The Asset Allocation Thread

[Matt]

In preparation for starting this thread I just wrote something about Asset Allocation and Asset Location. It is a little more 'esoteric' of a post, as I ask you to forget Stocks and Bonds for a moment and take time to think about the underlying principles of Asset Allocation. The thread is called Pirates and Hippies, Lessons on Asset Allocation and Location.

Ultimately, such a strategy is for diversification. And diversification is to reduce risk of loss. People without a lot of wealth will say that diversification is a bad thing, because they can't get rich from it, my argument to that is that you probably shouldn't be leaning on your investments quite so heavily. The solution here is to be earning and saving more until the size of your overall wealth is high enough to support a diversified strategy.

Allocations within Locations

You need to consider allocations within Locations, and the correlations within it, and also correlation between the assets independently of location.

For Example: If you have 80/20 (Stocks/Bonds) over two accounts, one IRA and one Brokerage both valued at $100,000, you need to ensure that within each account you have enough non correlated assets within each to protect and adjust in response to changes of the market.

The reason for this is that the tax shielding that certain accounts create can also force new money out, so if you need to rebalance or respond to changes in the market you have to be able to do so in a self sufficient manner. With this concept in mind I like to think of my accounts as individual businesses, that must survive in a standalone capacity.

However, even though they are standalone, from a risk management perspective you must be mindful of overexposure. If your risk tolerance was such that $1000 in a single stock within a $100K account is acceptable diversification, should you duplicate the position in another account you are keeping the same ratio, but you are now becoming increasingly exposed to the movements of a specific entity.

I personally extend such asset allocation concepts to accounts owned not only by myself, but also by my wife, and we balance one another up with this in mind. This is relevant because some people will have narrow options for 401(k) contributions, so they could leverage the strongest option within that, and use another account to hedge that position.

The basic notions of Asset Allocation

When thinking of asset allocation simplistically, many people will look only at what can be invested within the parameters of their account. This is a fallacious approach to investing. For example, you may have a 401(k) that only offers 4 funds, so your allocation is restricted to that, or you could decide to put less into that fund, and save on pretax money elsewhere. Or if you are 59 1/2 or over and have in service options it is also possible to do a rollover while still employed in some cases.

However, for the basis of initial discussion, let us focus on the traditional Stocks, Bonds, Funds type allocations that you can target your investment accounts towards. The general concept is to mix Equities with Bonds, and add in a variety of flavors from that.

Elemental concepts would include creating 'Lazy Portfolios' below you can see a Core 4 model as designed by Rick Ferri on the BogleHeads forum:

The notion here is to use low cost funds to create these overall allocations. The 4 asset classes in play here are:

1. US Stock Market
2. International Stock Market
3. US Bond Market
4. REITs (real estate investment trusts)

The idea is that based upon your age, risk tolerance, assets, goals, income etc you would decide how much to allocate to each of these 4. Typically this is split into the Stocks/Bonds idea, and the image shows how that could look with a 60/40 and a 80/20 allocation respectively.



Another well known model is the Permanent Portfolio:


For me personally, I think that the biggest issue with following such models is that they aren't factoring market timing - yes I know that we shouldn't be allowed to think of that, but when it comes to investments certain predictions are easier than others, such as stating that the current Bond horizon is very much at risk. Implementing one of these portfolio paradigms when interest rates are high is very different from doing so when low.

My own asset allocation is still something of a mess, I am very much in equities, probably 100% so. Though in truth I have such a diverse and messy set of investments that it is hard to know exactly. It is a plan to refine these over time, and it will be a journey I share with you.

What do you think about asset allocations and their paradigms, what works for you and why does it work? I'd be excited to argue the merits with you.

 

[Josh F]

There's no way I can rise to a level to argue with you. With that said, I use Target Retirement Date Allocations. As I'm in my early 30's, the distribute is roughly 85-90% equity and 10-15% bonds/cash/etc. As time goes on, the allocation changes appropriately and essentially re-balances itself. Probably the lazy man's way of investing... I think it's a reasonable strategy for long term investment a la 401K's, etc. If you're hoping to make a quick buck (or lose a quick buck++) it's not the way to go

 

[TeamZissou]

Matt, thank you for writing this post and helping to advance the forum's general knowledge. My strategy used to be simply making sure I saved some money in a work sponsored retirement account and wasn't too concerned with where it went. That also corresponded with the years that I really didn't have any assets to speak of and while I paid higher expense ratios, etc, the magnitude of my higher fees probably never crept into triple digit territory.

