David Swensen writes in his "Unconventional Success" book, "Construction of a financial-asset portfolio involves full measures of science and art. The science encompasses the application of basic investment principles to the problem of combining core asset classes in an efficient, cost-effective manner. The art concerns the use of common-sense judgment in the challenge of incorporating individual characteristics into the asset-allocation process." Long-time readers of ITA Wealth Management have the basics of investing drilled into them.
If you are an investor who is trying to figure out what to do with that new self-directed IRA money, this blog post is for you. [This is an updated version of an earlier post.] In the initial portfolio construction process, think diversity. At the very least, broaden your asset class horizons to include six basic asset classes. To iterate one more time, don't build your portfolio around sectors as you will miss too much of the global market. Think in terms of asset classes and for the Fundamental Six I'll list them as I see it.
- United States equities markets. I actually break this large asset class into six to nine sub-asset classes, but that can wait till later. Search this blog for "Big Six" and "Big Nine" and you will run into reasons why I think it is important to sub-divide U.S. equities into smaller asset classes. This is not a necessity as the "Big Nine" asset classes are highly correlated. One ETF, VTI, will cover U.S. Equities.
- Developed international equities markets. VEU will do the job. Remember that this ETF also includes emerging markets.
- Emerging markets or countries that do not qualify as a developed country. My ETF of choice is VWO. There are others such as EEM.
- Domestic REITs. Later we will expand this to include another asset class, international REITs. VNQ is my favorite REIT ETF.
- Domestic bonds. Again, we will expand to include international bonds. The first step is to include an ETF such as AGG or BND.
- U.S. TIPs. In the Dashboard worksheet of the TLH Spreadsheet we combine TIPs with bonds into one asset class. For this discussion I split them into two asset classes so as to emphasize the inclusion of the TIP ETF. Every investor should hold a certain percentage of TIP in the portfolio.
Now that you have the basic asset classes in mind, what percentage should be invested in each. This is one of the most, if not the most, difficult decision an investor makes. This is a personal decision as each of us has different needs and aversion to taking risks. For this reason, I prefer to recommend percentage bands for each of the six fundamental asset classes. Even these band recommendations are made to be broken.
- U.S. or domestic equities 25% +/- 15%
- Developed international equities 15% +/- 5%
- Emerging equity markets 15% +/- 5%
- Real Estate (REITs) 15% +/- 10%
- Bonds 15% +/- 10%
- U.S. Treasury Inflation Protected Securities 15% +/- 10%
Note the allocation bands permit one to go as high as 50% with bonds and TIPs. Some investors will likely want to push this as high as 60% so use these percentages as general guidelines. Most of the portfolios I track are growth rather than income oriented so they are skewed toward the first four asset classes listed above.
For portfolio asset allocation plans, seek out one or more of the portfolios tracked on this blog. Questions are welcome and highly encouraged. The focus of ITA Wealth Management is to educate the individual investor.