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The Asset Allocation Style of Investing

jeffkuo

Kent E. Irwin is the President and Co-Founder of eFinplan, LLC, the first online comprehensive financial planning software for consumers. He is also a Chartered Financial Consultant (ChFC), a Chartered Advisor in Philanthropy (CAP) and a Chartered Life Underwriter (CLU).

There are three ways to invest money, and the most boring way works best for most people: Asset Allocation.

The other two ways to invest: market timing or picking stocks are more sexy. Next time investing comes up at a cocktail party you will be sure to hear someone touting their get rich quick hot stock. When interest rates soar, or stocks drop you may even hear someone brag about how they got in or out at just the right time, or used some type of ‘option’ strategy and made a bundle. You will see people interested in these types of conversations, because many people’s investment portfolios have not performed well.

Most people are not good at picking stocks, even with the internet and greater access to information than ever, there are too many stocks and too little information about each one – and it gets outdated quickly. People are emotional. Even if they pick good ones, they often sell them at the wrong time, because their fears overtake their ability to objectively make decisions.

Market timing always becomes popular when the stock market drops, and people see their account values dropping as they are now. No one has consistently shown the ability to predict markets or securities. To win you have to have 60% accuracy just to cover the losses caused by mistakes of the other 40% – because of transaction fees and taxes. You have to be correct in all four decisions: what/when to buy and when/what to sell.

You are sure to put a damper on a party conversation by mentioning ‘asset allocation.’

What is asset allocation? It is the method of investing based on the study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991. They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. This traditional buy and hold method is boring – but it works.

When you asset allocate you invest a portion of your money into each of the major asset classes: Cash, Bonds, and Stocks. When it comes to your stock portion you split or allocate it into Large Cap, Mid Cap, Small Cap and Foreign Stock.

If you are conservative you allocate a greater percentage into cash and bonds and large cap stock. If you are aggressive your allocation has less cash and bond and more mid, small and foreign stock. Aggressive allocations will probably have a better rate of return over time than going conservative, but will be the most volatile, meaning your values will fluctuate up and down more. You can pick a model like the ones below or take a quiz utilizing software to help identify your tolerance for handling risk.

I have designed 5 fictitious model portfolios to help demonstrate different risk levels. I call the most conservative the ‘Volvo portfolio’. The ‘Volvo portfolio’ fits you because you want something solid (good rate of return) and protection from market risk. The ‘Lexus portfolio’ is for those you are conservative but want more speed (little better rate of return), but you still like a smooth ride. The ‘Acura portfolio’ fits those who want a little more sport (higher rate of return), and are willing to encounter a little more risk. Riskier investors may choose the ‘BMW portfolio’, to get great performance (higher rate of return), and because they can tolerate tricky roads (a lot of market fluctuation). Lastly, the ‘Porsche is for those who want maximum performance, and whose nerves can tolerate the riskiest of roads. This fictitious demonstration was done with premium cars, because investing with asset allocation over the very long term will hopefully position you to be able to eventually afford one. In conclusion, neither of these asset allocation models would be considered at the upper end of the high risk continuum. As you progress from conservative to aggressive asset allocation models, you increase your probability for volatility and rate of return, but not by wide margins over the long term.

‘The Volvo’ – Very Conservative
Cash 10
Bonds 50
Large Cap Stock 20
Mid Cap Stock 10
Small Cap Stock 5
Foreign Stock 5

‘The Lexus’ – Conservative
Cash 7.5
Bonds 40
Large Cap Stock 25
Mid Cap Stock 12.5
Small Cap Stock 7.5
Foreign Stock 7.5

‘The Acura’ – Moderate
Cash 5
Bonds 30
Large Cap Stock 30
Mid Cap Stock 10
Small Cap Stock 10
Foreign Stock 15

‘The BMW’ – Aggressive
Cash 2.5
Bonds 20
Large Cap Stock 35
Mid Cap Stock 15
Small Cap Stock 12.5
Foreign Stock 15

‘The Porsche’ – Very Aggressive
Cash 0
Bonds 10
Large Cap Stock 37.5
Mid Cap Stock 20
Small Cap Stock 15
Foreign Stock 17.5

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20 Comments

  1. Ryan

    Thanks for the great information — I often haphazardly guess at how to allocate my retirement contributions, so these formulas are very useful starting points.

    Are the Volvo and the Lexus listed backwards above? With more cash, more bonds, and fewer stocks, The Lexus looks more conservative to me than The Volvo does.

  2. Prateek

    What is the difference between cash and bonds? I may be wrong but doesn’t all cash in your brokerage account need to be in bond funds? Maybe I just have less choice in my 401K.

    I would also recommend a “Ferrari” allocation of 50% VTSMX (Total US stock market) + 50% VGTSX (Total foreign stock market).

  3. Nate

    Prateek, I’m guessing cash would refer to a money market account or a high-interest savings account (such as ING). Bonds would refer to a bond index fund, which is different (further off maturity dates, higher interest, more risk, more ups and downs than money market).