A couple years back I began to increase my knowledge on this topic and found it very interesting and enjoyable. I checked out Daniel Solin, Rick Ferri, William Bernstein, Roger Gibson, David Swenson and others to gain a better understanding of it and moved my investments around accordingly. I'm a definite believer in indexing, and spreading my assets into 4 overall classes: US equities, International Equities, Income and either real estate or commodities broad basket. Of my different accounts, I tend to have between 5 - 9 holdings depending on what's available as investment options and how I'd like to slice the different classes up.

Put simply, I agree wholeheartedly with asset allocation providing a more optimal risk/reward profile than not, I agree with low cost indexing solutions that attempt to match the market rather than beat the market, and I believe in rebalancing over time to maintain the percentages. I've been won over on investing in CDs over bonds on the income front. And depending on how you consider my home, I'm probably seriously overexposed in real estate at this time.

The couple of areas that I haven't dug into yet but have earmarked for whenever I get a chance relate to my home. Money is fungible and investments do not require perfect allocation within each account; rather the sum of the allocations across all accounts should be considered. Where does the market risk I'm exposed to in real estate due to home ownership play into optimal retirement account asset allocation? I haven't gone there yet in my planning The other area I need to look into further is the reasoning that 100% equity positions for me, in the early part of my prime earning years, would be more optimal because I continue to increase contributions that can hedge risk down the road. Don't know if I explained that thought well but I believe it's a topic covered in William Bernstein's new book Rational Expectations.

 

[Paul]

Meh. Such conservative investing strategies won't get you anywhere. You'll never do much better than the inflation rate. What they are good for is conserving wealth, not creating it. Find a sector you're interested in, spend the obligatory 10,000 hours, become an expert and watch your investments like a hawk. That's how you can significantly outperform the market and hacks masquerading as Fund Managers and investment advisors. If either knew anything about investing, they wouldn't be working for a paycheck. All they are is salespeople and middlemen.

 

[Haley]

I've been reading since I asked about this on the other thread.

In some ways I'm in perfect position to balance things. My husband changed employer for the first time in over 15 years. So we can roll over his 401k. We did pretty well throwing darts, but I'm less comfortable being reliant on blind luck these days.

 

[Matt]

There's no way I can rise to a level to argue with you. With that said, I use Target Retirement Date Allocations. As I'm in my early 30's, the distribute is roughly 85-90% equity and 10-15% bonds/cash/etc. As time goes on, the allocation changes appropriately and essentially re-balances itself. Probably the lazy man's way of investing... I think it's a reasonable strategy for long term investment a la 401K's, etc. If you're hoping to make a quick buck (or lose a quick buck++) it's not the way to go

First off, bollocks to that - we can all learn from a good argument! Now, I agree there is some value to Target Date (TDF) as a lazy solution, though we should also be mindful that some firms charge for this additionally (Vanguard does not I believe)

The real problem that is with TDF is that many industry boffins say that it doesn't work. I sat down with Jon Stein, CEO of Betterment for a coffee after blasting his product the first time around and this was a topic he brought up - are the target allocations within TDF correct for the current market and demographic? I personally held some TDF but I pushed the date outwards to 20 years beyond my actual retirement, making it more aggressive and more in line with the equity mix I was looking for.

 

[Matt]

Matt, thank you for writing this post and helping to advance the forum's general knowledge. My strategy used to be simply making sure I saved some money in a work sponsored retirement account and wasn't too concerned with where it went. That also corresponded with the years that I really didn't have any assets to speak of and while I paid higher expense ratios, etc, the magnitude of my higher fees probably never crept into triple digit territory.

A couple years back I began to increase my knowledge on this topic and found it very interesting and enjoyable. I checked out Daniel Solin, Rick Ferri, William Bernstein, Roger Gibson, David Swenson and others to gain a better understanding of it and moved my investments around accordingly. I'm a definite believer in indexing, and spreading my assets into 4 overall classes: US equities, International Equities, Income and either real estate or commodities broad basket. Of my different accounts, I tend to have between 5 - 9 holdings depending on what's available as investment options and how I'd like to slice the different classes up.

Put simply, I agree wholeheartedly with asset allocation providing a more optimal risk/reward profile than not, I agree with low cost indexing solutions that attempt to match the market rather than beat the market, and I believe in rebalancing over time to maintain the percentages. I've been won over on investing in CDs over bonds on the income front. And depending on how you consider my home, I'm probably seriously overexposed in real estate at this time.

