Asset allocation

Asset allocation is both the process of dividing an investment portfolio among different asset categories, and the resulting division over stocks, bonds, and cash. This process of determining which mix of assets to hold in a portfolio is a personal one. The asset allocation that works best at any given stage in an investor's life will depend largely on the need, ability and willingness of the investor to take risk. These depend on the investment time horizon and on both the investor's financial capacity and emotional capacity to tolerate risk and to stay the course.

While this may sound like a daunting task, there are straightforward guidelines to help in selecting an appropriate asset allocation.

How much in bonds? How much in stocks? That's the basic question of asset allocation. The more risk you can handle, the less bonds you need. When you are young, your prime earning years lie ahead, and it will be decades before you need to access the money. So, higher stock allocations may be suitable since big drops in stock prices will not hurt as long as you do not flee the market.

John Bogle advises that "as we age, we usually have (1) more wealth to protect, (2) less time to recoup severe losses, (3) greater need for income, and (4) perhaps an increased nervousness as markets jump around. All four of these factors suggest more bonds as we age."

Strategic asset allocation
A key reason for devising an asset allocation strategy is to help an investor reduce the risk inherent in volatile equity asset classes that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets. These balanced portfolios help reduce volatility and down-side risk, thus better enabling an investor to maintain a long term investment program (stay the course) without panic selling during bear markets.

With a strategic asset allocation - as explained in this article - an investor selects a base target allocation to a selection of different asset classes for the long run. Strategic asset allocation is used by investors following the Bogleheads® investment philosophy. It may be changed due to life events, but it should not be changed due to market conditions. The main asset classes are equities (stock), fixed-income (bonds) and cash.

The goal is to select an asset allocation that lets you sleep at night, and avoid the destructive urge to sell out in a panic the next time the market plummets; then having to agonize over when its a "good time' to get back in. This leads to selling low and buying high, the exact opposite of prudent investing.

Because the three main asset classes - equities, fixed-income, and cash equivalents - have different levels of risk and return, each will behave differently over time. As such the allocation to these asset classes is periodically rebalanced back to the target allocation to keep the target risk-return characteristics.

Alternatively, a tactical asset allocation shifts allocations according to economic or valuation factors. Vanguard has historically used tactical asset allocation for a limited number of its balanced funds. A dynamic asset allocation calls for allocations to shift in accordance with changing future liabilities.

Stocks and bonds
Owning stocks is necessary to get the expected return needed to accumulate funds for retirement. Stocks provide us with a share of the profits generated by publicly owned companies in the economy. But in exchange for the hope of high return, stocks are extremely volatile and risky. Many investors learned how risky stocks can be in 2008 when they fell 50% from their previous highs. Over time, stock prices roughly follow the trend of the economy, which is to grow. But prices can stagnate or decline for decade-long periods. This is why having an allocation to bonds is a necessary element of asset allocation.

Bonds are a promise to pay back a loan of money on a pre-set schedule. Bonds do not produce the same expected high returns that stocks do, but they are much less volatile. The way to get reasonable growth without stomach-churning drops is to hold a mix of stocks and bonds.

Impact of asset allocation on risk and return
The first table below shows the returns of various stock/bond allocations from 2000 - 2002. This period was marked by falling stock prices. The second table reflects the longer-term rewards investors hope to receive, assuming that the historical pattern of bond returns providing a premium return over inflation, and stock returns providing a premium over bond returns will be realized. The tables show why asset allocation is important. It determines an investor's future return, as well as the bear market burden of periodic losses that he or she will have to carry successfully to realize the returns.

Rules of thumb
Although an investor's exact asset allocation should depend on the goals for the money, some rules of thumb exist to guide decisions. Any rule of thumb is only a starting point for decision making, not the end.

The most important asset allocation decision is the split between risky and non-risky assets. This is most often referred to as the stock/bond split.

Benjamin Graham's timeless advice was:

John Bogle recommends "roughly your age in bonds"; for instance, at age 45, about 45% of the portfolio should be allocated to high-quality bonds. Bogle also suggests that, during the retirement distribution phase, investors include as a bond-like component of wealth and asset allocation the value of any future pension and Social Security payment expected to be received.

Investors choosing to use less conservative guidelines should understand why they feel they have the need, ability, and willingness to take on the greater inherent risk as explained in the next section.

