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How do you decide what YOUR OPTIMAL ASSET ALLOCATION should be?

personal finance Feb 19, 2021

Don’t put all your eggs in one basket!

10 years ago I was fixated on picking the best Dividend Aristocrats (best of the best dividend growth stocks) to add to my portfolio, I failed to realize that the biggest contributor to my portfolio’s overall return would be asset allocation. A 2000 study by economists Roger Ibbotson and Paul Kaplan concluded that more than 90% of a portfolio’s long-term returns were driven by its asset allocation. In other words, the selection of individual securities is secondary to the manner in which assets are spread across stocks, bonds, cash and other investment vehicles; this spread or weighting will be the most important determinant of your portfolio returns.

How then do you decide how you will be allocating your assets? Should you just follow a template that is out there? Where do you – your goals, your risk appetite, your beliefs about debt and the stock market – factor in? In the end, the goal of asset allocation (also known as portfolio optimization) is to build a portfolio that is generating the highest possible return at risk that is acceptable to you.

The chart below attempts to categorize the major investment vehicles based on risk and return to give you a bird’s eye view. With this in mind, let’s delve into the different asset classes and asset weighting; I will also outline frequently recommended asset allocation strategies. But I hope at the end of this post you will know enough about the different asset classes and their historic risk-return profiles to build your own personalized asset allocation strategy based on your risk appetite.

Source: Thomson Reuters Datastream. Data period: 3Q 1993-2Q 2013.

STEP 1: Pick your Asset classes

Listed from higher to lower risk IMHO:

  • Cryptocurrency – I am beginning to feel strongly that it deserves a place on this list
  • Commodities like Metals (gold is a hybrid commodity as it is also a financial asset and therefore has lower risk than other commodities), Agriculture, Energy
  • Equities or stocks:
    • Emerging markets: Securities issued by companies in developing nations. These investments offer a high potential return and a high risk.
    • International securities: Any security issued by a foreign company and listed on a foreign exchange
    • Small-cap stocks: Companies with a market capitalization of less than $2 billion. These equities tend to have a higher risk due to their lower liquidity.
    • Mid-cap stocks: Shares issued by companies with a market capitalization between $2 billion and $10 billion
    • Large-cap stocks: Shares issued by companies with a market capitalization above $10 billion
  • Real estate investments including more passive investments like Real estate investment trusts (REITs), syndication and more active direct ownership of rental real estate.
  • Fixed income assets: Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs)
  • Cash in Savings, Checking accounts. These have the advantage of being liquid and FDIC insured. Ideally, if you are far from retirement, a 6 month emergency fund (to cover expenses) is sufficient in cash.

Investing in Equities/ Stocks:

Let me mention that I started out investing in individual Blue-chip Dividend stocks 11 years ago using transfer agents for Dollar cost averaging DCA (infusing monthly fixed amounts into these stocks so that purchases occur regardless of the assets price, reducing the impact of volatility) and DRIP (reinvesting dividends to purchase more of the stock of the company without additional fees). Around 2013, I started investing in Vanguard index funds and turned into a quasi Boglehead. I am a firm believer that the best retirement stock portfolios are predominantly composed of passive index funds such as those offered by Vanguard – these are funds that track a market index and are preferred for their passive management, low costs, wide diversification reducing risk (that comes from investing in individual stocks) and tax efficiency. You could try to create your own diversified portfolio of individual stocks across the various sectors, however considering that most mutual funds do not outperform the indices, the odds are that you will do better with an index fund. So from a risk perspective, individual stocks are higher risk and index funds are much lower risk, most often with comparable or better returns when you invest in index funds. There are numerous indices, so you must first pick an index that you wish to invest in and then find an index fund that tracks it.

  • Large U.S. stocks: S&P 500, Dow Jones Industrial Average, Nasdaq Composite
  • Small U.S. stocks: Russell 2000, S&P SmallCap 600
  • International stocks: MSCI EAFE, MSCI Emerging Markets

The 3 most popular index funds in order of higher to lower risk and volatility are (but not in order of higher to lower returns):

  • Total International Stock Market Index fundVTIAX (admiral share class mutual funds with minimum investment 3000$) and VXUS (Exchange Traded Fund ETF with no minimal investment that is traded throughout the day like a stock).
  • Total US Stock Market Index fund providing exposure to over 3000 small, mid, large cap growth and value stocks- VTSAX (admiral share class) and VTI (ETF)
  • S&P 500 Index fund providing exposure to 500 large cap growth and value stocks – VFIAX (admiral share class) and VOO (ETF)

The Total US Stock Market Index Funds and the Total international Stock Market Index funds have not significantly outperformed the S&P 500 Index in the last 90 years and for those like me who prefer low volatility to diversification and possible higher returns, the S&P 500 index is a more conservative choice. In a more volatile market, like the one we are in today, the Total US Stock Market Index Funds and the Total international Stock Market Index funds may outperform the S&P 500 index, however I prefer a more long term outlook. It is important to note here that while the VTSAX has over 3000 small, mid and large cap stocks as compared to 500 large cap growth and value stocks in VFIAX, since the VTSAX is market-cap weighted, 75% of VTSAX is composed of S&P 500 stocks. So both these index funds usually have returns that are not very different. Target Date funds are an easy option used by many when they start out, but they do charge additional fees and it is important to ensure that their fund allocation and re balancing is aligned with your personal asset allocation goals. It is my belief that once you demystify equity investments, then you are better served by picking your own index funds and periodically re balancing rather than being invested in a Target Date fund.

