Asset allocation: Filling your portfolio with the right mix

But how do you know which assets to choose?

Nothing affects your long-term returns more than a good asset allocation plan. Asset allocation can even help mitigate the short-term effects of an inevitable market downturn.

How to tackle asset allocation

Before tackling asset allocation, it's important to understand that your situation is slightly different than anyone else's. So you must first decide on whether you want to DIY your own asset allocation, hire a professional advisor or use a robo advisor service to do it for you at an affordable price.

• Doing It Yourself – Obviously, handling your own asset allocation allows you to save some money on paying professional fees and expenses. The downside is that you might not be updated enough on the goings-on of the stock market to choose the best diversification strategy for your personal needs.
• Using a Robo Advisor – As a sort of middle-of-the-road option, a robo advisor (such as Betterment ) will choose a preset allocation strategy for you, based on your risk profile. This allows you to feel confident in your decision without paying a ton of fees.
• Hiring a Financial Advisor – A professional can help pinpoint the best allocation for your current situation and investment goals. However, they will be a bit pricier than if you tried tackling it yourself.

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What types of assets can you choose from?

The question is: What should you be investing in? A good place to start is with mutual funds and/or ETFs. These funds allow easy diversification without the possibly complicated process of stock picking. For most individuals, ETFs are usually the better choice. Though let’s discuss the differences between the two:

Mutual funds are collections of investments and can be either open-end or closed-end funds. Open-end funds are purchased directly from the fund manager. Their values are determined daily and there isn’t a limit on how many shares are issued. Closed-end funds have a limited number of shares and the NAV does not determine the price.

When a mutual fund is sold, the fund has to sell shares to pay the investor. Usually, this will cause a capital gain that must be distributed to shareholders. This mutual fund turnover could result in higher taxes for you.

ETFs, or exchange-traded funds, are made up of units of underlying investments. There are three main types: Exchange Traded Open End Index Mutual Funds, Exchange Traded Unit Investment Trusts, and Exchange Traded Grantor Trusts.

• Exchange-Traded Open-End Index Mutual Fund: Connected to an index, dividends are reinvested when received, and paid to shareholders quarterly.
• Exchange-Traded Unit Investment Trust: Required to fully replicate the designated index. Dividends aren’t reinvested automatically but they are still paid out quarterly.
• Exchange-Traded Grantor Trust: The investor owns the underlying investments.

Unlike mutual funds, there is no need to sell when an investor wants to redeem their shares. Therefore, capital gains tax isn’t generally a problem due to fund turnover. ETFs also offer the possibility of arbitrage.

For more information about these funds, read Mutual Funds vs. ETFs.

If you are interested in branching outside the “stocks/ bonds/ mutual funds/ ETF” routine, consider alternative investments. Different options you can explore include:

• P2P investing through Prosper
• Master Limited Partnership (MLP)
• Real Estate Investment Trusts (REITs)
• Ginnie Mae Bonds
• Commodities – Gold and Silver (Which is better?)

Read more about Traditional vs Alternative Asset Classes here.

Factors to consider

Here are some important factors to remember when creating your ideal asset allocation strategy:

1. Humans are emotional – It’s easy to invest when the market is good and really hard to invest when it’s not. When emotions come into play, you are likely to lean too far one way or another because it feels right.
2. Don't be afraid of what you don't know – By sticking to only stocks and bonds, you could miss out on some great investments. Educate yourself so you don’t miss out on these opportunities.
3. Investments aren’t scripted – Diversification will not protect your portfolio when all the asset classes tank at the same time as we saw during the financial crisis of 2007-08. That’s a big part of the game that people have problems with.
4. Avoid too many accounts – Managing multiple accounts can easily confuse you and cause you to forget to diversify one or more of them.
5. Be careful of diversification overkill – If you are diversifying your assets too much, you are likely missing out on potential gains and paying too much in transaction fees. The key is balance.
6. One strategy to consider is tactical asset allocation or TAA. TAA involves active portfolio management by rebalancing the percentages of assets based on current economic conditions. For example; let’s say stocks take a plunge. You may want to temporarily rebalance your portfolio to focus on stocks. Why? Buy low, sell high. When everyone is scared, there are deals to be had.

