Welcome to my All About Asset Allocation summary. Followers of the blog know that I love summaries — so much that they’re a regular feature around here. The last post in this series was my A Random Walk Down Wall Street summary.
Today’s book is All About Asset Allocation. The book covers, you guessed it, asset allocation. Broadly speaking, asset allocation is the art of deciding how to slice and dice your investments. What percentage should be stocks? How much should be bonds?
The book’s author, Rick Ferri, adopts a top-down approach to investing. A top down approach entails first deciding on a portfolio structure, and the allocating your capital thusly. This is in contrast to a bottom-up approach, which would consist of buying deals wherever they appear — a value investing approach.
For the alert reader, then, it should come as no surprise that there’s an ideological split between top-down and bottom-up investors. If you believe that the markets are efficient or nearly so, you’ll be inclined to adopt a top-down approach. After all, if all securities are efficiently priced, it would be a waste of time to go looking for bargains.
Those who doubt market efficiency, on the other hand, will tend to adopt a bottom-up portfolio: analyzing stocks, poring over balance sheets, and so forth, in an attempt to find good companies at cheap prices.
Given that Rick Ferri adopts a top-down approach, you would expect that he’s a proponent of efficient or nearly so markets and, indeed, he is. He’s associate with the “Boglehead” movement. Those individuals who have adopted the philosophy of John Bogle, founder of Vanguard, and built it into a near religion.
The book itself can be summarized this way:
- Determine a set of non-perfectly correlated asset classes to build a portfolio out of. Securities like stocks, bonds, commodities, real estate, and so on.
- Taking into consideration your risk tolerance, decide on an allocation between those assets.
- Once that’s done, precommit to rebalancing your portfolio once annually to ensure that you maintain these targets.
- Stay the course.
That’s really all there is to it. This is the main thesis of the book, along with a bunch of informative graphs, and a discussion of some of the finer historical points. But this is the core formula.
If any of this sounds interesting, I recommend buying a copy of the book. I have included my chapter notes below.
Chapter Notes: All About Asset Allocation Summary
Chapter 1: Planning for Investment Success
- Investment planning is critical to long-term success.
- Asset allocation is the key element of investment planning.
- Discipline and commitment to a strategy are needed.
- There are no shortcuts to achieving financial security.
Put your investment plan in writing, because a written plan is not soon forgotten. Your investment policy statement (IPS) should include your financial needs, investment goals, asset allocation, description of investment choices, and why you believe this plan should get you to your goals over time.
I recommend 3 to 4 months in cash if you are single, 6 to 12 months in cash if you have a family, and 24 months when you retire.
We tend to be brave in a bull market, and this means that it is not the ideal time to search for our risk tolerance. Soul-searching should be done in a bear market when we are not sure what is going to happen next.
Chapter 2: Understanding Investment Risk
- Investment returns are directly related to investment risk.
- There are no risk-free investments after taxes and inflation.
- Practitioners view risk as investment volatility.
- Individuals view risk as losing money.
Volatility creates lower returns and thus is itself a risk. If you can reduce the volatility in a portfolio, then the compounded return moves higher, closer to the simple average return of the weighted investments in the portfolio. This is how lower portfolio price volatility increases portfolio return over time.
Chapter 3: Asset Allocation Explained
- Diversification reduces the chance of a large loss.
- Rebalancing assets in a portfolio helps contain risk.
- Correlations between asset classes are not static.
- Low correlation among asset classes is preferred but difficult to identify.
I will state right now that there are no negatively correlated asset classes. There is also no benefit from purchasing new investments that have a consistently high positive correlation with other investments already in your portfolio.
You will lose money during your investing life and should expect to at times.
Chapter 4: Multi-Asset-Class Investing
- Owning several asset classes is better than owning a few.
- Each new and unique asset class can reduce portfolio risk.
- Choose asset classes that have positive real returns and lower correlation.
- You can select a good asset allocation, but not a perfect one.
John Bogle accepts an allocation of up to 20 percent in international stock index funds.
Don’t trust any research report or book that says, “The correlation between asset class 1 and asset class 2 is X,” because by the time those words are printed, the correlation may have changed.
Any diversification benefit tends to diminish after about 12 different investments, and the maintenance cost required increases.
Chapter 5: A Framework for Investment Selection
- All asset classes should have a real expected return over inflation.
- Asset class risks should be fundamentally different from each other.
- Varying rolling correlation levels test for unique risk among asset classes.
