Does an allocation less than 5% ever make sense?

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Louis Winthorpe III
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Does an allocation less than 5% ever make sense?

Post by Louis Winthorpe III » Fri Nov 08, 2013 7:21 pm

Is anyone familiar with academic research on what is the minimum allocation to an asset class that would have a meaningful effect on a portfolio? Intuitively, it seems to me that an allocation less than 5% would be too small to matter in terms of diversification benefit. For example, if someone invested primarily in stocks and bonds but allocated 3% to real estate, that 3% seems too small to impact the portfolio's returns or volatility. I'm interested in whether there have been any studies that confirm or refute that. And I just picked 5% for no good reason. It's possible that you need something closer to 7.5% or 10% before an asset class matters to portfolio performance. Just curious what has been written on this topic.

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Re: Does an allocation less than 5% ever make sense?

Post by livesoft » Fri Nov 08, 2013 7:26 pm

These "no less than 5%" rules are amusing to me because you have to start somewhere and folks cannot usually jump to 5% with an initial investment.

I think the suggestion arises because even if a holding of 5% returns 10% better than something else, that's just 0.5% of the whole portfolio. That's worth it in my book. Even a 0.1% effect on the total portfolio is worth it in my book. After all, think of all the people on the forum scrambling to get into Admiral shares with a small expense ratio reduction.
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Re: Does an allocation less than 5% ever make sense?

Post by Kalo » Fri Nov 08, 2013 7:47 pm

livesoft wrote:These "no less than 5%" rules are amusing to me because you have to start somewhere and folks cannot usually jump to 5% with an initial investment.

I think the suggestion arises because even if a holding of 5% returns 10% better than something else, that's just 0.5% of the whole portfolio. That's worth it in my book. Even a 0.1% effect on the total portfolio is worth it in my book. After all, think of all the people on the forum scrambling to get into Admiral shares with a small expense ratio reduction.
I agree. Also, one could divide up the three fund portfolio into 5% segments and say that any one of those segments is not meaningful. But you would not want to just give it away, and when you put all 20 segments together, that's your portfolio.

I have tilted my portfolio toward two funds that I believe in, putting 6.5% in each. No scientific reason for choosing those percentages. I would not want to tilt much further than that because I may be wrong in thinking these funds will outperform, and if I am, I don't want to pay too high a price for my tilt.

I don't know that there's going to be a scientific answer to your question. I think it's more about what makes you happy and what works out to a reasonable asset allocation (not so concentrated in any one area that you could get really hurt).

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Re: Does an allocation less than 5% ever make sense?

Post by dbr » Fri Nov 08, 2013 8:00 pm

I don't think there could be general academic research to that effect given that "meaningful" is an ambiguous term, as is the concept of what "make sense" means.

However, the question could be asked in a context where one could quantify the effect. For example, if one examines the effect of stock/bond asset allocation on safe withdrawal rate, studies typically show that between 40% stocks and 70% stocks the SWR varies by only a few tenths of a percentage point. If one further postulates, actual data being absent, that the uncertainty in the SWR is +/-.5%, then that would probably be an academic result that says a 5% shift in asset allocation within the above range does not have a meaningful effect and that it does not make sense to worry about it. Does that exemplify the kind of thing you want to know?

Livesoft, on the other hand, argues that a 5% allocation to a certain asset does make sense based on the contention that a postulated .1% increase in return is meaningful. That is a very simple proposition to contemplate, but I am not sure it rises to the level of academic research.

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Re: Does an allocation less than 5% ever make sense?

Post by Rodc » Fri Nov 08, 2013 8:48 pm

First it will depend on the expected return, expected risk, and correlation to other assets you hold.

Clearly changing from 40% total bond to 35% total bond and 5% intermediate treasury is not likely to make a difference that would pass any test for statistical significance. The difference in return is likely very small and the two are highly correlated.

Some claim the commodities (CCF) are volatile enough and negatively correlated to the extent that 5% makes a meaningful difference. I've never checked as CCF have no intrinsic expected return as I understand it and I prefer assets that have an expect return as counting on negative correlation is too iffy in my book.

As dbr notes, 5% is not likely to rise to the level of being useful and I note that nothing like a 0.1% win will ever be shown with any statistical significance as being different from random noise.

I personally think of 5% as an arbitrary lower bound on an allocation I would consider holding. If someone else said 10% I would not argue.
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Re: Does an allocation less than 5% ever make sense?