The couple of areas that I haven't dug into yet but have earmarked for whenever I get a chance relate to my home. Money is fungible and investments do not require perfect allocation within each account; rather the sum of the allocations across all accounts should be considered. Where does the market risk I'm exposed to in real estate due to home ownership play into optimal retirement account asset allocation? I haven't gone there yet in my planning The other area I need to look into further is the reasoning that 100% equity positions for me, in the early part of my prime earning years, would be more optimal because I continue to increase contributions that can hedge risk down the road. Don't know if I explained that thought well but I believe it's a topic covered in William Bernstein's new book Rational Expectations.

There is a lot to be said for just slamming away as much as you possibly can and tweaking it later. In fact I would advise this over what I see more of, putting away too little and managing it too hard to squeeze out a return. This I see a lot with people going down the active investing route. Thanks for including the names of people who have helped you, I would definitely like to see more knowledge sharing on good authors and resources.

I'll be going further with this thread, hope to make it something very useful to us all...

 

[Matt]

I've been reading since I asked about this on the other thread.

In some ways I'm in perfect position to balance things. My husband changed employer for the first time in over 15 years. So we can roll over his 401k. We did pretty well throwing darts, but I'm less comfortable being reliant on blind luck these days.

All you have to do is roll it into something like a Vanguard or other low cost broker and keep it in ETFs and you will instantly increase your earning potential from the lower fees, I'll be writing up some more about different allocations and the such soon.

 

[imjoe]

Being in my late 20s I'm playing a riskier mix. All stocks. Only 3% foreign because I'm not that risky. Pretty balanced between small, mid, and large cap funds. I'm dumping as much in now as I can, 11% on top of my employers 5% and I have it set to auto increase 1% each year. When I get to 20% combined I'll stop the auto increase. I started out only contributing into a traditional 401k but 3 years ago I shifted most contributions to a Roth. I'll adjust that as I age but I don't have a real strategy there. I definitely have a lot to learn still though. I hope I'm starting out alright.

 

[Matt]

Being in my late 20s I'm playing a riskier mix. All stocks. Only 3% foreign because I'm not that risky. Pretty balanced between small, mid, and large cap funds. I'm dumping as much in now as I can, 11% on top of my employers 5% and I have it set to auto increase 1% each year. When I get to 20% combined I'll stop the auto increase. I started out only contributing into a traditional 401k but 3 years ago I shifted most contributions to a Roth. I'll adjust that as I age but I don't have a real strategy there. I definitely have a lot to learn still though. I hope I'm starting out alright.

You are starting out right by saving a ton more than most people are, so great job there! As for tweaking and working on the allocations, I am sure we can explore that in the future.

 

[imjoe]

Also, where does real estate fall into this? I bought my house about 2 1/2 years ago and started out with a 30yr VA mortgage @ 4.375% but then decided to refinance to a 15 year @ 3.25% about 5 months ago. The market fluctuations were perfect and I managed to do it with 0 closing costs other than a required VA fee. This was a decision based off of some internet research I've forgotten now and waiting for some planets to align but was it the right move or would I have been better off investing the extra cash?

 

[cocobird]

Refinancing to a lower interest rate certainly makes sense and is a good move. Since we don't know the amount of the VA fee, it's hard to tell whether that amount of cash would have made much of a difference if invested because investments fluctuate with some increasing significantly and others losing money. It would depend on your investments. Also, if you take the money you save from the reduced mortgage payments, you can invest those. That might be a positive (cost averaging) versus taking a lump amount and investing it all at once.

I'd recommend that you not second guess your decision. It certainly is not a bad decision.

 

[Matt]

Refinancing to a lower interest rate certainly makes sense and is a good move. Since we don't know the amount of the VA fee, it's hard to tell whether that amount of cash would have made much of a difference if invested because investments fluctuate with some increasing significantly and others losing money. It would depend on your investments. Also, if you take the money you save from the reduced mortgage payments, you can invest those. That might be a positive (cost averaging) versus taking a lump amount and investing it all at once.

I'd recommend that you not second guess your decision. It certainly is not a bad decision.

There is some wisdom in focusing forward and not worrying too much about such decisions - and I agree with you if doing so is a detriment to future plans. However, I do also think it is good to explore such things further to see if we can learn and optimize more (even in theory) so will look into this a but.