- Liquid and low-cost funds should be accessible.
Potential asset classes for inclusion in your portfolio should have three important characteristics:
1. The asset class is fundamentally different from other asset classes in a portfolio.
2. Each asset class is expected to earn a return higher than the inflation rate over time.
3. The asset class must be accessible with a low-cost diversified fund or product.
You shouldn’t buy gold because, although it can be negatively correlated with stock returns, it has no return over inflation. How could it? It does not grow or create earnings. Neither do commodities.
Broad diversification within a fund ensures that the correlation between the investment vehicle and the asset-class category you studied is very high.
Chapter 6: U.S. Equity Investments
- U.S. stocks have produced about 6 percent in real compounded returns.
- The U.S. stock market can be subdivided into many different categories.
- Diversifying among these categories can aid a portfolio over time.
- Mixing a broad index fund with small-cap value has produced the best results.
Currently, over 26,000 U.S. company stocks have been issued in the United States; however, less than 20 percent meet the criteria to trade on a major exchange.
Make sure that the weighted market weight of the companies in which you have chosen microcap funds is no higher than $200 million and that the fund is widely diversified in at least 300 companies. Also ensure that the total expense is below 1 percent and that there is no commission for buying or selling shares. Good luck!
Over a 30-year period, a mix of 70 percent in the total market and 30 percent in the small-cap value index would have increased U.S. equity returns by 2.0 percent with very little increase in observed portfolio risk.
- Microcap are high risk, high return, but difficult to buy.
- Microcap and small stocks are not perfectly correlated with the market.
- Value stocks have higher returns and have had less empiricial risk than growth stocks. Academics assume these returns = more risk.
- Historically, small value > micro value, with lower risk.
- Available microcap: BRSIX, fees are .86% though.
- Small-cap value: VISVX, fees are .24%.
Chapter 7: International Equity Investments
- International equity provides currency diversification.
- Developed markets include advanced countries.
- Emerging markets and frontier markets expand into new geographic areas.
- International equities exhibit size and style premiums.
Building your own U.S and international stock allocation is a better method than using a global fund because there are greater diversification opportunities. In addition, holding different regional funds in a portfolio and rebalancing them annually helps you control the amount of risk exposure to any particular region and currency.
Developed markets are countries whose economy has advanced to the point where the per capita gross domestic product (GDP) exceeds approximately $10,000 per year and that have deep and mature securities markets.
Countries that have fledgling stock markets that are not categorized as either developed markets or emerging markets generally fall under the category of frontier markets
Accordingly, a permanent allocation to emerging market stocks is recommended for your potential investment list.
- Strong dollar equals more returns on US stocks, and vice versa.
- MSCI EAFE is like the S&P 500, but for the rest of the world and not the US.
Chapter 8: Fixed-Income Investments
- There are several fixed-income categories to invest in.
- Different categories exhibit unique risks and returns.
- A diversified fixed-income portfolio enhances return.
- Low-cost bond mutual funds are an ideal way to invest.
The global bond market is huge. At about $65 trillion, it has about the same market value as the global stock market.
Foreign bonds suck: I am not a big foreign bond advocate. These funds do provide some extra currency diversification; however, the cost of that diversification is high. The fees associated with foreign bond funds are two to three times higher than the cost of a U.S.-only bond fund. Those higher fees negate much, if not all, of the currency diversification benefit. This cost keeps me out of international bond funds.
Emerging market debt funds charge 1.0 percent per year in fees on average, according to the Morningstar Principia database. That is more than double the cost of any bond fund that I would invest in.
- Diversifying into TIPS + high yield bonds increases returns with little added risk.
Chapter 9: Real-Estate Investments
- Real estate is a separate asset class from stocks and bonds.
- Real estate investment trusts (REITs) are a convenient way to invest in real estate.
- REITs have low correlation with common stocks and bonds at times.
- Home ownership provides both a place to live and potential gains.
Real estate is one of the few asset classes that has exhibited low cor- relation with stocks and bonds over extended periods of time. A well-diversified portfolio that holds real estate investments alongside stock and bonds has provided superior portfolio returns over one that does not include real estate.
Dimson found that the long-term return on U.S. real estate has been on a par with the return on the U.S. stock market since the 1930s, as Table 9-1 shows.
A direct investment typically leads to the highest return because it eliminates most intermediaries by relying on direct participation by the owner.