Post by gasman » Fri Nov 08, 2013 9:02 pm

Emotionally, it might. I have just under 4% allocated to commodities. Intellectually, I know that it probably is meaningless. Howevever, for some reason it makes me feel better having token exposure.

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Re: Does an allocation less than 5% ever make sense?

Post by livesoft » Fri Nov 08, 2013 9:08 pm

Suppose one has a 401(k), an IRA, and a Roth IRA in ratios: 55:43:2 so that the Roth IRA amounts to 2% of one's portfolio.

Would anyone here begrudge the investor who has a REIT fund in the Roth with no REIT funds in the other two accounts?

Or suppose they have a 3-fund portfolio of Total US, Total Int'l, and Total Bond, but then decide to put Small-Cap Value index in the Roth as 2% of total portfolio?
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Re: Does an allocation less than 5% ever make sense?

Post by heyyou » Fri Nov 08, 2013 9:38 pm

I don't know that there's going to be a scientific answer to your question. I think it's more about what makes you happy
I agree that it will vary among different investors.

My choices, small as they are, help me to stay the course. Sometimes, I can use mental accounting to help me get through a tough time by ignoring the large losses and focusing on the one sliver of assets that is doing well. That is behavioral, not arithmetic.

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Re: Does an allocation less than 5% ever make sense?

Post by staythecourse » Fri Nov 08, 2013 9:54 pm

5% is arbitrary, but isn't that true of everything in life? Why 65 mph? Why 20 mph in school zone? Why random blood sugar >200 is bad? Why age of 21 to drink? Why age of 25 to rent car? Why 18 to sign up for military. Boy just realized you can fight for your country ?7 yrs. before renting a car. Anyways...

Now if you want the theortical answer is I would say the lower the % in an asset then less it contributes to the expected return AND S.D. of a portfolio. I am not going to regurgitate the equations (you can just google them), but each asset's impact on the portfolio's ER and S.D. is hinged on its WEIGHTED AVERAGE. That means 0.05 times asset A ER is much less then .25 times asset B ER for example.

Good luck.
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Re: Does an allocation less than 5% ever make sense?

Post by abuss368 » Fri Nov 08, 2013 10:46 pm

According to David Swensen, it has no impact.
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Re: Does an allocation less than 5% ever make sense?

Post by BradMajors » Fri Nov 08, 2013 10:53 pm

You need to monitor the funds in which you are invested. Lots of funds (even index funds) eventually go "bad" and need to be replaced. Monitoring 20 funds (5% each) might be too much work for some people.

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Re: Does an allocation less than 5% ever make sense?

Post by Random Walker » Fri Nov 08, 2013 10:54 pm

The contribution of an asset class to a portfolio depends on its expected return, it's correlations to other portfolio components, and its volatility. If an asset class has very low correlation and high volatility, even small amounts around 5% can have a meaningful effect on portfolio efficiency. CCFs are certainly the extreme example of this, but other asset classes may fit this criteria as well: us reit, int REIT, EM.

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Re: Does an allocation less than 5% ever make sense?

Post by Archie Sinclair » Fri Nov 08, 2013 11:51 pm

livesoft wrote:Suppose one has a 401(k), an IRA, and a Roth IRA in ratios: 55:43:2 so that the Roth IRA amounts to 2% of one's portfolio.

Would anyone here begrudge the investor who has a REIT fund in the Roth with no REIT funds in the other two accounts?

Or suppose they have a 3-fund portfolio of Total US, Total Int'l, and Total Bond, but then decide to put Small-Cap Value index in the Roth as 2% of total portfolio?
I am such a person. My Roth IRA is currently 3.3% of my portfolio. It consists of Vanguard Small Cap Value, and is my only holding of that fund.

If I had yet another Total Stock Market or Total International holding in the Roth instead, it would not really reduce the complexity of the portfolio. So instead I choose to dabble in very slight size- and value-factor diversification.

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Re: Does an allocation less than 5% ever make sense?

Post by BrandonBogle » Sat Nov 09, 2013 12:54 am

For those of us who hold TSM as well as another fund, like a REIT or a small cap (or small value), would you say your allocation is X, where X is simply how much of your total portfolio the extra fund is? Or would you say your allocation is Y, where Y is X + whatever representation of this asset class is in TSM?

I do the latter and have a REIT (VNQ) of "5%", which means VNQ is actually 3% of my total holdings and 2% comes from TSM.