 

[traderprofit]

Your home is generally your largest asset. Anyone who is financing at less than their return on investments should be very happy, because you can deduct the mortgage interest and real estate taxes in the US if you are below a certain income.
As to employer sponsored investments, if your employer is making any contribution at all to the plan, you should max out your matchable contribution.I am not a fan of average returns like one of the posters, but I have the time, and knowledge to invest worldwide. It's a full-time job when you want to exceed normal returns,but in any cae I have the wherewithal to avoid the 40 bps of an index fund by buying all of the stocks in the index....thus a one time fee. The indexes do rebalance and change constituency, so there are additional fees. I do believe there is a site where you can pay a fixed fee and roll your own index. If you are young, you have time on your side, but should definitely protect yourself with long-term disability insurance. I can't stress the importance of a personal policy versus the crap your employer may offer.
Don;t assume the past will augur the present--just look at the Japanese market. Stocks can stay down for long periods. I lived through the 70's. Find some solid dividend payers that are not on anyone's radar and reinvest the dividends. And please do look overseas in markets where purchasing power parity is increasing

 

[Matt]

Also, where does real estate fall into this? I bought my house about 2 1/2 years ago and started out with a 30yr VA mortgage @ 4.375% but then decided to refinance to a 15 year @ 3.25% about 5 months ago. The market fluctuations were perfect and I managed to do it with 0 closing costs other than a required VA fee. This was a decision based off of some internet research I've forgotten now and waiting for some planets to align but was it the right move or would I have been better off investing the extra cash?

So the consideration I would add here is simply on the opportunity cost side. You are saving interest by reducing from 4.375% to 3.25% however you are also by nature accelerating payments as you have just reduced the term on your loan from 27.5yrs to 15yrs. This will mean that you pay less in interest twice, once at the lower rate, and once again at the faster payment rate.

Personally I think it is something I would do too, as I do not like long term loans and I do not like paying out interest, but the opportunity cost would be:

• Payment (15yr) minus Payment (30yr) = Increased Monthly Outflow (IMO)

The question therefore would be - could you get a better guaranteed return from the IMO to make it wise to not force save into the mortgage payment and instead direct those funds elsewhere? Clearly this isn't possible without taking on more risk, so the further question would be how much would the risk premium be worth for this.

Many people opt to pay down mortgages faster, or refi shorter to capture a guaranteed rate of return, but others might seek additional return in exchange for additional risk on their cash flow.

 

[asthejoeflies]

I have to admit sometimes I read your money threads Matt and my eyeballs bleed. Personally I don't have much time to mess around in the market, so my strategy is low cost index funds with a rebalance once per year. A book I really like about the matter is The Elements of Investing; the general thesis is stock market goes up over time so goal is to just minimize fees (that's a super simplified version).

My money is all in stocks, though I have a small percentage in REITs in my retirement accounts. This thread really reminds me that I need to reconsider my retirement/non-retirement accounts as one whole. One good piece of advice I received is to have a small percentage in "discretionary stocks" so if I feel the urge to try to beat the market with a single stock the damage is minimized - at the time I didn't have the discipline to not try (but now I have no time!)

My personal allocations for my non-retirement accounts (plus wife's):

US Stocks - 43%
International - 25%
Emerging - 17%
Cash - 7%
Discretionary - 8%

I'm pretty aggressive I guess with all the overseas stuff - probably need to dial it back a little now that we have a kid - I'm just not super high on bonds, I tend to just have cash to protect against market swings. Also in reality my allocations in discretionary and emerging are lower than the targets, so I'm more into the US market than my targets would otherwise indicate.

Work for the government so no 401K (403B) matching unfortunately. Those of you who have it - lucky!

 

[snuggling]

I am 33 and only invest in the 1 401k fund S&P 500 index fund. Although many say you cant time the market Id like to believe if you are very cognizant and keep abreast of financial news that you can pump the brakes, to halt major losses. My strategy is to go all out on the index fund and pray that I retire during the years of a good market.

So far my 401k history ROR shows this starting from 2010

2010 - 18%+
2011 - -1%
2012 - 14%
2013 - 30%
2014 - 4% currently

 

[Tom Juhn]

I have a simple formula which has made me a good dollar in the past decade. I buy a S&P 500 Index fund once the market drops 5%. I proceed to buy double the previous amount every time the market drops another 5%. I wait until the market is up 25% from the lowest point and I enter a trailing stop loss order at 5%.

 

[Nguyen]

Throughout the years of investing, I learn that buying great companies and keep them for a long time would give me a higher profit. This would also help to keep me sleeping better at night. My portfolio consists of dividend stocks, S&P 500 index, utilities fund, some short-term bond and high-yield bond, and some REITs. However, I am thinking of following WB's advice of 90% S&P 500 index, and 10% short-term bond. Tom's simple formula is also very interesting. Thanks.

