Investing 101: Portfolios and asset allocation
Last updated on 9/6/21.
Asset allocation refers to the construction of your overall investment portfolio. It is one of the most important aspects of successful investing. In this Investing 101 article, we’ll take a look at some best practices of portfolio construction and asset allocation.
Asset allocation is usually expressed as either ratios or percentages. If all of your assets are in a bank checking account, then your asset allocation is 100% cash. If you keep a minimal amount of money in cash and invest the rest into stock market index funds, your asset allocation might look like 10% cash and 90% stocks. An investment portfolio describes the allocation of all of your investable assets. Portfolios can be as simple or as complicated as you like, and no two portfolios are identical. But coming up with the “correct” asset allocation (if such a thing even exists) is one of the most enduring questions of investing.
Why have more than one asset class?
One of the most basic principles of investing is a concept known as diversification. It is very important to invest in more than one asset, because you don’t want to have all your eggs in one basket. This is one of the reasons that buying broad index funds is preferable to picking an individual stock. But diversification goes beyond just spreading your investments across different assets within the same class; it also means investing in multiple asset classes.
Different asset classes (such as stocks, bonds, real estate) tend to perform differently under different market conditions. For example, when interest rates are low, stocks tend to perform well, as companies can borrow money cheaply and grow quickly. On the other hand, bond returns will be low when interest rates are low. However, during a stock market downturn, bonds are usually unaffected. This is a gross simplification of very complex market dynamics, but the point is that often, when an entire class of assets performs poorly, there is another class of assets that performs well. For any particular time period, it is possible to retrospectively find the best performing assets, or mixture of assets, for that time. It’s a bit like knowing yesterday’s lottery numbers. However, because the future is unknowable, it is impossible to know which asset will perform best in a future time period.
Therefore, most investors diversify their portfolio by holding assets that are uncorrelated in terms of performance. The idea is to end up with a “balanced” portfolio that will minimize risk and provide reasonable performance under a wide variety of possible future market conditions. A balanced portfolio might not necessarily be “optimal” for any given time, but is likely to do well over long time periods, where the portfolio is almost guaranteed to experience a variety of market conditions.
Another aspect of investing is that there is a universal relationship between risk and returns. Assets which are extremely safe almost certainly provide very low returns (i.e., CDs, treasury bonds). Assets which are extremely risky, however, have the potential for much higher returns (i.e., cryptocurrency). In fact, riskier assets must provide the potential for higher returns, because otherwise nobody would ever invest in riskier assets. However, there is an economic principle known as Modern Portfolio Theory (MPT), which states that by using a mixture of assets with different risk and return profiles, it is possible to construct a portfolio that maximizes returns for any given level of risk, or minimizes risk for any given level of returns.
General asset allocation principles
Conventional assets, or stocks and bonds, form the starting point for most portfolio asset allocations. In fact, many people do not hold any alternative assets at all, so their entire portfolio is composed of stocks and bonds. Cash is usually not accounted for in asset allocation, as cash provides no returns (see this article for discussion about emergency funds). Generally speaking, stocks are more volatile (riskier) compared to bonds, but also provide higher returns in the long-term. In the short term, however, stock markets can experience massive volatility, and even broad market index funds can lose 50% or more of their value. Bonds, on the other hand, offer much better preservation of principal, but at the cost of lower long term returns.
From my article on bonds. During the global financial crisis, the S&P 500% fell by over 50%, but bonds were almost unaffected.
Therefore, a basic portfolio can simply be expressed as the ratio of stocks to bonds. Younger investors in the accumulation phase of their nest egg are almost certainly better off with a stock heavy portfolio to grow their nest egg faster. On the other hand, older investors who are close to retirement might want more bonds to maintain the value of their nest egg, because if the stock market crashes, they have less time to wait for the market to rebound. Shifting the asset allocation in a portfolio over time is known as rebalancing.
A commonly cited “rule of thumb” when it comes to asset allocation is “age in bonds”, meaning that an investor at age 30 would have a 70/30 allocation, or 70% stocks and 30% bonds, shifting to more bonds as the investor ages. Using this rule of thumb, the investor would gradually rebalance their portfolio to a 35/65 allocation at age 65 upon retirement. But since bond returns are low, a more “aggressive” allocation might be (120 - age) in stocks, so that the 30 year old investor would have a 90/10 allocation and shift to 55/45 at retirement age. All else being equal, this investor is likely to experience more portfolio growth over 35 years and end up with a larger retirement nest egg. However, they are also more likely to be affected by market crashes. These allocations are just a rule of thumb, and each investor’s asset allocation depends on their individual preferences and risk tolerance.
Of course, portfolios can get as complicated as you want, although more complicated isn’t necessarily better. A simple stock and bond portfolio using just index funds can capture almost the entire global public equities market and debt market by using only 3 or 4 funds. But some investors want to dabble in alternative assets as well. So an investor with a lot of alternative investments instead of conventional investments might have 20% stocks 60% real estate, and 20% cryptocurrency, etc. There really is no perfect portfolio.
