ETF Investing Guide: Do You Really Need Help With Asset Allocation?

Asset allocation is the process of carving up your savings between different types of investments, such as US and foreign stocks, bonds, and real estate. Why would you want to do that, instead of putting all your savings into an S&P 500 index? Because modern portfolio theory has demonstrated that by combining different types of assets in your portfolio you can reduce the overall volatility of your investments for a given level of return, or raise the returns for a given level of volatility. In other words, building a portfolio of multiple asset types can lower your risk and boost your returns. And asset allocation combined with portfolio rebalancing further boosts returns. (Rebalancing is discussed in detail in the section on How to Manage Your Portfolio to Reduce Risk & Raise Returns.)

Asset allocation is a lively topic of research and debate, in both academic and commercial investment circles. I’m going to limit myself to a few key points that should allow you to draw up an asset allocation plan. If you’re interested in delving deeper, try William Bernstein’s book The Intelligent Asset Allocator, and see my review of it on Amazon.com.

Much of the academic literature about asset allocation is focused on defining optimal portfolios (asset mixes) based on historical data. Some assets have grown faster than others, while some are more volatile; the question is how to combine assets to reach the optimal trade-off between risk and return (known in the literature as “the efficient frontier”)? The academic literature on this topic has strongly influenced practical financial management. In his book, for example, Bernstein recommends buying historical data from Morningstar for the key asset classes, and attempting to optimize your own portfolio.

My view is that focus on historical data is of limited value and has made asset allocation overly complex. Unlike Bernstein, I don’t think you need to buy historical asset class data from Morningstar to design your portfolio. Here’s why. Many of the practitioners of asset allocation are also believers in relatively strong market efficiency; so they typically reject active stock picking. But they lapse into inconsistency when it comes to the performance of entire asset classes. Many advocate devoting significant portfolio weightings to small value stocks, for example, based on the claim that historically small cap value stocks have outperformed larger stocks.

But the argument for market efficiency can be applied equally to asset classes as to individual stocks. If some asset classes outperform in the long term, why doesn’t the market know this and price the assets accordingly? And in fact, three researchers (Dimson, Marsh and Staunton, in their outstanding book Triumph of the Optimists) showed that as soon as the outperformance of small cap stocks became widely discussed in academic literature, the phenomenon disappeared. In practice, this means that trying to optimize future portfolio performance based on historical data is largely futile.

Moreover, asset class risk and returns are clearly impacted by world events. Let me give one graphic example with clear practical consequences. Few people would argue that the US stock market faces greater risk of terrorism since September 11th 2001 than in the decades before, while geo-political risk in other markets may have lessened since the end of the Cold War. As such, I would argue that it makes sense for US investors to lower their risk from geo-political events by diversifying their assets globally by devoting a greater allocation than previously to foreign stock funds. But pre-9/11, Soviet-era historical data about the performance of global asset classes would have nothing to say about this.

Nobody knows how various asset classes will perform over the next few decades. So you should focus on diversification, an asset allocation containing a reasonable mix of stocks and bonds, and attention to your individual circumstances. Your personal situation includes your age, your current and projected requirements for cash, and your risk tolerance. Your age matters because stocks are volatile in the short run, but tend to rise over very long periods. So if you are about to retire and will need to live off the principal of your investments, putting a large amount of your portfolio in stocks exposes you to excessive short-term risk. Your current and projected requirements for cash matter for a similar reason: if you know that you will need a large proportion of your savings (say to pay for your child’s college education), then you should lower the short-term risk in your portfolio by allocating more of your funds to low-risk (short-term) bonds. Your tolerance of risk matters because if you tend to panic and sell when volatile asset classes (such as stocks) go down, you’ll end up consistently buying high and selling low - a sure recipe for losing money.

