Asset Allocation -- What's in your future?

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There has never been a time when having solid, proven investment strategies was more important.

  • We expect government cuts to reduce the benefits available for us in the future and we are going to have to be responsible for our own financial destiny
  • We expect choppy market conditions and none of us want to go through the gut wrenching ride of 2007 and 2008

Asset allocation is a key component to successful investing and we present simple to understand data to back up this hypothesis.

Our hypothesis (to which the vast majority of financial experts will agree) is that asset allocation is the most important aspect to get right when investing. It is more important than trying to pick the best funds or companies (not that this is unimportant) and that asset allocation will be the largest determining factor to your returns.

The major asset classes are:

  • US stocks
  • International stocks (developed world)
  • Real Estate trusts
  • Emerging market stocks
  • Commodities
  • Bonds (fixed income)

You may have diversified within one class -- for example Large and Small US company stocks but that is not the same as diversifying into US and international stocks.

To test this hypothesis we have build SIB (Simpler Is Better) portfolios in which we have one index fund per asset class.

SIB portfolios for different numbers of asset classes are built and used to benchmark returns. From this, conclusions can be drawn as to what is an effective investment strategy for today.

SIBs are comprised of:

Index Funds

Asset Class

Ticker

Name

US Stocks

VTSMX

Vanguard Total Stock Mkt Idx

Foreign Stocks

VGTSX

Vanguard Total Intl Stock Index

Emerging Markets

VEIEX

Vanguard Emerging Mkts Stock Idx

Real Estate

VGSIX

Vanguard REIT Index

Commodities Broad Basket

DBC

PowerShares DB Commodity Fund

Intermediate-Term Bond

VBMFX

Vanguard Total Bond Market Index

The SIBs are simple and all returns will be based on asset allocationKey aspects of SIBS

  • These are index funds so no effort has been spent in picking any particular stock or sector
  • This is intended as a benchmark and we have not attempted to select the best fund for each asset class

Now we build portfolios for 3, 4, 5, and 6 asset classes and run historical simulation for tactical (TAA) and strategic asset allocation (SAA) for moderate risk profile

A moderate SAA portfolio will have 40% of the assets in fixed income (VBFMX or BND) and the remaining 60% of the assets equally distributed between the other asset classes.

A moderate TAA portfolio will have 40% of the assets in fixed income (VBFMX or BND) and the remaining 60% of the assets will be targeted to the best performing asset classes -- including fixed income so, in down markets, all of the assets may be in fixed income.

Three Asset Class SIB: The three core assets are U.S. and international equities and fixed income. This represents what used to be conventional wisdom: Heavy dependence on the U.S. and the rest of the developed world.

Three Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA

15%

3%

6%

TAA

2%

3%

6%

If you are using three asset classes and have the option, you should look to upgrade your portfolio immediately.

Four Asset Class SIB: There are two variants for the four asset class SIB. Either add emerging markets or real estate trusts to the three asset class SIB. Note that the international asset class means established nations such as those in Europe and emerging asset classes are represented by developing nations. In this case we are toing to report on the portfolios that has a REIT asset class.

Four Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA

16%

5%

5%

TAA

12%

7%

9%

Adding another asset class improves the performance as it balances risk. TAA is also able to increase its long term benefit over SAA as there are more asset classes to move into when one of the asset classes is not performing properly.

If you are using a four asset class portfolio, you are doing OK but could be doing better.

Five Asset Class SIB: The five class SIB takes both REIT and Emerging markets so is a fusion of the two four asset class SIBs.

Five Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA

16%

5%

6%

TAA

10%

8%

10%

The five asset class SIB is a strong platform for portfolio creation. It has broad diversification and, with tactical asset allocation, good returns.

If you are using a five asset class portfolio, you are in good shape – but take a look at the six asset class portfolio because it will be increasingly important in the current macro economic climate to have exposure to commodities as inflation will likely raise its ugly head over the next few years.

Six Asset Class SIB: The last asset class adds commodities to the portfolio. This gives another type of asset class and will further help diversification

Adding another asset class does not significantly improve the result within the 5 year time frame. It may be asked whether the extra effort of building and managing a six asset class portfolio is worth it. Broader diversification is good, but is it really necessary? In our view, the addition of commodities will be increasingly important as commodities will protect against inflation as the recovery slowly continues and there is increasing inflationary pressure.

Six Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA

15%

3%

6%

TAA

12%

10%

12%

Takeaways

The results show the benefits of increasing diversification into different asset classes. That is not the whole story, there are benefits from choosing the best funds and understanding whether you want a strategic or tactical asset allocation strategy.

It is also possible to replicate the index funds with ETFs which are index funds anyway. You can see our six and five asset class ETF portfolios with this link.

Don't be fooled by diversifying within an asset class -- make sure you have diversified into multiple major asset classes.

Disclosure

MyPlanIQ does not have any business relationship with the company or companies that provide the funds in this article. It does not set up plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.

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