All age-based guidelines are predicated on the assumption that an individual's circumstances mirror the general population's. Individuals with different retirement ages (earlier or later), asset levels (those who have saved enough to fund their retirement fully with TIPS, or needs for the money (e.g. college savings) would be well-advised to consider what circumstances make their situation different and adjust their asset allocation accordingly.

Ability, willingness, and need
Risk is the uncertainty (variation) of an investment's return. Risk tolerance is an investor’s emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep. To know whether an asset allocation is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?". This is very hard to accurately assess before you have already gone through a bear market.

Author Larry Swedroe has written a multi-part guide for selecting your asset allocation; how much to invest in stocks versus bonds. Four articles by Author Larry Swedroe are referenced here:

Part I: Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.

Part II: Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.

Part III: Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.

Part IV: Asset Allocation Guide: Dealing with conflicting goals, CBS Moneywatch, February 25, 2014.

There are three additional articles in the series:

Part V: Asset Allocation guide: U.S. vs. international equity, CBS Moneywatch, March 4, 2014. Determine the appropriate mix between domestic and international stocks. (This article is US focused.)

Part VI: Asset Allocation Guide: Value vs. growth, CBS Moneywatch, March 13, 2014. Decide how much to invest between value and growth stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)

Part VII: Asset Allocation Guide: Small-cap vs. large-cap, CBS Moneywatch, March 18, 2014. Decide how much to invest between small-cap and large-cap stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)


 * Ability: An investor’s ability to take risk is determined by four factors:
 * 1) Investment horizon - when do you need the money?
 * 2) Stability of your earned income
 * 3) The need for liquidity - if you need the money in a hurry
 * 4) Options that can be exercised should your existing plan fail to meet your objectives


 * Willingness: Define your willingness to take risk. Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough?


 * Need: The need to take risk is determined by the rate of return required to achieve financial objectives. The greater the rate of return needed to achieve one's financial objective, the more risks with equities one needs to take. A critical part of the process is differentiating between real needs and desires. Any investor deciding to take more risk because of perceived "need" should do so keeping in mind that taking extra risk could well backfire and lead to lower returns.


 * How you should handle difficult choices among ability, willingness, and need to take risk.

In general, Swedroe suggests choosing the lowest equity allocation from among ability, willingness, and need to take risk (and adjusting goals as needed).

In the case where the ability is greater than the need to take risk, it is possible to choose an equity allocation in the range between these two factors, based on your willingness to take risk.

Rebalancing
Over time an individual's asset allocation may change from it's original position as a result of the difference in returns from the various asset classes. Rebalancing is the act of bringing the asset allocation in line with current investment policy. A typical recommendation is that an investor should review the portfolio asset allocation once a year, and if necessary, rebalance as specified in the investment policy. Rebalancing is often the most difficult part because it is counterintuitive, it requires one to sell a portion of an investment that went up, and buy more of what went down.

Asset allocation portfolios
Strategic asset allocation strategies range from simple to complex. Lazy portfolios are designed to perform well in most market conditions. Most contain a small number of low-cost funds that are easy to rebalance. They are "lazy" in that the investor can maintain the same asset allocation for an extended period of time, suitable for most pre-retirement investors.


 * John Bogle is a proponent of simple asset allocation portfolios. He frequently advises that most investors should allocate investment portfolios using two asset class index funds: a U.S. total market stock index fund, and a U.S. total bond market index fund.


 * A widely held portfolio among Bogleheads® Forum members is the three fund portfolio allocating investments among a U.S. Total market stock market portfolio; a Total International stock market portfolio, and a U.S Total bond market portfolio.  This portfolio is frequently expanded to include a fourth asset class, U.S. inflation-indexed bonds.


 * Some strategic asset allocation funds add additional asset classes or sub-asset classes to the asset mix. For equity investments these additions can include value stock funds, real estate funds (U.S. and international), gold, and commodity futures funds. Fixed income additions to the asset class palette include U.S high yield bond funds, international developed market bond funds, and emerging market bond funds. In addition, depending on an investor's risk tolerance preferences or tax situation, bond market allocations can be restricted to U.S treasury bonds or investment grade municipal bonds.

