Optimal index fund asset allocation

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Optimal index fund asset allocation

Postby Swampy » Tue Jan 22, 2013 6:52 am

I've been giving a lot of thought to putting a significant amount into a nonqualified index fund account that I would be managing and rebalancing once a year or so. One idea that has popped up often is the three fund approach: 1/3 total US stock; 1/3 total international stock; 1/3 total US bond.

My concern is that this approach seems to be most heavily weighted in favor of US large cap/core/growth stocks. Is there a viable, easily managed option of diversifying across the world universe of stocks to make sure that there is an equal allocation (proportionate?) to value stocks, mid caps, small caps, emerging markets, natural resources, etc. It would seem a logical approach to not put all my eggs in one basket.

I understand that such an approach could possibly lead to owning multiple funds, perhaps with an overlap.

Additionally, the case for total bond index funds is flawed in that there seems to be undue risk to longterm bonds held. With interest rates at historically low numbers, it's only a matter of time before interest rates, along with inflation, start to rise (especially since DC seems to have unfettered access to printing new 'funny money' which just dilutes the value of money already in circulation) eroding the principal invested. What suggestions do you have for short term and intermediate term bond allocation? What funds to you recommend that are primarily in international short term and intermediate term bonds?

Most index fund asset allocation strategies rely not only on core/growth large cap stocks, but seem heavily weighted in favor of the US stock market as opposed to international funds.

Personally, I think it would be safer to take $---- and invest in a fund that has diversified across multiple nations and continents than [the USA.] [highly political comments along with various follow up comments by several authors removed by admin alex]
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Re: Optimal index fund asset allocation

Postby Aptenodytes » Tue Jan 22, 2013 7:18 am

SWAMPY wrote:I've been giving a lot of thought to putting a significant amount into a nonqualified index fund account that I would be managing and rebalancing once a year or so. One idea that has popped up often is the three fund approach: 1/3 total US stock; 1/3 total international stock; 1/3 total US bond.

My concern is that this approach seems to be most heavily weighted in favor of US large cap/core/growth stocks. Is there a viable, easily managed option of diversifying across the world universe of stocks to make sure that there is an equal allocation (proportionate?) to value stocks, mid caps, small caps, emerging markets, natural resources, etc. It would seem a logical approach to not put all my eggs in one basket.

You should read some of the basic references on this question. The Wiki has a brief overview (http://www.bogleheads.org/wiki/Slice_and_Dice). Larry Swedroe's book The Quest for Alpha might be a good starting point too.

At its core your question is "Can I implement a 'slice and dice' portfolio that exploits differences in risk and return across different asset categories?" The answer is yes. Setting targets on value, mid-caps, small-caps, and emerging markets is easy. Natural resources is more dubious and more difficult but some people try. I don't know where you are heading with "et cetera" but pretty much anything other than "international" is going to have a "no" answer.

You ask a good and a not so good question about international exposure. Many of us would agree that 1/3 international exposure is low. Moving towards 50% might make sense for you. However, basing your investment decisions on a prediction about the collapse of the U.S. economy is not very wise. You can move to market weights for geographic exposure without engaging in that kind of speculation.
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Re: Optimal index fund asset allocation

Postby nisiprius » Tue Jan 22, 2013 8:06 am

1) Have fun searching for the "optimum," but be aware that you'll mostly be kidding yourself. Like the quest for the optimum beer, there is endless argument and nobody really knows. The people who sound most confident probably know the least--or are selling something.

2) Beware of soundbite arguments--short, snappy, convincing-sounding slogans.

3) There isn't any objective optimum. The optimum for you depends on your personal level of risk tolerance. Task number one is to determine that in the best way you can. Don't let other people tell you what it should be, say that because you're young it must automatically be high, etc. Selling off in 2008-2009 did more damage to peoples' portfolios than any subtleties of weighting.

4) The portfolio you mention is not "heavily weighted in favor of US large cap/core/growth." Both Vanguard Total Stock Market and Vanguard Total International include large, medium, and small-cap stocks. They are "capitalization-weighted," meaning weighted equal weight voting by dollars. Most index funds use cap-weighting for a number of reasons. It is a theoretical optimum under some theories, it offers cost advantages, and is widely regarded as being fully diversified.

Of course, there are many products (and advisory services) competing with index funds. In addition to active management, there are an increasing number that use passive techniques but use some modified or "tilted" weighting. A skeptic like me would say that they have to do something different from an ordinary index fund or they wouldn't have a reason to exist--and that the firms selling them have to publicize any plausible reason for believing these weighting systems are superior.

5) Beware of the soundbite argument that cap-weighted indexes are "concentrated" in large-caps. Well, it's not crazy that some other weighting might be marginally superior. But it's far from cut-and-dried--but claiming that equal weighting by dollars is "concentrated" seems like spin or sloganeering. To me, it's like claiming that a bread recipe calling for 3-1/2 cups of flour, and 2 teaspoons of salt, 1 teaspoon of yeast is "concentrated" in flour and "underexposed" to salt and yeast--simply because the amounts are unequal.

If you want to go with a Schwab "fundamental index" fund instead of Vanguard, or perhaps use the TILT ETF, nobody will say you nay. But do it because you feel these departures from cap-weighting are better than cap-weighting, not that cap-weighting is intrinsically wrong just because it holds more Exxon than Millepore.

6) The portfolio you mention, with equal quantities of U. S. and international does not overweight the US. is in fact very close to world stock market capitalization. If you think the difference can possibly matter, it is certainly easy enough to changes the proportions to make the stock allocation be 46% US and 54% international, i.e. 30.7% Total Stock, 36% Total International, 33.3% Total Bond. But I don't think even the most vigorous advocates of international investing in this forum would claim that that changes matters much.

7) If you want a simple portfolio that incorporates the thinking of the "slice-and-dice," multi-asset, value and small-cap-value tilt faction, look into Bill Schultheis's "Coffeehouse Portfolio."

8) Finding some optimum allocation within bonds is less important than within stocks, because the entire universe of bonds isn't as diversified as the entire universe of stocks, and because bonds fluctuate so much less that if you have any significant stock allocation, the behavior of your portfolio is going to be dominated by the behavior of the stocks.

9) Finding some optimum allocation within either bonds or stocks is less important than the simple, basic decision of what percentage of your portfolio should be in stocks. The biggest question about the 1/3-each portfolio is not the stocks and bonds in it, but the basic proportions of 2/3 stocks, 1/3 bonds. Not that that's unreasonable, but it's a cookie-cutter one-size-fits-all proportion.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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Re: Optimal index fund asset allocation

Postby rkhusky » Tue Jan 22, 2013 9:31 am

If the "market-cap over-weights large growth" argument resonates with you, these threads on equal weight indices may be of interest:

http://www.bogleheads.org/wiki/Equal_Weighted_Indices

viewtopic.php?t=64294
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Re: Optimal index fund asset allocation

Postby Alex Frakt » Tue Jan 22, 2013 6:28 pm

Thread was temporarily removed for moderator action. Please remember that politics is off topic on this site.
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