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Re: Does an allocation less than 5% ever make sense?

Post by Bob's not my name » Sat Nov 09, 2013 3:58 am

My AA is 50% stocks and 25% of my stocks international, which means 13%. I have a note in my plan that Larry Swedroe recommends no more than 33% of international in EM, and TISM is 18% EM, so I have 10% TISM and 3% EM, which puts my EM a little above the Swedroe rule. But my total EM is <5% of my portfolio. I don't know if that's dumb or not. I get Vanguard EM at 0.18% ER, and it's no extra work to hold it.

I lied to keep it simple. I have 7% TISM, 3% International Explorer, and 3% EM. International Explorer appears to be about 16% EM, so my EM allocation still holds. But now I'm admitting that I have two allocations under 5%.

I actually have three allocations under 5%, because I have 2% in a stable value fund. Well, maybe four, because I have 2% in a municipal bond fund.

Perhaps five, because I have 4% in Total Bond Market.

Well, six, because I have a small amount in an inherited stock fund, which I'm deferring selling until my tax rate on long term gains drops below 40% (it was inherited from a trust, so, yes, there is a taxable gain).

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Re: Does an allocation less than 5% ever make sense?

Post by abuss368 » Sat Nov 09, 2013 7:35 am

While it may not move the needle if it makes one feel or sleep better, by all means go for it. What is the harm?
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Re: Does an allocation less than 5% ever make sense?

Post by YDNAL » Sat Nov 09, 2013 7:39 am

Louis Winthorpe III wrote:Is anyone familiar with academic research on what is the minimum allocation to an asset class that would have a meaningful effect on a portfolio?
What matters is the diversification you attempt to achieve with your savings/investments.
  • 1. Is the 3-fund portfolio all diversification you need ? IF your answer is yes, then you will *likely never* run across a 5% allocation to any of 3 funds.
    2. The more granular the investments, the lower the percentage allocation to some component.
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Re: Does an allocation less than 5% ever make sense?

Post by livesoft » Sat Nov 09, 2013 8:04 am

BrandonBogle wrote:For those of us who hold TSM as well as another fund, like a REIT or a small cap (or small value), would you say your allocation is X, where X is simply how much of your total portfolio the extra fund is? Or would you say your allocation is Y, where Y is X + whatever representation of this asset class is in TSM?

I do the latter and have a REIT (VNQ) of "5%", which means VNQ is actually 3% of my total holdings and 2% comes from TSM.
There seem to be two major camps of folks when describing their asset allocation.

One camp describes their asset allocation in terms of funds: "I have 50% Vanguard Target Retirement Income and 50% Vanguard Wellesley."

The other camp describes their asset allocation in terms of asset classes: "I have 65% fixed income and 35% equity with 23% of stocks in foreign companies."

I am in the second camp because I have several different accounts: his and her 401(k)s, his and her Roth IRAs, his and her traditional IRAs, his and her inherited IRAs, 403(b), HSA, 529s, joint taxables W, F, T, V, etc. I imagine that folks in the first camp might be those folks who are just starting out with a 401(k) and those long retired who have consolidated accounts at a single firm.
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Re: Does an allocation less than 5% ever make sense?

Post by SpringMan » Sat Nov 09, 2013 8:13 am

I have heard this said about funds, that is less than 5% in a fund is meaningless. This is obviously false. A large chunk of money invested in 25 funds each representing 4% of the portfolio will never be meaningless. Overly complicated does not equate to meaningless. I doubt if there are 25 asset classes so the concept may be apply to asset classes.
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Re: Does an allocation less than 5% ever make sense?

Post by YDNAL » Sat Nov 09, 2013 8:17 am

livesoft wrote:There seem to be two major camps of folks when describing their asset allocation.

One camp describes their asset allocation in terms of funds: "I have 50% Vanguard Target Retirement Income and 50% Vanguard Wellesley."

The other camp describes their asset allocation in terms of asset classes: "I have 65% fixed income and 35% equity with 23% of stocks in foreign companies."
Yes, "describing;" but I don't see it amounts to a hill of beans.
  • Camp #1 *should know* exactly what they want for FI/US/non-US allocation, and chose 2 funds accordingly.
  • No different than camp #2 even if they choose 10 funds.
What matters is the overall diversification and exposure to risk(s) we are searching. Of course, costs and efficiency (tax and otherwise) matter as well - but that should go without saying.
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Re: Does an allocation less than 5% ever make sense?

