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Investment Allocation Guide

Bull or Bear? Doesn’t affect to our investment allocations or strategy.

Before we left our advisor, we became comfortable that our investing strategy didn’t have to be hard.   We decided against picking stocks, timing the market, or chasing hot sectors.  We would move our money to Vanguard and go with completely passive funds.  So the question of allocation remained: which funds, and how much of each?

William Bernstein handled the allocation questions well in The Intelligent Asset Allocator.  Great analytics and sound reasoning, with a straightforward methodology to apply to each individual situation.

I especially liked how he considered the irrational/human side of all of us.  If we sell because we are scared, we’ll likely lose in the long term.  If we switch strategies relatively often, we’re opening up ourselves to recency bias (chasing fads) – again a long term loser.  Setting up a process to control our unhelpful natural tendencies is a  key to investment management.

The general process is to determine your goal asset allocation based on the factors below. Then set your portfolio to match – in simple low cost mutual funds or ETFs.  Only adjust your funds at a set interval (at least a little more than annually for tax reasons) to rebalance to your original goal percentages.

Know Thyself

The question of target asset allocation should come down to three decisions.  As you answer these questions, be sure to heed the Greek advice to Know Thyself.  Maximizing your long term return lies in being honest and personal with the answers to:

  1. Risk Tolerance
  2. Conventionality
  3. Complexity

 

Risk Tolerance

Risk can be personalized with the question of “how much of a decline would mess up my investment plan (closer to retirement = more conservative) or scare me to sell (any age)?”  Take the answer from that question, and get a shade more conservative.  We’re all a little more cowardly (1) than we would admit, and (2) while losing money in a downturn.

Risk tolerance is answered in the language of stocks versus (short term) bonds.  Here’s a table offered by another financial author, Larry Swedroe, to translate your answer to stocks vs bonds.

 

Asset Allocation %
(Stock/Bond)
Maximum Loss
Comfort
20/80 5%
30/70 10%
40/60 15%
50/50 20%
60/40 25%
70/30 30%
80/20 35%
90/10 40%
100/0 50%

 

Although you’ll hear people recommend 100% stocks, very few serious researchers/writers recommend beyond 75-80% – for anyone.  There is evidence that in most cases the highest levels of stocks add risk without any extra return.

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.

— Ben Graham, The Intelligent Investor

Conventionality

Conventionality means how closely do you want your investments to track:

  1. Averages your see reported on the news
  2. Investments of other people (who might tell you about their portfolios, and make you jealous in the short term).
herd-behaviour-following-the-crowd-650x406 (1)
Queue the generic herd picture

Conventionality is getting at our human desire to be a part of the herd.  To win (as much or more) when others are winning.  And certainly not lose while they are winning.  If CNBC is reporting the new highs for the DOW (just 30 US large stocks), are you going to be comfortable with decreases in your portfolio (1000s of stocks from around the world)?

The assumption is that if you can’t control your pain/jealousy during short term aberrations in return, you might sell or abandon the investment strategy.  So conventionality tries to bring you back to your pain threshold as relatively measured against others.

A generally accepted “conventional” portfolio has about 70% US stock investments.  Unfortunately for diversification, 70% of the world’s market capitalization does not rest in the US – it’s more like 52%.  So you likely get a bit better return for your risk getting closer to 50% US.

Likely because obviously no one really knows what markets will do going forward.  In the long term though, the math usually wins.  But “in the long-term, we’re all dead” (John Maynard Keynes).

Also remember that there is an argument that your portfolio should hedge toward your home market due to currency risk – especially as you near retirement.

Complexity

Complexity means how many fund/ETFs do you want to deal with?  The math aruges that you can get maybe 80-90% of the return and keep a realtively simple portfolio.  That final 10-20% comes from having enough complexity to rebalance when markets swing in & out of favor.

A simple portfolio might have equal weightings of just 3 funds:

  1. Large Cap US
  2. Small Cap US
  3. Foreign

A complex portfolio might have 11-15 funds:

  1. Large Cap US Growth
  2. Large Cap US Value
  3. Small Cap US Growth
  4. Small Cap US Value
  5. REIT
  6. International Developed Large Growth
  7. International Developed Large Value
  8. International Developed Small Growth
  9. International Developed Small Value
  10. Emerging Growth
  11. Emerging Value

International Developed can be further split into Europe vs Pacific.

You can see that the complex portfolio will be more management.  But you’ll probably make a buck or two more if growth stocks are uncorrelated to value stocks, or Europe moves differently than emerging markets – and your rebalancing catches this.  I think more than anything, do what you can stick to – only get complex if you like tinkering with stocks and figuring out how to fit the pieces across your accounts.

Applying the Lessons

Risk: I’m ok with risk and like the idea of as much long-term return as possible so wanted to go with 80% equity. But trying to be more conservative, I’ve started at 75% stocks and will move to 65% if and when the 10 year bond yield gets to 4%.

Conventionality: I hate to lose relative to someone else…probably more than I enjoy winning. To manage myself, I have a more conventional portfolio than not. About 2/3 US stocks.

Complexity: I like complexity and tinkering with investments, so have split my stocks into 8 investments, and left my “bonds” portion split between one bond fund and a money market (paying 1%).  The real complexity comes in the fact that I have lots of investment accounts, so I’ve started running into some headaches in rebalancing. I might have to slim down my portfolio holdings in the future.

Other factors: as I have mentioned in other posts, I have a significant portion of my investments in direct real estate ownership. So I don’t own a direct REIT fund. I’m actually trying to go the other way – get more money into conventional stock/bond investments as we dispose of real estate assets.

I’ll write a future post to go through my actual investments and rebalancing/cost averaging strategies.  If you are really thinking of DIY asset management, I highly suggest reading actual investment books (after tweeting & sharing this post, of course).  Blog posts are for hearing about ideas.  Books are for learning deeply about subjects.

 

4 thoughts on “Investment Allocation Guide

  1. Hey there Bubba – The asset allocation discussion often touches on ‘preferences’ and ‘feelings’ of how people would handle risk without having much experience what that risk may mean.
    At least I know for me it’s the case.
    I could guess what’s good for me based on what I’ve read but it’s not a mathematically defined, clear-cut decision.

    What do you think of the “intelligent asset allocator”?
    Is that a reading that explains the details and reasoning behind choosing a certain allocation vs another?

    Also looking forward to the next post 🙂

    1. Yes, risk tolerance is the translation of feelings to math. So not all clear cut, but does not have to be overwhelming. A good place to start is 50/50 stocks/bonds – as Benjamin Graham recommended. Then see if you are comfortable with that expected return. If not, edge up your stock % until the potential loss (table in post) almost makes you uncomfortable.

      I loved The Intelligent Asset Allocator. It’s lots of details and math so might be up your alley as well!

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