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Warren Buffet
  • Investing in Real Estate: can be passive (REIT, syndication) or active (Joint Ventures or direct ownership). As expected, the rewards are more for direct ownership (between 25- 50% returns) and you retain more control over how the asset is managed; however you will need to spend more time educating yourself and managing the assets. You do need to pick your market well- preferably one that is landlord friendly, has both potential property appreciation and current cash flow (I favor cash flow over appreciation for more conservative, safer investments). Pick a niche – Single Family Homes vs Multifamily Homes vs Apartments, Commercial Real estate – and go from there. My preference has been to buy and hold Single Family homes in Class A and B neighborhoods in landlord friendly states as well as our home state of CA. Although the goal is to build equity for retirement, with interest rates being so low in 2020, we were able to tap into the equity of our oldest properties with cash out refinances that will fund more real estate investments in 2021.

STEP 2 : Optimal asset weighting

This depends on two factors: your risk appetite and years to retirement.

For a pure stock : bond portfolio, a popular strategy is the 3-fund portfolio, which includes in varying proportions (based on your need for diversification, risk appetite and time to retirement)

  1. Total US Stock Market Index Fund (VTSAX)
  2. Total International Stock Market Index Fund (VTIAX)
  3. Total US Bond Market Fund(VBTLX)

Your exposure to Domestic and International stocks will again depend on your risk appetite and need for diversification. One example would be splitting your money equally between all 3 funds, or your could invest 50% in VTSAX, 20% in VTIAX and 30% in VBTLX. You can hold a 3 fund portfolio as suggested above if you seek more diversification and have a larger risk appetite. Or if you are more conservative like me and prefer lesser portfolio volatility, you can stick to a 2 Fund portfolio comprised of VFIAX (S&P 500 Index fund) and VBTLX (Total US Bond Market Fund).

A good rule of thumb for stock: bond asset allocation is to subtract your age from 120 to give you the percentage of your portfolio that should be invested in the stock market. This ensures that your portfolio is more aggressive when you are younger and transitions to a more conservative portfolio as you age.

For example at 40, you would invest 80% (120-40 = 80) of your portfolio in stocks and the remaining 20% in bonds. This allocation in retirement factors in historic returns for stocks and bonds as well as inflation, permitting you to have a safe annual withdrawal rate of around 4 % and have your portfolio last at least 30 years. Check out the specifics in this post I wrote about saving for retirement. If you have a lower risk appetite, you can use 110 instead of 120 to allow for a more conservative portfolio allowing you to invest 70% in stocks and 30% in bonds at age 40. If you are very conservative and are tempted to avoid the stock market entirely, I still urge you to have some exposure to stocks to give you higher overall returns to help offset inflation(2-3%). You can invest the equity portion in a conservative S&P 500 index fund.

STEP 3: Additional strategies to optimize asset allocation

First Fund your tax advantaged accounts such as 401 (k) or 403 (b) plans, solo 401 (k), Traditional or Roth IRA (including backdoor Roth IRA for high income earners), HSA (Health savings account), 529 savings plans.

Stick to your plan for asset allocation through market ups and downs. Over long periods the market will go up despite short term volatility and the withdrawal rate calculations only work if you stick to the plan at all times.

“Keep buying it through thick and thin, and especially through thin,”

Warren Buffet

Periodically re balancing your portfolio to revert back to your preferred asset allocation helps you stay on course and reallocate back into stocks during a market downturn without falling prey to emotional investing. I choose to dynamically re balance my taxable accounts, which I did in March and April of 2020 – this just means I infuse more money into the asset that is below my intended allocation without selling other assets to re balance as there are tax implications.

Tax Loss Harvest when possible (ie sell securities that are at a loss to offset capital gains tax liability). Follow this link to a step by step guide on tax loss harvesting by Physician on Fire.

Take advantage of Compound growth by front loading your investments if you can. If you do not have the funds or the appetite to invest large amounts into the market at once, Dollar Cost Averaging (DCA) is a safe strategy where you are set up to automatically put in a fixed amount every month or every two weeks into your chosen allocations, this way emotions are out of the equation. You should also be set up to reinvest dividends ie Dividend Re Investment Plan (DRIP) which also helps accelerate growth.

Asset location: Tax disadvantaged holdings (due to dividends) such as bonds, REITs and high dividend stocks are best held in tax deferred or tax free retirement accounts (401 (k), Roth IRA) when possible. International funds are best held in taxable accounts as you get a Foreign Tax Credit.

Planning Withdrawals for tax efficiency is beyond the scope of this post but I am posting a link here for those interested.

That brings us to the end of another long post, but I hope it gives you the ammunition you need to build a portfolio that best suits you. Good luck!

Looking for Resources to help you Start or Scale your Real estate portfolio so you can hit Financial Independence faster


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