Post by Rodc » Sat Nov 09, 2013 8:53 am

SpringMan wrote:I have heard this said about funds, that is less than 5% in a fund is meaningless. This is obviously false. A large chunk of money invested in 25 funds each representing 4% of the portfolio will never be meaningless. Overly complicated does not equate to meaningless. I doubt if there are 25 asset classes so the concept may be apply to asset classes.
The question was about asset classes, not funds.

As you note in your example the asset allocation that pertains to the question is not the 4% in each fund.

So, I don't see how your post addresses the question.
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Re: Does an allocation less than 5% ever make sense?

Post by The Wizard » Sat Nov 09, 2013 9:25 am

BradMajors wrote:You need to monitor the funds in which you are invested. Lots of funds (even index funds) eventually go "bad" and need to be replaced. Monitoring 20 funds (5% each) might be too much work for some people.
No.
Index funds in particular almost never "go bad". Only way I can see that happening is for an ER to go from 0.2% to 0.5%, for instance.
And as RodC mentions, it's hard to get 20 funds (or even 10 funds) in distinct asset classes.
Often when folks have many different funds, there's considerable overlap/duplication, which is a different issue...
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Re: Does an allocation less than 5% ever make sense?

Post by SpringMan » Sat Nov 09, 2013 9:46 am

Rodc wrote:
SpringMan wrote:I have heard this said about funds, that is less than 5% in a fund is meaningless. This is obviously false. A large chunk of money invested in 25 funds each representing 4% of the portfolio will never be meaningless. Overly complicated does not equate to meaningless. I doubt if there are 25 asset classes so the concept may be apply to asset classes.
The question was about asset classes, not funds.

As you note in your example the asset allocation that pertains to the question is not the 4% in each fund.

So, I don't see how your post addresses the question.
Maybe it does not. My point was you often hear this 5% rule said with respect to investing in a specific mutual fund. Back on topic, the rule still seems arbitrary. Less than 5% in some cases may be a significant dollar amount, the question becomes what dollar amount is meaningless. The answer would be subjective.
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Re: Does an allocation less than 5% ever make sense?

Post by dbr » Sat Nov 09, 2013 9:47 am

Rodc wrote:
As dbr notes, 5% is not likely to rise to the level of being useful and I note that nothing like a 0.1% win will ever be shown with any statistical significance as being different from random noise.
I think Rod and I agree that one form of an answer that rises to the level of an academic argument is whether or not any difference is statistically significant.

I do not have a cite for examples of academic work putting numbers to where one asset or another becomes meaningful by that criterion. I am not especially familiar with mean variance optimization, for example, but one would hope that one would not optimize a portfolio by indicating the addition of asset classes where the effect of the addition is not statistically significant. It should be kept in mind that statistical significance is an arbitrary criterion, often one of those 5% or 95% things.

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Re: Does an allocation less than 5% ever make sense?

Post by Dandy » Sat Nov 09, 2013 10:06 am

Sorry not aware of any studies re 5% being too low. But if you have 5% in REITS in a $100,000 portfolio and the REITS went up 20% and the rest of the portfolio was flat your new portfolio would be $101,000. So a 20% gain gives a 1% boost to your portfolio. I don't know if you really need much more research to decide is that worth it for you.
I think a major concern is that some investors and advisors try to over complicate their portfolios by having too many small allocations. Advisors may do this to make investing seem too complicated and/or to justify lots of trades to keep diversifying or to rebalance.

I wanted to have a small allocation to more volatile investments such as REITs, Energy and Small Cap. In total they probably equaled 6% of my portfolio and have done well. But, if I had it all to do over again I would just have used the Total Stock Market.

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Re: Does an allocation less than 5% ever make sense?

Post by watchnerd » Sat Nov 09, 2013 10:18 am

Depends what it is.

A 200% or 300% leveraged inverse ETF (i.e. negatively correlated and with 2x-3x swings bigger than the market) will surely have a noticeable impact on your portfolio, even at small percentages.

Of course, you may not like that impact :) , but that's another matter....
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Re: Does an allocation less than 5% ever make sense?

Post by Twins Fan » Sat Nov 09, 2013 12:39 pm

I am not familiar with any research or proof... But, my personal feeling is that it depends on the size of the portfolio if a 5% or so allocation makes sense.

