Last post we talked about the simplest investment plan on the planet: Buy the Vanguard Total Stock Market Index Fund (VTSAX) and continuously put money into it every month regardless of performance. That is it. That gives you a very easy way to buy a piece of the entire US stock market for very low fees.
For some people, understandably, that sounds a little weird. If you go talk to anybody in the finance industry or any of your colleagues they will talk about all these different things they do and how they have certain percentages in different asset classes. This is called Asset Allocation. What I want to do in this article is give you some simple tweaks you can do to the simple investing plan above to make it a little more personalized for your goals.
Tweaks On The Funds
Above we chose the VTSAX for it's low fees and for the fact that it was designed to follow the US Stock market as a whole. We saw in the previous article that the long term rate of return for the total stock market (S&P 500) was around 7 to 10%.
This is a great return for only having to invest in one fund, but can we do some tweaks on this to get any better? The short answer is yes. Different sectors of the US stock market also have different returns and different levels of volatility. So let's look at some simple allocations that you can do just within the US stock market.
In general, the way it works is you can stand to get a greater average annual return if you invest in sectors with greater volatility. That is you can get a greater average return, but it will be a much bumpier ride. For example, small cap stock (stocks with market capitalizations of less than $2 billion) tend to have higher long term average returns than large cap (market caps greater than $10 billion) but they tend to be much more volatile. An easy tweak to make to our plan within the US stock market is to split it into different funds that index to different sectors. From the past post, I explained why I liked Vanguard for fund investing so I will list some good Vanguard funds here: the Vanguard Small Cap Index Admiral Shares (VSMAX) and the Vanguard Mid Cap Index Admiral Shares (VIMAX). Both of these follow the same idea as the VTSAX. They are both low fees (.09%) and both are index funds without the need of a money manager and their fees. A simple allocation would be 50% VTSAX, 25% VIMAX, and 25% VSMAX. You can also choose any other allocation that you feel is right for you. This would be a good time to consult a financial adviser to help with your personal situation.
Further Asset Allocation
If we take this a step further, we can diversify our investments in not only the class of stocks, but the class of asset. The idea around this is usually to lower the amount of volatility in your portfolio. This is used mostly in the retirement space. Let's say you are in your 50's and are looking to retire soon. Maybe they don't want to have too many bumps in their portfolio and want something a little more smooth (I will talk about the pitfalls of this train of thought later). They will then diversify into some more "stable" asset classes. There are four main asset classes: US stocks, bonds, real estate (REITs), and international stocks. The bonds are considered the "safest" asset class as they are mostly issued by AAA rated companies and the US treasury. The likelihood of these two entities defaulting on their interest payments is fairly slim. Especially for the US government as all they need to do is print more money, but that is for a different time. Bonds, therefore, tend to have the lowest volatility and the lowest average return. What I want to do is show you some popular asset allocations along with their general returns. For reference, here is the results for a 100% stocks portfolio from 1926 to 2014:
- Average Return: 10.2%
- Best Year (1933): 54.2%
- Worst Year (1931): -43.1%
- Years With a Loss: 25 of 89
The Stock/Bond Split
This one is pretty simple. You have a certain percentage in stocks and the balance in bonds. This comes in flavors ranging from 60/40 to 80/20. Below are the numbers taken from Vanguard. Historical data is from 1926 to 2014:
- Average Return: 8.8%
- Best Year (1933): 36.7%
- Worst Year (1931): -26.6%
- Years With a Loss: 21 of 89
- Average Return: 9.2%
- Best Year (1933): 41.1%
- Worst Year (1931): -30.7%
- Years With a Loss: 22 of 89
- Average Return: 9.6%
- Best Year (1933): 45.4%
- Worst Year (1931): -34.9%
- Years With a Loss: 23 of 89
As you can see our previous thought holds true. The larger percentage of stocks in the portfolio the larger the average return, the larger the max/mins are, and the more years in loss thus more volatility.
