Thinking about Asset Allocation

In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction.  In this financial blog post I’m going discuss a hypothetical investing situation:

Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs.  She transferred her 401K to an IRA, and has $100,000 now sitting in cash.  Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K.  How might she invest her IRA funds?

As a proponent of diversified index investing, I suggest the following category questions… What percent  1) Domestic vs. foreign?  2) Stock versus bond?

I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio.  (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)

Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her.  Working out the math that’s $80,000 for US investments and $20,000 for foreign investments.  Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.

The US part is pretty easy to achieve.  Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND.  The foreign stock component is easy too; but $12,000 into VXUS.  Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.

There you have it.  A simple example of asset allocation.

My personal opinion is that an initial asset allocation process can be very simple and effective.  Notice that I was able to avoid several secondary asset allocation measures such:

  • Value vs Growth (stocks)
  • Large-cap vs Small-cap (stocks)
  • Sector allocation (stocks)
  • Developed vs Emerging markets (stocks and bonds)
  • Short-term vs Long-term (bonds)
  • Average Maturity or Duration (bonds)
  • Government vs Corporate (bonds)
  • Investment-grade vs non-investment grade (bonds)
  • Average credit rating (bonds)

All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above.  Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe.  Essentially, a total US stock fund seeks to own a piece of the whole US stock market.  Similarly with a total US bond fund, etc.

In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond.    [If you don’t have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]

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