 

[Gail]

When you are looking at retirement funds, consider a Roth IRA. With a traditional iRA you pay the full tax rate upon withdrawal, as most everyone knows; with a Roth IRA there is NO tax due. This ends up making a huge difference when you are retired. If you need to sell assets to maintain a standard of living your tax rate might be higher then than now, and there are all sorts of penalties with social security and Medicare for higher income taxpayers.

 

[skuldyie]

In early 30s. Been somewhat lazy so have been mostly keeping target date fund with maxing out 401k, but a more aggressive date than what they would pick for my retirement. Also maxing out as much of my Roth IRA as possible, but I can never put money in until I do taxes since I'm capped based on income. Started dipping toes into actual separate index funds where I got some Vanguard admiral funds due to low expense ratio, but trying to figure out what benefit of index fund vs ETF is for long term holding. I'm just too lazy to move things around too often.

 

[Jig]

Short version: Extensive review of statistical studies of investment returns and theories over 500 years demonstrates that the best risk adjusted returns across asset classes comes from 3 sources. The first is Momentum, buying what has been rising most in price over the last 3-6 months, and holding it for the next 3-6 months, and this works across most asset classes except commodities. The second is Value in equities at industry or country levels, buying what is cheapest based on real metrics such as Enterprise Value compared to Operating Income before Taxes and Interest or 10 Year CAPE [Edit: Holding period to get returns:12-24 months]. The third is non-public material information if dealing with individual equities. Any other theories or sources of return tend to either be one of the above in a different skin or very short lived.

Time of life and retirement cycles are irrelevant to your investment choices, because even attempting to fix your nominal income through CDs or similar instruments leaves you exposed to other factors such as inflation rates. There is no way to remove financial risk entirely, only to manage risk by selecting which ones you are exposed to. The way one does that consciously or through neglect is by selecting which assets you are exposed to. To lay out an example in today's environment, I hear a lot of folks saying they want to remove all risk by paying off all variable rate debt, fixing their mortgage rate and investing all cash in CDs. Well, if stagflation occurs with low growth and interest rates but high commodity inflation, that is a bad strategy where their job income and investment growth is low but their living costs are rising fast. The point is that the economic environment and asset performance are unpredictable beyond a 3-18 month horizon. The only edges that are verified in the historical record are Momentum, Value and insider information. Take advantage of the 2 legal edges to maximize your investment performance without regard to local, foreign, age, retirement horizon.

A particular warning to some of the recent posters that speak about being 90-100% in S&P 500 index funds. Momentum does favor the S&P 500 currently, but Value metrics have reached extreme levels in the last 3 months according to 10 Year CAPE. Historically, those Valuation levels portend losses over a 12 month period. Personally, I manage that risk at present by focusing my investments on other asset classes and geographies that have begun demonstrating strong Momentum but have much better Valuation profiles than US equities as represented by the S&P 500. Some have high correlation to US equities, but most do not and may therefore perform well despite a drop in the S&P 500.

 

[Matt]

Avoiding the wash sale rule is what I was referring to when I mentioned skipping a month when repurchasing last months losers.

Are you still long bonds because of market valuations Matt? I will pull back when the CAPE hits 30.

I've never been long bonds - don't have that much cash yet

 

[Miles Dividend MD]

Oh?

I was referring to this post last year ..

http://saverocity.com/finance/actively-switching-defensive-asset-allocation-week/

(Which I remember arguing with you about. )

 

[Matt]

Oh?

I was referring to this post last year ..

http://saverocity.com/finance/actively-switching-defensive-asset-allocation-week/

(Which I remember arguing with you about. )

Yep, I remember that now.. I remember perhaps arguing with you but don't see any comments - perhaps we did that elsewhere, or perhaps they vanished... I know some older posts had comments issues. I moved out of a lot of positions, because I didn't like the market at the time, but I did not get into bonds. Once I started researching the bond market, interest rate risk, duration etc I thought it not for me.

I re-evaluated and rebalanced my positions. As an aside I am doing that all over again this week as I am consolidating accounts, I have slowly moved from very active trading of individual stocks to indexes to now a more passive model. I hold no bonds, though I have (quite limited) exposure through some funds that the wife holds in work plans.

I'm actually holding way too much cash right now, and considering my next move. I have a bit of a different investment strategy from the norm, because I don't have a dollar cost average option available. (Maybe we should take this to the Asset Allocation thread!)

 

[Mountain Trader]

I forgot to hit "Read first unread" so wound up reading this whole thread again. Matt's advice to sock away all you can, even if you don't have time to super plan where to invest is so, so true. Put it in an S & P index fund if nothing else. Come back later-it will be there.