The Bernstein Portfolio
Made popular by William Bernstein in his book The Intelligent Asset Allocator, Bernstein recommends a very simple breakdown for asset allocation: 25% US stocks, 25% Small Cap Stocks, 25% International Stocks, 25% bonds. In terms of Vanguard index funds this would be: 25% VTSAX, 25% VSMAX, 25% VTMGX, and 25% VBTLX. Here are the numbers below from Meb Faber's blog post. Historical returns are from 1973 to 2013 and are not indicative of the index funds I just mentioned specifically:
- Average Return: 10.49%
- Max Draw Down: -42.26%
- Std Deviation: 12.65%
- Percentage of Positive Months: 63.75%
So we see a slight improvement over the 80/20 above. Although this is over a different time period which did not include the great depression so I would wager that it would be damn close if you factor that in.
The Ivy Portfolio
To further give some more options we can look at what is called the Ivy Portfolio. This was a book written by Meb Faber which is who I am getting some of this data from. In this book he recommends 20% US Stock, 20% International Stock, 20% Bonds, 20% Commodities, and 20% Real Estate. Here is the performance of that portfolio again from 1973 to 2013:
- Average Return: 9.92%
- Max Draw Down: -46%
- Std Deviation: 10.28%
- Percentage of Positive Months: 67.08%
As you can see these results do not differ much from the above mixes. Next I will show you one on the other end of the complicated spectrum.
The Arnott Portfolio
This was written by Rob Arnott in this article on ETF.com. This represents one of the more complicated asset allocation models out there. Arnott splits his allocations into 10ths by putting 10% in each of the following asset classes:
- US Stocks
- Foreign Stocks
- Emerging Market Bonds
- High Yield Bonds
- US Govt Long Bonds
- Unhedged Foreign Bonds
- US Investment Grade Corporate Bonds
The individual classes themselves are not too important if you don't know what some of them are. You can look them up if you are interested. Here is the performance:
- Average Return: 10.13%
- Max Draw Down: -32.5%
- Std Deviation: 7.98%
- Percentage of Positive Months: 69.79%
You can see that the average return is on par with the rest of the allocations. It does however offer a smaller standard deviation and a smaller max draw down so it might not be as volatile. Below is a summary table of the returns and the max draw down:
What Does It all Mean?
Here is the thing. People spend countless hours and entire careers on picking the perfect asset allocation. They worry about it all the time and you will see countless books and articles on it (as I am contributing to this number). In the end, all of these asset allocations performed pretty similar. Sure, some had a little higher return and some were a little more volatile but if you realize that the future is unpredictable and that just because something worked well in the past doesn't mean it will work well in the future then the certain asset allocation you choose is not very important. The important part is that you invest continuously over time no matter what. Whether you go with the simple plan of just VTSAX or a more insanely complicated allocation like the Arnott the most important factor will be that you stick to it. So the bottom line: don't worry yourself to death with what allocation to pick. Find something that makes you feel comfortable and just roll with it.
Cautions With Asset Allocation
It is not all gravy when it comes to asset allocation. There are a couple of things I want to caution you to think twice about.
First is the widely accepted thought process that as you get older you want to make your investments more conservative. On the surface this looks okay, but I think people tend to underestimate how much they will really need/want in retirement. Let's say you follow the general advice and go mostly into bonds as you near your fifties. You could see your returns drop to 6 or 7 percent. This may not be bad, but realize that life expediencies are getting longer and longer. It is not uncommon for people to live into their 70's and 80's. Missing out on 20 years of stock returns can mean the difference between in-home care or a medicare nursing home. If you are young like I am then by the time we are eligible for retirement the life expectancy is likely to be even better with advances in medicine. The point is that just because something is a little bumpy doesn't mean you should just abandon it when you are ready to retire. Investing doesn't stop when you retire. Personally, I don't plan on going more conservative over time although I may use other techniques to lower volatility that I will write about in the future.
Next I want to caution you on Target Funds or other investments that automatically alter your investments over time. I very strongly believe that you should ALWAYS have control over your investment choices and you should always personally understand why you are investing in what you are. Financial advisers can "advise" you on what to do, but ultimately it is you that pulls the trigger. The problem with them is two fold. First you need to take responsibility for your financial life. There will come a time when you will see a large draw down and lots of fear in the markets. If you understand why you chose what you did for investments then you are less likely to run when it gets tough. Second is there are some not so nice people in the financial markets. Time and time again you hear stories of people promising great things, taking your money, and then never to be heard from again. Don't be this person. Take responsibility and manage your own investments. It takes a few hours EACH YEAR if that when using these passive strategies.