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My own asset allocation for retirement

As I've mentioned in my profile, we have a decent-sized nest egg for retirement. The million-dollar question (pun intended), is what assets should we invest in? To me, good asset allocation is the most important thing you can do to ensure long-term success. For this post, I'm not going to go into the technical details of proper asset allocation. That is a whole other discussion, which I may talk about in the future. The purpose of this post is to discuss my current allocation as well as openly discuss the allocation strategy and methods to help improve returns while reducing risk.

For those who wish to understand the technical details, I recommend reading the following books:

• The Intelligent Asset Allocator — William Bernstein
• The Four Pillars of Investing — William Bernstein
• The Investor's Manifesto — William Bernstein
• A Random Walk Down Wall Street — Burton G. Malkiel

I will mention that good asset allocation is based upon the modern portfolio theory (or MPT for short), using indexed-based funds, buy-and-hold, and minimizing expenses. During the 2008–2009 crisis, it was said that buy-and-hold was dead. During this period pretty much all assets went down in value: stocks, bonds, commodities, sectors, regions, etc. MPT has its disadvantages and its critics.

Other investment strategies are available but the topic of another discussion. For now, it's best to assume, while it won't give you outstanding returns, you'll lose less than most other professional investors during the long run. I will say our allocation is mostly index-based, where we do have a percentage (under 20%) that is actively managed by me. If you feel you can do better than the market, it's recommended to allocate no more than 20% for active investing (i.e. picking specific stocks). This means 80% of your investments are kept to the plan of proper asset allocation and buying index-based funds.

A little background on our financials. I'm 41 years old and have 3 children (6 years, 3 years, and 25 months old). The asset allocation discussed in this post only includes our retirement accounts. It does not include any of our taxable accounts, our children's 529 accounts, or other assets (i.e. rental property). Each has their own investment objectives and timelines, so in my opinion, they should be treated separately. As we approach retirement age (mid 50's and early 60's) I do plan on incorporating more of our taxable investments into our asset allocation. For now, they are separate.

insert highlight box My asset allocation is simply meant as a guideline. What may make sense for our risk tolerance, financial objectives, and timeline might not be appropriate for you. end highlight box

High-level asset allocation

• 62% Stocks
• 25% Bonds
• 7% Commodities
• 3% Real Estate (does not include a primary residence or rental properties)
• 3% Cash

Often in financial planning literature, they recommend allocating your bonds based upon your age. Meaning if you are 39 years old, you should allocate approximately 40% to bonds. I've decided to keep the stock allocation based upon our age, but add other investments such as commodities, real estate, and some cash, which takes away from the bond allocation. This was based upon a few factors from my research:

• Commodities and real estate have a much different
• Commodities and real estate have a higher beta than bonds, so, therefore, have higher returns for the long run
• I wanted to have some cash on hand to help in adjustments and for possible purchases when markets are cheap

The allocation will vary slightly over time, but this is the bird's eye view of how the money is invested. As we get older I plan on adjusting our allocation, though stocks will be always at least 50% of our portfolio. Within the high-level allocation of stocks and bonds, I sub-divide the allocation into specific sectors.

Depending upon the amount you invest, it may or may not make sense to sub-divide your allocations. The reason is simply because of statistical significance, and in some cases the minimum amounts required to invest. If you have only $10,000 to invest allocating 3% to international bonds means you would invest $300.00. On the other hand, if you have $1,000,000 to invest, $30,000 of international bonds is a decent amount and would generate some returns.

Stock allocation

Within stocks, we divvy up the 62% into:

• 32% Domestic (52%)
• 20% Foreign (32%)
• 10% Emerging Markets (16%)

The percentages in parentheses represent their total allocation within stocks only. A common mistake for U.S. investors is to think the world revolves around us. This is no different than an employee owning too much stock of the company they work for. You have too much invested into one asset class.

Based upon trends, and my opinion, our economic power is decreasing. We represent 27% of the world GDP and that has decreased since 2006. Since this is the case, I have increased my emerging market allocation, to a higher percentage (initially it was 0%) but kept our foreign allocation pretty much the same.

