Asset Allocation

[CaptainDan]

I've been thinking about the definition for asset allocation for a few minutes and came up with the following: it's what you invest in. That's pretty much it. Different types of investments are considered different types of assets. How you allocate those assets is pretty straightforward. For example, let's say you purchase Exxon-Mobile (XOM) stock with 100% of your available funds. Well, you just allocated everything you have to an equity. See? It's easy.

Now, I'm not saying that this type of above investment strategy is a good one. In reality, when finance people talk about asset allocation, they're really referring to what mix of assets an investor holds for reasons such as meeting goals for a specific time-horizon and reducing overall risk. Investors generally try to balance the risk they perceive with their short and long term goals. By placing a portion of their funds in equities, some in fixed income, and keeping some in cash, they reduce the risk of loss while still maintaining some sort of growth. Honestly though, an investor needn't invest across asset classes to have an asset allocation. They can invest all they've got into one stock and still have it.

What Makes Asset Allocation So Important?

For most of my life, I've been listening to people talk about this stock or that. With them, it's always a get rich quick scheme. The best stock pick. As I grew older, I began to realize that while one certainly does need to see a healthy return on investment, they also need to be mindful of how much risk they face in losing what they've invested. I once read that the very wealthy don't chase returns. Their primary goal is to actually avert losses. I found that both interesting and enlightening.

It's long been known among successful investors that choosing the right mix of asset classes is more important than choosing individual securities. It's about how the asset classes play off one another to achieve the risk aversion/reward the investor is after. In general, when investors choose a strategy of asset allocation, they'll also periodically rebalance their portfolios. The two strategies go hand in hand.

What are Some Common Example Asset Allocations?

I've heard about all different types of asset allocations though the years. It's common knowledge that bonds are generally less risky than equities (or more stable in the short term with less volatility), so an investor might want to direct their funds to be invested in both equities (stocks) and bonds. One common asset allocation is the 50/50 stock/bond split, where the investor would place half of their money in stocks and the other half in bonds. A good equity ETF for this would be the Vanguard S&P 500 fund. And a good bond ETF for this would be the Vanguard Total Bond Market fund. I've also heard about an asset allocation rule that many refer to as the "100 Rule." This rule states that an investor should take the number 100 and subtract their age. So if the investor is 45 years old, the result would be 55. That result is the percentage of what the investor should place in equities. For this example, if the investor had $100,000 to place in the market, they'd buy $55,000 of VOO and $45,000 of BND. It's really that simple.

Now, people do all sorts of things when they get into asset allocations. While a stock/bond mix is good, there are also many other asset classes that play well off of each other. As you look more into this type of thing and do your research, you'll find that almost and asset class that's inversely correlated with another can be helpful. For instance, gold is usually inversely correlated with both the U.S. dollar as well as stocks. So if you were attempting to mitigate the risk of stocks, you may want to invest in gold at the same time. Personally, I like to diversify my equity holdings between domestic stocks such as the S&P 500 (VOO), developed market international stocks (VEA), and emerging market stocks (VWO). I also like to have a real estate fund (VNQ) and a healthy portion of bonds (BND). My asset allocation is as follows:

BND - 40%
VNQ - 5%
VOO - 30%
VEA - 20%
VWO - 5%

This mix has been working well for me for years, especially during times of great volatility. Every so often, when these percentages stray from their original values, I'll go ahead and rebalance the funds. I'll be writing posts on both the pros and cons of rebalancing as well how to create your own excel spreadsheet that will handle all of your rebalancing calculations.

If you have any questions regarding asset allocations or if you'd like to share your personal allocation, I'd love to hear what you have to say. Comment down below. Thanks!

 

[CaptainDan]

Example Asset Allocations​

When it comes to asset allocation, the sky really is the limit. There's no end to the arrangements and strategies to take advantage of. From the simple 50% equities, 50% bonds split to the much more complex time horizon, bond variation, stock variation, large-cap, small-cap, developing market, developed market conglomeration, it's up to the individual investor to settle on what makes him or her feel best. We each have different risk/reward tolerances and it's certainly possible to come up with a mix of assets that will allow each one of us to sleep well at night while making a decent return.

If you haven't already done so, you might want to read a few posts that lead to this one. They are:

What's Portfolio Rebalancing?

What's Asset Allocation?

