My asset allocation

I've danced around it a bit, partly because I knew I had more changes to make, but I think it's time to go ahead and post my allocation. Silicon Valley Blogger over at The Digerati Life has put up a second post highlighting some bloggers' asset allocations, so I figure this is a good time to share mine as well. I've struggled with this a lot, and am only 90% settled on this as a long-term allocation strategy. Specifically I am still deciding how much I want invested in the international markets.

Keep in mind, this does not include my emergency cash reserve (about 3 months' expenses)-- this is my retirement/investment portfolio. I got these images as screen captures from Vanguard, where I keep up with all of my accounts.

So as you can see, I'm 99.9% in stocks (all in mutual funds with an overall expense ratio of 0.72%) with the 0.1% being unused cash in my brokerage account. My domestic stocks are tilted towards value with an increased position in small cap stocks to help maximize long-term growth.

The value tilt isn't a trend thing. While it's important to have some balance, as growth stocks have outperformed value before, value, over the long haul, has had better returns with less volatility along the way. I will probably keep a significant value tilt in my portfolio unless something makes it less reasonable to do so.

As I said before, I'm considering increasing my position in foreign stocks (perhaps to 30%), but I'll probably do so gradually with increased contributions in my retirement accounts. I briefly had some 10% in bonds, but my research last week convinced me that now was not a good time for me to put my money there; not even a small percentage. So for awhile I will be invested nearly 100% in stocks, ready to ride the peaks and valleys to (hopefully) high returns down the road.

You're young. Do you need bonds?

Conventional wisdom says everyone needs some bonds. If you don't need them for income, you need them for a diversifier, to balance out those bad years in the stock market. Right?

Wrong.

At least when your investment horizon is at least 10 years it is wrong. I recently came across a spreadsheet with total annual returns for most of the major segments of the financial marketplace, dating back to 1972 . . . it also has a handy tool that calculates what your return would be with a certain asset allocation. I added functionality to see what return would be by 10 year periods, since I am not interested in short-term behavior as a long-term investor.

When looking at the total US stock market and the total US bond market, care take a guess in how many 10-year periods bonds beat stocks? Once. Out of 26 10-year periods, bonds beat stocks once, from 1973-1982, by a score of 8.32% to 7.44%.

In only one period out of 26 did holding bonds enhance your returns over the returns of the total stock market. Not what I would have expected, but then I had never held all the numbers before.

Is there a better option to limit the chance of a "bad" decade in the market? Yes, there is. Let's start with Large Cap Value stocks. In the short term they are clearly more volatile than bonds. But when smoothed out over 10 years, they are never beaten by bonds. Ever. Not once in 26 periods. The worst period for large cap value stocks was from 1993-2002, where it saw 9.27% gains. That was the worst period. Read that again . . . let it sink in. The average return for bonds since 1972 is 8.06%. The worst 10-year period for large cap value stocks is 9.27%.

Hello.

And Large Cap Value isn't alone. Mid Cap Blend (10.64%) and Small Cap Value (10.92%) also outperformed the average bond return in their worst 10 year period. I didn't have info on mid cap value, but I would be willing to bet that it did too.

So it's clear here that there are better investments when it comes to minimizing long-term risk-- and they return much, much better. But what of the possible return enhancements of diversifying with bonds? Is it possible that in some years, their higher returns over stocks will actually improve the overall return? Assuming you aren't psychic and can't time the market, you'll have to keep some bonds all the time if you hope to accomplish this.

So I took this question and some handy common portfolios to try it out. Here are the portfolios:

• Swenson: 30% US market, 20% REIT, 20% international, 30% bond. The total return of this portfolio over 35 years is 11.56%. The worst period was 8.35% and the best was 16.78%. What happens when we replace the bonds with
• Large Cap Value stocks? Total return of 13.00%, worst period of 8.83%, best of 18.55%.
• Mid Cap blend? 13.89%, 9.48%, 19.05%
• Small Cap Value? 13.55%, 9.44%, 21.18%
• CoffeeHouse: 10% large cap value, 10% large cap balanced, 10% small cap balanced, 10% small cap value, 10% reit, 10% international, 40% bonds. Returns of 11.68%, 8.63%, 17.04%. Replace bonds with:
• LCV? 13.61%, 9.29%, 21.02%
• MCB? 13.71%, 10.13%, 21.73%
• SCV? 14.26%, 10.01%, 24.56%
• My portfolio: 35% large cap blend, 15% mid cap blend, 10% small cap blend, 30% international, 10% bonds. Returns of 12.26%, 8.14%, 18.89%. Replace bonds with:
  
• LCV? 12.70%, 8.24%, 19.46%
• MCB? 12.73%, 8.48%, 19.40%
• SCV? 12.91%, 8.50%, 19.46%

Hm. So in all 3 of those portfolios, replacing bonds with one of the other 3 asset classes raised returns EVERY time. Overall, in the best times, and in the worst times. So much for the diversification benefits of bonds.

I'm almost convinced that I need to get rid of my bonds and get into something better. I'll do some more reading first. If my investment window were less than 10 years, I would reevaluate bonds over that short timeframe. As it is, my investment horizon is at the very least 20 years away. From the looks of it, I'm only going to lose money by keeping anything in bonds.

I made some changes to my AA

After giving the matter a lot of thought, I made some changes in my accounts that "fix" my allocation problem without forcing me to go all-small or all-big in the accounts. I also discovered that there is a really good bond fund (Calvert Income: CINCX) available in my 401k, so I used that to get my allocation in bonds to near 10%.

I'm going to get on my horse and make several short posts today . . . I have a lot on my mind. Stay tuned.

Asset Allocation isn't so easy

The last couple of weeks I have been giving asset allocation a lot of thought. Everyone has their own ideas about this topic, and I'm still trying to lock down what I want my target to be. I'm currently thinking 20% international, 10% bond, 35% large cap domestic, 20% mid cap domestic, and 15% small cap domestic. That would get me a lot of exposure to the high risk/reward smaller companies but still diversify me across large caps and bonds. As young as I am I need to be willing to put money into high long-term return vehicles.

That's all well and good, but how does one go about achieving their target asset allocation? I'm a big believer in the efficiency of the market and thus a big believer in index funds. Low cost, good returns, simple to manage. But I'm pretty young, and my employer-related benefits (401k and alternative 401a pension) make up some 60% of my portfolio. That would be okay if my fund options in those vehicles included index fund choices and especially if there were small- and mid-cap options. Those choices are slim, though. I have one S&P 500 index in the 401k, and then small- and mid-cap index funds from ING in the 401a. Beyond that there aren't index funds to speak of, so currently I have considerable assets in managed funds.

The bottom line is, I can get large-cap exposure in the 401k and small- and mid-cap exposure in the 401a, but ONLY if I devote all of my funds that way in the respective plans. I know I should be looking at my overall portfolio allocation, but for some reason having all my eggs in one basket within a plan makes me nervous. What to do? Well, for now I have a Roth IRA with Vanguard and a Rollover IRA with Fidelity, and both afford me many more low-cost options, but those are a much smaller percentage of my total portfolio, so their influence isn't great. I guess if I truly want to achieve my target allocation, I'm going to have to move nearly all my 401k assets to large cap and nearly all my 401a assets to small- and mid-cap. Do my nerves regarding this seem irrational? Maybe those of you with more experience can advise.