The other aspect is we are truly living in a global economy. It used to be assumed that if America was in a recession, other parts of the world would be thriving during that same period. That's not necessarily true today.

Some studies have shown in the past 20 to 10 years, a correlation between international and domestic stocks has increased. This was also shown anecdotally during the 2008-2009 recession. Based upon this, I've decided it's best to spread my stock investments throughout the world.

Mind you, it's almost impossible with today's multinational companies to get completely accurate percentages invested in each of these areas. For example, companies like Coca-Cola have operations in all parts of the world. They, in fact, have a business in each of the sectors mentioned. So when owning an S&P 500 fund, most people consider it domestic only. When in fact, over the past 10 years S&P 500 stocks have dramatically increased into international and emerging markets. Like I mention in my Morningstar review, I recommend their X-Ray service to determine if your asset allocation is on target. Not just your bond/stock ratio but also geographic regions and sectors.

More: How to invest in stocks

Bond allocation

Most books on asset allocation discuss stocks only. Little is mentioned about bond allocation (I guess because most consider bonds ‘boring'). The questions I've had with bond allocation:

• How much do you allocate for inflation-based bonds (i.e. TIPS)?
• How much for corporate bonds or foreign bonds?

William Bernstein in his latest book “The Investor's Manifesto” mentions total bond allocation, but did not go into much detail. He does state when investing in bonds, you should be mostly short-term (i.e. 5-10 years or less). Very little of your asset allocation should be in long-term bonds. Based upon his research, I've set up our bond allocation as follows:

• 10% U.S. Long Term Bonds. 5–10 year maturity (40%)
• 10% U.S. Short-Term Bonds. 1–5 year and includes TIPS (40%)
• 2% U.S. Short-Term Corp Bonds (8%)
• 3% International Bonds — 3% (12%)

I've recently added a small percentage to international bonds, for the same reason I've increased my stocks into emerging markets.

Commodity allocation

With commodities, since it's only 7% of the allocation, I currently do not subdivide into other asset classes. At the moment it's comprised of only metals and mining stocks. Mutual funds and ETFs that own things like gold, silver, and copper. I currently do not own agriculture, oil, natural gas, or soft commodities. This may be adjusted in the future as the portfolio grows in value, but I don't plan on adjusting the overall 7% allocation.

Real estate allocation

About 3% is allocated to real estate, and it is not divided into subcategories. This part of the allocation is invested in REIT funds that cover the entire market. Real estate does not have a strong correlation to stocks or bonds and should be part of your asset allocation. Often times, your personal residence is a big part of your net worth and should be taken into consideration how much to invest in REITs. In our case, we have a primary residence and a rental property, so our allocation into real estate is small. I did want some coverage in commercial real estate by owning REITs. I suspect in the next year I will increase this to 5% while decreasing overall stock allocation to 60%. Others may want to increase or decrease their allocation accordingly.

Cash

This allocation may range from 0% to 10%, but no higher. This is somewhat of a misnomer as it's not really cash, but investments in cash-like equivalents. They are short-term instruments that don't vary. Things like money market accounts, short-term CDs, etc.

It's meant to keep some reserve for rebalancing. Should a major stock market correction occur, use it to add to stock investments. I'm not really timing the market per se; I'm simply increasing our stock funds when stock corrections of 10 to 20% occur. When these do occur, it becomes more obvious stocks are a bargain and should be used to increase our allocation.

Rebalancing rules

Common questions I had with MPT: when do you adjust; how often do you adjust?  Based upon some research, and my own opinion I've setup the following:

• Adjust once or twice a year. This is based upon the size of our portfolio, and how much your portfolio has gotten out of whack.
• Adjust if the allocation is greater than 3% different than what you are shooting for.
• Over the years we have somewhat modified our allocation of stock/bond ratio but plan on doing it birthdays of the youngest (that's me). Then only adjust the ratio on birthdays that end in zero (i.e. my soon to be 40th birthday)
• I sometimes tweak the bond, and stock ratios slightly to increase the amount of cash.