Pros & Cons of Portfolio Rebalancing

Most people don't really care about the theory and that's why I thought I'd write this post. To offer you real life allocations. Take a look at what I share down below to get a feel for what various percentages of real allocations look like. Then, share some comments on what you like about each and don't like about each. I'd love to get your opinion on all of this.

Now, just so you know, I'm only going to give some very basic asset allocations below. I'll add some ETF ticker symbols to each for good measure, but I won't get into much depth. In the comments and discussion that follows, we can dive deeper into the technical aspects of everything. Also, there are many different asset allocation strategies, such as age based, life-cycle funds, constant weight, tactical, insured, and dynamic. Discussion is welcome for each.

Example Asset Allocation

Stocks
Small-Cap Growth Stocks – 25% (VBK)
Large-Cap Value Stocks – 15% (VYM)
International Stocks – 10% (VEU)

Bonds
Government Bonds – 15% (VGLT)
High Yield Bonds – 25% (VWEHX)

Cash
Money Market – 10%

Please take these ETFs with a grain of salt. Do your own research when purchasing or researching investments. Also realize that you may not have to purchase separate small cap, large cap, growth, and value stock ETFs if an overall market ETF may serve you just as well. I like Vanguard's VOO because it covers the entire S&P 500. Many people like that ETF. Of course, if you'd like the lion's share of your equity holdings to be small cap stocks or something similar, then you'll need to keep the investments separate.

Here are three different common allocations based on investor type:

Aggressive Investor
Large-Cap Stocks - 20%
Mid-Cap Stocks - 20%
Small-Cap Stocks - 20%
International Stocks - 20%
Emerging Markets Stocks - 10%
Intermediate Bonds - 10%
Short-Term Bonds - 0%

Moderate Investor
Large-Cap Stocks - 20%
Mid-Cap Stocks - 20%
Small-Cap Stocks - 10%
International Stocks - 15%
Emerging Markets Stocks - 5%
Intermediate Bonds - 30%
Short-Term Bonds - 0%

Conservative Investor
Large-Cap Stocks - 25%
Mid-Cap Stocks - 10%
Small-Cap Stocks - 10%
International Stocks - 5%
Emerging Markets Stocks - 0%
Intermediate Bonds - 40%
Short-Term Bonds - 10%

Obviously, you'll need to research your own ETFs for those above examples, but that should point you in the right direction. If you aren't familiar with companies who offer ETFs, check out Vanguard. They're very inexpensive and I like them a lot.

Also, you might want to look at different sectors of the market to further diversify into. I like having a real estate ETF in my mix (VNQ), just because I love real estate. To learn more about that, check out this really great post by Lyn Alden.

And finally, please do comment below. Tell me what type of asset allocation mix you prefer and why.

 

[KodyWallice]

Do you know of any asset allocations that are broken down by sector? I have read a lot about adding real estate and gold. Real estate has got good returns and gold is going sky high right about now. I read that it's a good hedge against inflation as well as economic uncertainty.

 

[CaptainDan]

Do you know of any asset allocations that are broken down by sector? I have read a lot about adding real estate and gold. Real estate has got good returns and gold is going sky high right about now. I read that it's a good hedge against inflation as well as economic uncertainty.

I love your ideas about real estate and gold. What you described sounds like one of my portfolios. If my best friend asked me to lay out an asset allocation plan for her, this is what I'd tell her to invest in today:

Large-Cap Stock ETF: Companies with market cap larger than $10 billion. (VV - 10%)

Mid-Cap Stock ETF: Companies with market cap between $2 billion and $10 billion. (VO - 10%)

Small-Cap Stock ETF: Companies with market cap less than $2 billion. (VB - 10%)

International Stock ETF: Companies listed on foreign stock exchanges. (VEA - 5%)

Emerging Market Stock ETF: Companies from developing countries. (VWO - 5%)

Bond ETF: Well rated corporate and government bonds. (BND - 35%)

Money Market ETF: Short term debt such as Treasury Bills. (ICSH - 5%)

Real Estate Investment Trust (REIT) ETF: Shares in an investor pool of mortgages or properties. (VNQ - 5%)

Gold ETF: Shares of investments that hold gold as an underlying asset. (GLD - 5%)

This portfolio works well because both the bonds and the gold aren't correlated with the equities. This bodes well for the rebalancing portion of the strategy. Also, I would only suggest this portfolio to my friend if she had at least $100,000 to invest. If she had any less, I'd say to simply invest the top three asset classes in the S&P 500 (VOO) and combine both the bonds and money market into just overall bonds (BND).