Your personal situation should arguably be the overriding factor in determining your asset allocation. Brokers, fund companies and independent financial planners differ in the exact allocations they recommend for people of different ages. In the end, it’s an art and not a science, and a plausible asset allocation could fall within a fairly wide range of possibilities. A reasonable starting point for the split between stocks and bonds as a function of age could be:

• Investor aged <25: 80% stocks, 20% bonds
• Investor aged 25-35: 70% stocks, 30% bonds
• Investor aged 35-45: 60% stocks, 40% bonds
• Investor aged 45-55: 50% stocks, 50% bonds
• Investor aged 55-65: 40% stocks, 60% bonds
• Investor aged 65-75: 30% stocks, 60% bonds
• Investor aged >75: 20% stocks, 70% bonds

Starting from a basic allocation between stocks and bonds plus cash, you can now fine-tune your portfolio to add other asset classes. Divide up your stock portfolio into US and foreign stocks, and large, medium, and small cap stocks; and re-allocate a small percentage of your assets from stocks to real estate, in the form of real estate investment trusts (REITs). There are other ways to make the cut: you could divide your stocks into growth stocks and value stocks (though these labels are often arbitrary), or into different industry sectors such as technology, pharmaceuticals, consumer cyclicals, and industrials. But personally, I think the following broad asset classes are sufficient:

• Bonds x%
• Stocks x%, of which:
• US large cap y%
• US medium cap y%
• US small cap y%
• International y%
• Emerging markets y%
• Real Estate (REITs) x%
• Cash x%

(Total of x=100%)

One important aside: your goal is to allocate your savings between different asset classes taking account of your overall financial situation, including all your assets and liabilities. It’s crucial to look at the whole picture. There’s no point investing in stocks or bonds if you have outstanding balances on your credit cards, as the expected rate of return on stocks and bonds is almost certainly lower than the interest rates on credit card balances. So consider immediately allocating some of your assets to paying off all your credit card bills before you do anything else. (According to Cardweb.com, the average US household with at least on credit card has 6.0 bank credit cards, 8.3 retail credit cards, and 2.4 debit cards - in other words, a total of 16.7 cards. Average credit card debt for families with at least one credit card is $8,400. And as of October 2003, the average interest rate on credit card balances was 14.7%.) Remember also that a mortgage is also debt.

Can you do this on your own, or do you need paid advice? My gut feeling is that most investors can draw up an asset allocation plan as good as that provided by any financial professional. After all, I argued earlier that asset allocation is not a science because nobody can predict future asset class returns, and historical data is of limited use. Also, there are excellent asset allocation tools available on the Internet for free. I’ve listed some of them in the companion resource to this book, The ETF Resource Page. Look in the section called Asset Allocation Tools.

In contrast, the retail financial industry tries to convince investors that they need (and should pay for) help. But the reason most people need professional advice about asset allocation is not because they are incapable of doing it themselves; it’s because they’ve never thought about the question. The goal of this book is to show you how to build and manage a diverse portfolio at minimal cost (and thus higher returns) without resorting to expensive advice.

If you do feel you need help determining how much you should be saving for retirement, and how to allocate your assets and liabilities (pay down your mortgage?), pick an advisor carefully. If you’re considering consulting a broker or a financial advisor that bills you as a percentage of your assets, read the warnings later in this book in My Broker's An Honest Fox first. While they’re aimed particularly at wealthy investors, the comments about how advisors charge for their services apply to mainstream investors too. You can look for financial advisors to advise you about asset allocation and financial planning at the web sites of the National Association of Personal Financial Advisers and the Garrett Planning Network.

Your next task is to find the lowest cost and easiest-to-manage way of implementing the allocation you have selected. It won’t be by purchasing individual stocks, because you don’t have an edge and they don’t provide enough diversification. And it won’t be by using actively managed mutual funds, because they generally under-perform on an after-tax, after-fees basis, and have un-trackable allocations to cash and unforeseen overlaps in holdings and deviations from style. Instead, it will be by using market indexes in the form of exchange traded funds.

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Comments

[Telling:]

The article makes sense, broadly. I would correct one thought about "nobody can predict future asset class returns" - it has been my observation that everyone can predict; perhaps nobody might do so connsistently and accuretly. Somewhere in the article "should" should be inserted.l All investors "should" be better at establishing an allocation and re-addressing it accordingly. The allocations broadly noted appear to assume (they may not - I couldn't tell) a traditional US investor in the US market in US dollars.

The world of course is changing both demographically and fiscally and allocations may have to adjust accordingly - which might mean a bit of strategic observation and forward thinking - indeed, opposed to the rear view mirror.

Yes we can, and "should" utilize VaR analysis in our allocation matrices, and re-address risk as guesses become facts. We might also acknowledge that volatility may be an imperfect risk measure...

But overall, a pretty good article...

2008 Jul 25 03:51 PM

[Nidhi Kadalbal:]

Yes, asset allocation is important ..

creating-wealth.blogsp...

2008 Aug 21 12:30 PM