REIT prices tend to be much more volatile than the price of the underlying real estate, and at times shares can trade at steep dis- counts and large premiums to NAV.
For practical reasons, home equity from the house you live in should be left outside the asset allocation of your investment portfolio.
REITs are 3% capitalization of the US and, as a result, should not be more than 10% of a portfolio.
Chapter 10: Alternative Investments
- Alternative asset classes extend beyond traditional stocks and bonds.
- Many alternative asset classes are difficult to invest in.
- Illiquidity and high costs often overshadow any advantage.
- Some mutual funds and ETFs are now available at a moderate fee.
Commodity funds are extremely tax inefficient.
- Commodities suck because they have no return over inflation — copper doesn’t grow into more copper.
- Investing in hedge funds is a terrible idea, high risks, returns comparable to bonds (when you calculate out all the bias), high fees, and high minimum investment. “If you still believe that hedge funds are a good idea, please stop believing it.”
Chapter 11: Realistic Market Expectations
- Realistic market expectations are important to investment planning.
- Market volatility is more predictable than market return.
- There is a relationship between market risk and long-term expected return.
- Market forecasts are useful in the long term but not in the short term.
A realistic and conservative return for stocks over inflation is 5 percent annually.
The Federal Reserve has a target for overall GDP growth, and it attempts to control that growth through changes in monetary policy. That growth number is about 3.0 percent after inflation.
The long-term correlation between annual GDP per capita growth and S&P 500 earnings growth has been over 0.9.
Chapter 12: Building Your Portfolio
- A proper asset allocation is designed to match an investor’s needs.
- The overall risk cannot be above one’s tolerance for risk.
- The life-cycle method is a good place to start.
- A modified version of “your age in bonds” is also helpful.
You may want to limit the number of funds you have in your portfolio to 12 because after that you reach diminishing returns and higher costs.
Saving regularly will build an account faster than anything else a young person can do.
Ideally, a young person will start saving at the same time he or she lands the first full-time job. The amount of saving at this stage does not need to be excessive. A rate of 10 percent of annual earnings per year is a good start.
When stocks fall in value, investors should take that opportunity to buy more stocks. A 100 percent stock portfolio precludes this from happening. A 20 percent bond allocation will allow stocks to be purchased in a down market.
A typical retiree may have about $72,000 in nondiscretionary expenses each year, which is $6,000 per month.
As such, the median asset allocation for people in early retirement is 50 per- cent in stocks and 50 percent in fixed income.
Chapter 13: How Behavior Affects Asset Allocation Decisions
- Behavioral finance is the study of investor decision making.
- Staying below your maximum tolerance for risk is critical to investment success.
- Asset allocation stress testing helps refine investor risk tolerance.
- Rebalancing keeps your portfolio in line with your investment policy.
Interestingly, the Vanguard Group found that the poorest- performing investment accounts in 401(k) plans belong to those participants who have the most education, have the highest incomes, and consider themselves skilled investors.
Rebalancing a portfolio requires that investors sell part of a winning investment and buy more of a losing one. It is hard for investors to sell what makes them happy and buy more of what makes them sad, especially during a deep bear market when everyone is gloomy.
When money is added to a portfolio, this is an ideal time to check the asset allocation and invest the additional cash where it is needed.
Chapter 14: When to Change Your Asset Allocation
- Asset allocation decisions are typically not permanent.
- Life changes lead to asset allocation changes.
- Too much risk in a portfolio should be managed downward.
- Estate planning needs eventually set asset allocation.
If you can’t sleep, lower your equity position by 10 percent.
Panic sellers almost always capitulate near a market bottom in prices, and then they lose again when they don’t get back in during the recovery, and then again because their own actions create a life-long bias against Wall Street, banking, and the American economic system.
Chapter 15: Fees Matter in Asset Allocation Planning
- Expenses have a direct impact on investment returns and should be low.
- Taxes can be controlled through proper management.
- Discipline is the key to investment success.
- Professional investment advisors can provide assistance.
About 6 percent of all mutual funds reported expenses below 0.5 percent per year. These are the funds you should be selecting from.
Tax swapping involves selling one investment and incurring a tax loss while simultaneously buying another investment that is very similar to the one sold but not “substantially identical” to it. That keeps your overall asset allocation on target while harvesting the loss. The tax loss can then be used to offset gains from other parts of the portfolio, to offset mutual fund distributions, or to offset up to $3,000 per year in ordinary income.