neither absolute nor guaranteed.
I think this needs to be separate thread. But very briefly, people are typically in lower tax brackets in retirement. Even if you're in the same tax bracket in retirement, inflation means you'll pay less in taxes if done in the future. Deferring taxes also allows you to invest more of your money today.
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Re: 3-fund portfolio rebalancing

Post by etfan »

fijoy wrote: Mon Aug 02, 2021 9:00 am
etfan wrote: Sun Aug 01, 2021 12:32 pm Isn't it true that this "tax inefficiency" is just a matter of deferring taxes? The "bright side" of having to pay taxes on bond funds in taxable accounts today, is that I won't have to pay those taxes later. Am I describing that correctly?

It's true that I may be in different tax brackets, but it also means that this is not a dollar-to-dollar comparison. I may be paying one dollar in taxes today instead of paying 75 cents in taxes in the future, but I may also be paying one dollar today to avoid paying $1.75 in the future. The "advantage" is therefore neither absolute nor guaranteed.
I think this needs to be separate thread. But very briefly, people are typically in lower tax brackets in retirement. Even if you're in the same tax bracket in retirement, inflation means you'll pay less in taxes if done in the future. Deferring taxes also allows you to invest more of your money today.
Good point. Thanks.
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Re: 3-fund portfolio rebalancing

Post by kissmoneyblog »

etfan wrote: Sun Aug 01, 2021 12:32 pm Isn't it true that this "tax inefficiency" is just a matter of deferring taxes? The "bright side" of having to pay taxes on bond funds in taxable accounts today, is that I won't have to pay those taxes later. Am I describing that correctly?

It's true that I may be in different tax brackets, but it also means that this is not a dollar-to-dollar comparison. I may be paying one dollar in taxes today instead of paying 75 cents in taxes in the future, but I may also be paying one dollar today to avoid paying $1.75 in the future. The "advantage" is therefore neither absolute nor guaranteed.
It is actually more than a matter of deferring taxes. Placing the right type of asset (stocks and bonds) in the right "location" can "save" you taxes and not just defer them in the long run.
https://kissmoneyblog.blogspot.com/2023 ... -on-3.html
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