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:
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.
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:
- US Stock Market
- International Stock Market
- US Bond Market
- REITs (real estate investment trusts)
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.
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