I'm open to tweaks or suggestions on this allocation, so if anyone has anything they'd like to share, please do.

By the way, I found this excellent article that explains what asset classes are and gives examples of each. It's well worth the read:

https://www.jagoinvestor.com/2016/06/asset-classes.html

Here's a graphic from their site:

 

[CaptainDan]

Asset Allocation During Covid 19 Recession: Ray Dalio​

I have watched more videos and have read more articles in the past few weeks on how the sky is falling than I've ever read in my entire life. Someone's got to be making a lot of money off of this stuff because it seems like no one's got anything else to say. As far as I know, the market dropped quite a bit in February and March, but began climbing shortly thereafter. It always climbs after one of these cataclysmic shocks because central banks pump money into the system. Things eventually get back to normal. Humanity figures it out, especially now that humanity has something called the computer. I always get a kick out of when people compare the Great Depression with any modern economic downturn. They do realize that computers didn't exist back then, right? With the touch of a finger on a keyboard, central banks can invent money today. It's linked to nothing, so I don't know what all the hubbub is about.

Now, this isn't to say that we should just rest on our laurels as all of this turmoil is taking place. There is some strategy that needs to occur and that's what Ray Dalio touched on in an interview I recently watched. Basically, he said that similar instances have taken place throughout history and when circumstances like this converge, we need to take notice and act. What are the circumstances? Well, first there is the long term debt cycle that needs to be addressed. Second, there's the wealth gap between the rich and the poor that affects the economic environment tremendously. And third, there's a rise in a large political power that's challenging the existing order.

In the video, Ray goes on to discuss each of these factors, which I found interesting. It was sort of like a financial history lesson. What I found much more interesting though was Ray's prescription for all these events.

From the interviewer, Ray was posed the following question: What is the correct asset allocation for this sort of environment?

To answer the question, Ray explained that the investment environment going forward will be very different than that of the past. The most prolific characteristic of the market going forward will revolve around very low returns. Ray seems to think that the one thing investors need to focus on in this day and age is diversification. While someone may have been able to get away with little to no diversification in the past because of the long running bull market, they likely won't fare nearly as well today.

A typical asset allocation for many investors is what's known as the 60/40 split. That's 60% in equities and 40% in bonds. Typically, this split will use ETFs to satisfy its necessity and those ETFs popularly describe the S&P 500 and the entire bond market. VOO and BND, if you will. Ray claims that this simple diversification may not suffice any longer. Portfolios need to be much more broadly diversified, even within the same asset class. Examples of this diversification might include gold (GLD) and inflation protected bonds (TIP). He also mentioned that cash is a terrible asset to be holding at the moment. If I read him correctly, I'd tend to think that currency destabilization is right around the corner and inflation will rear its head thereafter. Both TIPS and gold will somewhat protect an investor from those things.

I'm sure you've seen this scenario out there. Friends and family tell you how they like to keep their money under their pillows. They keep their cash in the bank. Unfortunately, cash actually has a negative real rate of return at the moment. It's costing you money to hold onto your money. If a bank savings account is offering a 0.01% interest rate and there's a 2% rate of inflation per year, a pile of cash's purchasing power is being reduced by 1.99% every year. And in a high inflation environment, that cash can be worth much less year over year. Some people call this an invisible tax. It certainly is insidious.

Overall, Ray says that because of all the uncertainty and risk in the financial environment today, it's critical that an investor diversify well and watch their cash holdings. If you think about it, he's very much correct. The world is in a geopolitical upheaval, we've got a pandemic going on, and economies are on lockdown. And, we're heading into hurricane season in the U.S. to boot. I don't even want to ask what else can go wrong because I don't want to know. But for the markets to be up as much as they are, I don't want to rock the boat.

As a final note, I'd like to mention Ray's emphasis on the value on money and how important he says that will be going forward. Living in the United States, this isn't something that we have to think about all too often, but it seems that the time to concern ourselves with the issue may be arriving. I can't find one person who's financially literate who isn't concerned with inflation in the future. Personally, I'm not sure how severe it'll be or if it happens at all, but I'm not about to bet against it. I'd rather diversify my portfolio correctly. Bottom line: start thinking about taking some money that you've got in growth assets and moving that money into inflation hedges.

Before this video, I had only limited exposure to Ray Dalio. I think he's worth paying attention to though because I like the way he thinks. How do you feel about the current investment environment? Do you think everything will fall apart or are there places to make money in the market. Let me know below.