  4. arjun

    so are the volvo and lexus swapped or do i have my basics wrong

  5. jeffkuo

    Ryan, Arjun I thought so too, but I’ll check with the author before making any changes…

  6. Matt

    I agree that diversification is a good thing, but what does that mean in practice? Why should I invest in bonds? Looking at the period from 1925-2004, bonds yielded ~5% per year versus ~11% for stocks. For someone investing with age 65+ horizon (I am 25), I would say bonds while less volatile are a much riskier prospect than investing in a low cost index fund. After taxes and inflation, bonds yielded a ~1% gain versus a ~5% gain for stocks over that same period. I would say a lack of a “real” growth of my money is a greater risk in my investment strategy than the short term volatility of stocks. Despite the conventional wisdom, this data suggests bonds are excellent for short term holdings but unwise for retirement investments.

    After tax and inflation data comes from slide 10 in the presentation “How Much Money Are You Willing to Lose for a Theory?” posted here:
    http://muhlenkamp.com/slide_show_index.php

  7. björn

    Great article – but within a certain asset class you should obviously also consider what instrument you buy. E.g. if you decide to go with 15% large cap stocks – what large cap stocks should you buy? ´There might be some need for diversification here too.

  8. Fiscal Musings

    I think there are a few more ways to invest money than just three. And there are definitely more ways than just asset allocation, market timing, and picking stocks. What about real estate, commodities, or private businesses. The stock and bond markets aren’t the only game in town. There are other asset classes as well that are perhaps deserving of our allocation as well.

  9. Laura

    Good article. I use asset allocation with my retirement money, but my hands are tied to mostly high fee funds in my 401(k) at work (argh!).

    I agree with Arjun’s and Ryan’s observation on the portfolios mix-up. I thought it was because I hadn’t put my contacts in yet.

  10. Kent Irwin

    Yes the Volvo and Lexus should be swapped.

    Real estate, commodities or private business are options, and perhaps good ones, but these usually have much more risk and require a lot more experience and knowledge, someone may want to consider them but probably after establishing a good base of investments and emergency reserves.

  11. Andrew

    Overall this a good article for investors. The Brinson at al. study though is misquoted. Their study concluded that asset allocation explains more than 91% of the volatility of returns of an overall portfolio.

    The more appropriate paper to cite regarding portfolio performance is “The Cross Section of Expected Stock Returns”, where Professors Eugene Fama and Ken French (1992) proposed that the month-to-month performance of a portfolio is explained by:

    1. The portfolio’s exposure to the market itself i.e. stock vs. bond weighting.
    2. The portfolio’s overall exposure to small-cap stocks.
    3. The portfolio’s exposure to value stocks (defined by the book to market ratio)

    As small-cap companies are riskier than large-cap and value stocks are riskier than growth, Fama and French reasoned that the higher the portfolio’s exposure to each factor (small-cap and value) the higher the portfolio’s expected return.

    Until someone can disprove the above, I would recommend that your asset allocation use the following strategy:

    1.Decide how much equity risk you can personally stomach, and adjust your stock/bond allocation accordingly.
    2. Allocate your stock assets among a wide variety of global regions to achieve diversification.
    3. Overweight in value and small-cap stocks as appropriate.

    In many markets, all of the above can be achieved using low-cost exchange traded funds (ETFs).

  12. jeffkuo

    The numbers have been corrected. Thanks!

  13. AJC @ 7million7years

    Warren Buffet says that if you don’t know what you’re doing that you should simply buy into a low-cost index fund and wait …but, he doesn’t ‘allocate’ because he has higher financial goals … neither do most other rich people (certainly not while they are busy acquiring wealth).

    So, if your goals are humble and modest … diversify and allocate (but keep your advisor and fund costs as LOW as possible).

    But, if your goals are more extravagent, you need to do what other rich people do: ignore conventional wisdom.

  14. Ray

    One very important aspect this article leaves out is the age of the investor. Younger investors want less bonds and more in stocks as they have more time in the market and can afford the risks associated with stock fluctuations.

  15. Kent Irwin

    Ray, many advisors bring the age factor into the asset allocation picture, while others feel that is it an outmoded approach. I think it is up to the investor. Also, for today what is young? There are many people retiring and they have 30 or more years to live, and they need to not just default to more bonds (and lower rate of return) now that they have more gray hair. Whether someone should assume more or less risk is a function of their goals, comfort level, portfolio size, lifestyle etc. Some recomend that if you are 60 then 60% of your portfolio should be bonds, age 70 – 70% and so on. Not sure this works for everyone.

  16. Kent Irwin

    björn is right, each class should probably have diversification within it. For example, within the large cap category, you may want large cap value and growth, and international as Andrew noted. However with bonds, diversify the type – short to intermediate term / govn’t and corp -but be careful going with long term durations, as you may not always achieve that much of greater rate of return and longer term bonds may be subject to greater price volatility when interest rates increase.

  17. Michael CFA/CFP/CAIA

    I like the simplicity of your articles, however I think you lead people on by telling them they will be rich by what you are stating. As far as buying your book why should anyone buy it when I can go to INVESTOPEDIA.COM and find out all of the above and more .

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