Impact of Asset Allocation
Recently, Vanguard published 95-year historical data on various classic portfolios (composed of conventional assets only), with data from 1926 to 2020. Per Vanguard’s model, a 100% stock portfolio had average annual returns of 10.3%, with the worst year having -43.1% returns. On the other end of the spectrum, a 100% bond portfolio had average annual returns of 6.1%, with the worst year having -8.1% returns. Mixed stock and bond allocations fall somewhere in-between:
Vanguard portfolio allocation models
All data and images are from Vanguard. I have simply condensed the results into one image. The full results of this study can be found here and I highly recommend taking a look.
From 95 years of historical data, the results speak for themselves: stocks offer higher average returns than bonds, but experience much more market volatility. The effects of adding bonds to a portfolio reduces long-term returns, but smooths out short-term volatility. This behavior remains consistent with long-held principles of asset allocation. Younger investors should invest more heavily into stocks to capture more portfolio growth, and they can also “wait out” stock market crashes. Older investors should shift into bonds to preserve their nest egg.
It may appear that bonds only reduce returns slightly, but don’t be fooled, as compounding magnifies even small differences over time. For example, a 100/0 portfolio had 10.3% average annual returns over 95 years, and an 80/20 portfolio had 9.8%. A $10,000 initial investment compounded at 10.3% annually over 95 years yields $110.83 million, whereas the same $10,000 investment compounded at 9.8% over 95 years yields $71.98 million, a difference of over $38 million!
If these numbers seem shocking to you, I suggest you go back and re-read Investing 101: Why invest?. The power of compounding cannot be underestimated.
Asset allocation examples
The Bogleheads community, inspired by John Bogle, who invented the index fund, has a site devoted to simple portfolio allocations, starting with something known as a Three Fund Portfolio. A three fund portfolio, as its name implies, contains only three index funds:
U.S. domestic stock market index fund (either a total U.S. stock market index fund, or a S&P 500 index fund)
International (excluding U.S.) stock market index fund
U.S. total bond market index fund
(Optional) International (excluding U.S.) total bond market index fund
Some people are proponents of adding an international bond fund to create a four fund portfolio instead of a three fund portfolio. The above portfolio can be easily created and self-managed at any major brokerage, such as Vanguard or Fidelity.
The beauty of a portfolio like the one above is that despite its simplicity, it is incredibly well-diversified. With just a few funds, an investor can capture almost the entire global public equities market as well as the global public debt market. The only real decision that the investor has to make is what percentage of assets to allocate to each fund.
Bogleheads also has a section called Lazy Portfolios, which are specific portfolio recommendations that are designed to perform reasonably well under most market conditions.
Single Fund Portfolios
Investors who are looking for even more simplicity at the cost of giving up control of their asset allocation can turn to single fund products, such as Vanguard’s targeted retirement date funds. These funds are in fact a combination of multiple index funds, usually a domestic stock market fund, an international stock market fund, a domestic bond fund, and an international bond fund. Basically, this is a four fund portfolio as described above, except with pre-determined allocation percentages and packaged into a single product. The constituent funds within the targeted retirement date funds are automatically rebalanced over time as the “target date” approaches using the same principles of increasing bond allocation over time.
In exchange for simplicity, these all-in-one funds have a few disadvantages. The investor gives up the ability to fine tune their asset allocation percentages to their own liking. The expense ratios on these funds is quite a bit higher than buying the constituent funds individually on your own. Finally, these funds may be slightly less tax efficient, because with individual funds, an investor can put the income-oriented assets such as bonds in tax-advantaged accounts instead. For most people, this is unlikely to make any difference.
Other asset allocations
Of course, a three or four fund portfolio is just a starting point. An example of some other “famous” portfolios can be found here. The most common deviation from standard stock/bond portfolios is the addition of alternative assets, such as real estate or cryptocurrency, to your investment portfolio (although note that a total market index fund contains around 3% public real estate in REITs). Beyond this, there are portfolios that employ leverage through the use of leveraged ETFs or derivates such as options. There are also various long/short strategies, such as the so-called 130-30 strategy, which invests 130% of starting capital by obtaining 30% from short positions. There are equity portfolios that seek to mimic fixed-income assets through investing in only dividend stocks, or by generating income through strategies such as selling covered calls. There are market neutral or zero-beta portfolios, which seek to generate returns without any exposure to market risk.
As I already mentioned, portfolios can get as complicated as you want, but more complicated isn’t better. Active trading is a zero-sum game, and becomes negative-sum with fees. A simple, passive portfolio of diversified index funds remains the best investment for most average investors.
A Frugal Doctor’s allocation
I track my asset allocation once per year. My 2020 in review article shows my portfolio allocation as of December 31, 2020. I will update my asset allocation again at the end of 2021.
Due to the relative strength of the U.S. stock market compared to bonds in 2021, I estimate that whereas my portfolio was 80/20 in December 2020, it is now 83/17. I now also own a negligible amount (<0.1%) in cryptocurrency.
Summary
Every investor’s portfolio is different, constructed to suit their circumstances, such as investment time horizon and risk tolerance. There is no perfect portfolio or asset allocation, but a diversified portfolio of uncorrelated assets is likely to perform reasonably well under a variety of future market conditions. Such a portfolio does not have to be needlessly complex, and can be achieved with only a few stock and bond index funds. Any beginner investor would do well by starting with a basic portfolio of stock and bond index funds, and modify their asset allocation to suit their tastes and investing experience over time.
In the next article, Investing 101: Important steps before you invest, we will look at how to organize your personal finances so you can finally start investing. Thanks for reading and happy investing!