Funds that implement target asset allocations
An asset-allocation fund or a balanced fund is a mutual fund that holds multiple asset classes. Typically these funds hold a stock component; a bond component, and in some instances, a cash component. Many balanced funds maintain a fixed asset allocation; some pursue a variable allocation policy, changing asset weightings according to market conditions.

Target date funds are balanced funds that gradually change asset class weightings in harmony with an investor's supposed changing need for a lower risk profile over time. These funds attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

Choices for equity
For equity allocation an investor needs to choose the split between domestic (=US) and international (=ex-US) stocks. An investor may decide to select a set portion of regional stock markets, for example: North American markets, European markets, Asian markets, and Emerging markets. At the same time the investor needs to decide whether to follow the full market or to select a portion (large-cap, mid-cap or small-cap); or to tilt in style (value, blend or growth); favor REITs, or to allocate among sectors

Choices for bonds
Bogleheads like to own bond funds instead of individual bonds for convenience and diversification. Using individual corporate or municipal bonds require a very large holding in order to achieve the broad diversification and increased safety of a bond fund. The high number of different bonds in bond funds let you ignore the risk of any one bond defaulting. Interest rate risk can be managed if you select funds with short and intermediate-term duration, while default risk can be managed by selecting funds with high credit ratings. The central idea here is that your bond holdings are for safety, to reduce violent up and down swings in overall portfolio value. Bogleheads tend to take risks on the equity side, not the bond side.

Bogleheads typically divide bond allocations between just two categories: nominal bonds such as the Vanguard Total Bond Market Fund, and U.S. Treasury Inflation Protected Securities (TIPS) such as the Vanguard Inflation Protected Securities Fund. The use of a TIPS fund provides additional diversification as well as inflation protection.

I-Bonds are also an attractive alternative to TIPS. They are sold directly to investors by the U.S. Treasury; can be bought using your IRS tax refund; don't need to be held in a tax-protected account; and accrue interest tax-deferred for up to 30 years. There are annual limits on how much you can buy in I-bonds.

Importance of asset allocation

 * Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. "Determinants of portfolio performance." Financial Analysts Journal (1986): 39-44.
 * Brinson, Gary P., Brian D. Singer, and Gilbert L. Beebower. "Determinants of Portfolio Performance II: An Update." FINANCIAL ANALYSTS JOURNAL 500 (1991): 40.
 * Sharpe, William F., Asset Allocation: Management Style and Performance Measurement, Reprinted from the Journal of Portfolio Management, Winter 1992, pp. 7-19.
 * Bogle, John C., The Riddle of Performance Attribution: Who's In Charge Here—Asset Allocation or Cost?, July 20, 1997
 * Bernstein, William J., The Brinson 93.6% Hoohah, or, The Fable of the Blind CFAs and the Portfolio, 1997
 * Ibbotson, Roger G., and Paul D. Kaplan. "Does asset allocation policy explain 40, 90, or 100 percent of performance?." Financial Analysts Journal (2000): 26-33.
 * The Vanguard Group, Sources of Portfolio Performance: The Enduring Importance of Asset Allocation, July 2003.
 * Ibbotson, Roger G., The Importance of Asset Allocation, Financial Analsts Journal, Volume 66 • Number 2, March/April 2010, CFA Institute
 * Xiong, James X., Ibbotson, Roger G., Idzorek, Thomas M. and Chen, Peng, The Equal Importance of Asset Allocation and Active Management, Financial Analysts Journal, Volume 66 • Number 2, March/April 2010, CFA Institute.

White papers

 * The global case for strategic asset allocation, Vanguard, 7/31/12
 * Asset allocation in a low-yield and volatile environment, Vanguard, 11/30/2011, viewed January 5, 2015.
 * The asset allocation debate: Provocative questions, enduring realities, Vanguard, 2007 (reprint of 2006 article), viewed January 5, 2015.
 * Time diversification and horizon-based asset allocations, Vanguard, 05/16/2008, viewed January 5, 2015.
 * Recessions and balanced portfolio returns, Vanguard, 10/06/2011, viewed January 5, 2015.
 * The theory and implications of expanding traditional portfolios, Vanguard, May 2012, viewed January 5, 2015.

Academic papers

 * Sa-Aadu, Jarjisu, Shilling, James D. and Tiwari, Ashish, Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions, (March 12, 2006).
 * Statman, Meir and Scheid, Jonathan, Correlation, Return Gaps and the Benefits of Diversification, (November 2007).