If someone has a portfolio in the millions, then a 5% allocation may be a significant little chunk and I can see some sense to that. An extra 1 or 2% on $200k (for example), yeah why not? Those folks have likely won the game already and can just let a chunk like that do what it will do. If someone is just starting out, has a small sum of a porftolio, and wants to do a 5% allocation to something (which we see how often in folks' first posts?), then I see that as basically pointless. An extra 1 or 2% on $1000, why bother? They should simply concentrate on contributing.

Just how I wrap my mind around it anyway.

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Re: Does an allocation less than 5% ever make sense?

Post by wintermute » Sat Nov 09, 2013 12:50 pm

If you have a $2mil portfolio, 5% is $100k. That's at least couple years living expenses.

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Re: Does an allocation less than 5% ever make sense?

Post by dratkinson » Sat Nov 09, 2013 1:01 pm

Could invoke the BH play money clause and sub-allocate one 5% exposure (total), as you like, to keep yourself amused.
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Re: Does an allocation less than 5% ever make sense?

Post by steadyeddy » Sat Nov 09, 2013 2:11 pm

livesoft wrote:These "no less than 5%" rules are amusing to me because you have to start somewhere and folks cannot usually jump to 5% with an initial investment.
+1. There's also a benefit to holding something so you can learn about it. Right now I have no idea what a REIT fund does as the Dow moves ups and down. If I held some, even a few percent, I would be more likely to watch it.

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Re: Does an allocation less than 5% ever make sense?

Post by M_to_the_G » Sat Nov 09, 2013 2:26 pm

Yes, it makes perfect sense if it's incidental and unintentional. For example, international bonds comprise 0.13% of my portfolio because I hold VASGX. :mrgreen:
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Re: Does an allocation less than 5% ever make sense?

Post by Rodc » Sat Nov 09, 2013 3:25 pm

http://www.bogleheads.org/forum/viewtopic.php?t=2520

Using the spread sheet in the link above to see how adding 5% of X would have played out in the past.

The danger is getting some small % increase or decrease, which is just noise (ie can't be expected to repeat) and then compounding for decades until the different looks large (but is still just noise).

With that caveat, you can play to your heart's content.
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Re: Does an allocation less than 5% ever make sense?

Post by larryswedroe » Sat Nov 09, 2013 5:34 pm

Don't have time to read the whole thread but
What matters is both correlations and volatility, not just the percent you add. In other words adding a large percent of something that has a high correlation with other assets doesn't help much but adding something with negative correlation or low correlation with high volatility can make a bigger impact even with a much smaller percent.
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Re: Does an allocation less than 5% ever make sense?

Post by BradMajors » Sun Nov 10, 2013 3:12 am

The Wizard wrote:
BradMajors wrote:You need to monitor the funds in which you are invested. Lots of funds (even index funds) eventually go "bad" and need to be replaced. Monitoring 20 funds (5% each) might be too much work for some people.
No.
Index funds in particular almost never "go bad". Only way I can see that happening is for an ER to go from 0.2% to 0.5%, for instance.
For example, IVV outperforms SPY by 0.48% even though they track the same index. VTI is a "better" index fund than SPY, but VTI did not exist when SPY was created. SPY is the older index fund and has gone "bad". You would have to spend some time researching your fund to be aware that you should not invest any more money in SPY.

http://www.bloomberg.com/news/2013-09-1 ... equal.html

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Re: Does an allocation less than 5% ever make sense?

Post by sperry8 » Sun Nov 10, 2013 8:23 am

steadyeddy wrote:
livesoft wrote:These "no less than 5%" rules are amusing to me because you have to start somewhere and folks cannot usually jump to 5% with an initial investment.
+1. There's also a benefit to holding something so you can learn about it. Right now I have no idea what a REIT fund does as the Dow moves ups and down. If I held some, even a few percent, I would be more likely to watch it.
Agreed. And I do this. I hold some small %'s in REITs and Foreign REITs in fact. Probably own like .75% each (1.5% in total). But now, I pay attention to this asset class. Closely. And I can identify whether I want it to hold a higher % of my portfolio or remove it altogether. I have other classes I'm thinking of adding (like frontier markets), but because they aren't actually in my portfolio I monitor them so much less frequently that they'll probably never make it in unless I just put them in there at even .1%. Once it's in - I watch stuff like crazy! (to my detriment I'm sure).
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