Asset allocation

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Asset allocation is both the process of dividing an investment portfolio among different asset categories, as the resulting division over stocks, bonds, and cash [1][note 1]. 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." [2]

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[3].


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

Main articles: Stock Basics and Bond basics

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.[4]

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

In short, during the next 20 or 30 years, there will be a single, best allocation that in retrospect we will have wished we have owned. The only problem is that we haven't a clue what that portfolio will be. So, the safest course is to own as many asset classes as you can; that way you can be sure of avoiding the catastrophe of holding a portfolio concentrated in the worst ones.

William J. Bernstein, The Four Pillars of Investing, pg 244, McGraw Hill

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.

Cumulative return after inflation from 2000-to-2002 bear market[5]
80% stock / 20% bond -34.35%
70% stock / 30% bond -25.81%
60% stock / 40% bond -19.99%
50% stock / 50% bond -13.87%
40% stock / 60% bond -7.46%
30% stock / 70% bond -0.74%
20% stock / 80% bond +6.29%
Projected 10 year Cumulative return after inflation
stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly[6]
80% stock / 20% bond 52%
70% stock / 30% bond 47%
60% stock / 40% bond 42%
50% stock / 50% bond 38%
40% stock / 60% bond 33%
30% stock / 70% bond 29%
20% stock / 80% bond 24%

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.[note 2] 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:[7]

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.

— Ben Graham, The Intelligent Investor

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.[note 3]

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.[note 4]

  • An investor’s ability[note 5] to take risk is determined by four factors:[8]
  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
  • Define your willingness to take risk.[9] Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough?
  • The need to take risk is determined by the rate of return required to achieve financial objectives.[10] 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.[11]

Rebalancing

Main article: 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.[12]

Asset allocation portfolios

Main article: Lazy 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.[13]
  • 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.

Funds that implement target asset allocations

Main articles: Balanced fund and Target date funds

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 a US investor needs to choose the split between domestic (=US) and international (=ex-US) stocks. 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); or to allocate among sectors[note 6] or favor REITS.

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[14], and U.S. Treasury Inflation Protected Securities (TIPS) such as the Vanguard Inflation Protected Securities Fund.[15] The use of a TIPS fund provides additional diversification as well as inflation protection.[note 7]

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.

Notes

  1. There are three asset allocation strategies employed by investors.
  2. Rule of thumb: A principle with broad application that is not intended to be strictly accurate or reliable for every situation. (Reference: Wiki: Asset Allocation - Update "Age in Bonds"?, forum discussion, direct link to post.)
  3. John C. Bogle elaborates his position, in the 2010 edition of Common Sense on Mutual Funds, pp.87-88:
    "Long before the crash, I had fine-tuned my rule-of-thumb asset allocation model, centered at 50/50 for older investors in the distributions phase of their investment plan. Rather, I recommended -- as a crude starting point -- that an investor's bond position should be equal to his or her age. An investor age 65, then, would consider the propriety of a 65/35 bond/stock allocation. Clearly, such a rule must be adjusted to reflect an investor's objectives, risk tolerance, and overall financial position. (For example, pension and Social Security payments would be considered bondlike investments.) But the point is 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."

    "Age in bonds" and its variants, (age - 10) or (age - 20), are very general rules of thumb to be adjusted for the investor's circumstances; a key circumstance being the presence or absence of a pension, which would change ones willingness or need to take risk. Some Bogleheads do not add pensions and Social Security to their asset allocation of bond holdings. (Reference: Wiki: Asset Allocation - Update "Age in Bonds"?, forum discussion, direct link to post.)

  4. 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.)

  5. Ability relates to an investor's ability to withstand the ups and downs of the market without getting nervous and making changes to the asset allocation. Selling in the face of a decline is about the worst thing an investor can do. Here is a table offered by author Larry Swedroe, based on the 1970s bear market, showing the amount of decline for various stock/bond allocations:
    Asset Allocation %
    (Stock/Bond)
    Exposure to
    Maximum Loss
    20/80 5%
    30/70 10%
    40/60 15%
    50/50 20%
    60/40 25%
    70/30 30%
    80/20 35%
    90/10 40%
    100/0 50%

    For example, an investor would be willing to accept a loss of 35% in the portfolio if she held an allocation of (80% stocks / 20% bonds). This table is from the 1970's; performance during other time periods will have different results. The general idea is for investors to select an asset allocation they are comfortable with. Source: Investment Planning, forum discussion.

  6. Common reasons for sector allocation include:
    1. An investor may be employed in a segment of the economy with low job security and thus desire to reduce or eliminate exposure to that sector in the investment portfolio.
    2. 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
  7. Bogleheads' Guide To Investing, John Wiley & Sons, Inc., 2007, page 103.

See also

References

  1. Beginners' Guide to Asset Allocation, Diversification, and Rebalancing, from the SEC; with modifications according to this forum post: Re: Wiki comments requested: The importance of asset allocat.
  2. John Bogle, Common Sense on Mutuals Funds, (2010) pp.87-88
  3. Strategic Asset Allocation - Definition of Strategic Asset Allocation on Investopedia - A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.
  4. Davis, Joseph, Ph.D. and Piquet, Daniel, Recessions and balanced portfolio returns, October, 2011, Vanguard Institutional
  5. Stock return from a Wilshire 5000 index fund; bond return from a Barclays Capital Aggregate Bond Index fund; inflation data from US Treasury Department.
  6. Input parameters use exactly the same return rate each year, with no variations, no variance, no co-variance. This is a simplified calculation for illustrative purpose only; actual returns will vary.
  7. Graham, Benjamin. The Intelligent Investor (2003 edition annotated by Jason Zweig ed.). Collins Business. p. 93. ISBN 978-0060555665.
  8. Swedroe, Larry, Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
  9. Swedroe, Larry, Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
  10. Swedroe, Larry, Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
  11. Swedroe, Larry, Asset Allocation Guide: Dealing with conflicting goals, CBS Moneywatch, February 25, 2014.
  12. Ferri, Richard A. (2010). All About Asset Allocation: The Easy Way to Get Started (Second ed.). McGraw-Hill, Inc. p. x. ISBN 978-0071700788.
  13. Bogle argues this position in his classic text, Common Sense on Mutual Funds, ISBN 978-0470138137
  14. Total Bond Market Fund
  15. Inflation Protected Securities Fund

Further reading

Importance of asset allocation

White papers

Academic papers

External links