I’m really excited about this course. Since we handled the four main pillars of investing – compound interest, diversification, fees, and taxes – now we can put that knowledge into practice and plan out what will be in our portfolio!
By the end of this course, the goal is for you to know what types of funds you’ll have in your portfolio and in what percentages. This is your target asset allocation, what you’re aiming to invest in. This is slightly different than your asset allocation, which is what you are actually investing in. In this course, we’ll create our target asset allocation, with the hope of getting you on track to move that into practice in the coming courses.
It’s important not to get obsessive about keeping your actual asset allocation in sync with your target asset allocation. We occasionally rebalance our portfolio to move our asset allocation closer to our target – taking into account the tax implications for any rebalancing. If you’re too OCD about keeping it right, you may end up paying more in taxes for the privilege.
We’ll dig into your specific situation in lesson 5, Questions YOU Need to Answer, but for now, we’ll focus on portfolio theory. Portfolio theory is the overall concept of how you design your investments to maximize risk for your desired level of return.
In other words, you don’t want to have a super-risky portfolio that doesn’t return much. You also can’t expect massive returns for a safe portfolio.
Luckily there’s no such thing as a “perfect” asset allocation. In any given year, the “perfect” allocation would be 100% in whatever one thing did the best in the previous year. That’s unrealistic and not diversified. Instead, we can focus on getting the best return for a specific level of risk.
There are really only two parts of modern portfolio theory that you need to know:
First, the idea of risk vs reward is based on your allocation of equities vs bonds. Equities, in this case, means index funds. For this example, we’ll be using $VTSAX, Vanguards Total US Index Fund that invests in only companies in the United States. The bond side is based on a general bond fund. We’ll use $VBTLX, Vanguards Total Bond Market fund. The allocation between just these two gives a good look at what kind of risk we should expect and what returns we could get.
My favorite visualization of this is Personal Capital’s Efficient Frontier graph. It shows the relationship between risk and reward. If you connect Personal Capital to your accounts (or enter your accounts manually as I do), it’ll show where you are on this line.
What’s always been interesting to me on this chart is where the 100% stock and 100% bond portfolios are. The 100% stock has a 10.2% return with a 19.8% risk. This “risk” is based on the standard deviation of stock performance as calculated by Personal Capital. Unfortunately, there’s no generally accepted “risk” calculation, but this one works for me.
The 100% bond portfolio has a 5.7% return for a 5.3% return. So stocks have twice the return for four times the risk.
This line isn’t straight either! You’ll notice it curves slightly. It’s also mathematically impossible to go above the line. If there was, then that would be the recommended way to invest!
When it comes to allocation stocks vs bonds, Ben Graham has some well-timed words of wisdom:
We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.
Ben Graham, The Intelligent Investor
In other words, Ben Graham says you should have 25%-75% in stocks with the rest in bonds. Any more stock than that has diminishing returns where your risk is going up faster than your returns. Graham’s advice was originally written in 1949 in a time when bond returns were quite a bit higher than they are today. Because of that, many people nowadays recommend even more in stocks.
Ben Graham is one voice amongst many. We’ll look at a few sample portfolios in lesson 4, Popular Asset Allocations, including a few popular ones that don’t follow this advice.
I think this is a good guideline for most people though. If you want to go above 75% in stocks – go for it! But understand the risks.
Historically, here’s what the returns look like for various portfolio allocations from Vanguard.
| Asset Allocation %(Stock/Bond) | Worst Year | Best Year | Avg |
| 0/100 | -8.1% | 32.6% | 5.3% |
| 10/90 | ~-9.1% | ~31.3% | ~6% |
| 20/80 | -10.1% | 29.8% | 6.6% |
| 30/70 | -14.2% | 28.4% | 7.1% |
| 40/60 | -18.4% | 27.9% | 7.7% |
| 50/50 | -22.5% | 32.3% | 8.2% |
| 60/40 | -26.6% | 36.7% | 8.6% |
| 70/30 | -30.7% | 41.4% | 9.1% |
| 80/20 | -34.9% | 45.4% | 9.4% |
| 90/10 | ~-39% | ~49.8% | ~9.7% |
| 100/0 | -43.1% | 54.2% | 10.1% |
The average column is the key here. The more you have stocks, the higher your average return. It’s that simple.
Second, your target asset allocation will change over time! When you’re young and have decades of work ahead of you it makes sense to invest more aggressively. As you get older and have fewer working years ahead of you, that’s a time when your investments generally lean more conservative.
There are even strategies where your asset allocation gets extra conservative right around retirement, then gets aggressive later. This is similar to the approach that I’m personally using.
Assuming that you’re working now, one way to create your target asset allocation over time is to define guideposts along the way. Define an asset allocation for 30 years until retirement, 20 years, 10 years, 5 years and retirement. Also define your allocation for 5 years after, 10 years after, 20 years and beyond.
So how much should you put in stocks and how much in bonds?
One common recommendation is “your age in bonds” with the rest in stocks. This advice was started decades ago when bonds had higher returns. It’s still useful to hold some bonds in your portfolio to reduce risk, but “age in bonds” is likely overkill. Another recommendation is “age/2 in bonds”, or even “40 – absolute(years until retirement)”. All of these approaches have a built-in mechanism that adjusts with age.
I really like 40-abs(years until retirement). That matches up with a bond tent approach that gets more conservative right around retirement but then gets gradually more aggressive later. Note: you’ll want to set a lower bound later in life too, so you don’t go to 0% bonds.
Ok takeaway time!
#1, your target asset allocation is what you’re aiming to invest in. You don’t need to always be invested in this allocation, but it’s good to have a plan to be moving towards.
#2, when you think about risk vs reward, think about how much of your portfolio is in stocks vs bonds. The more you invest in stocks, the higher your risk but also the higher the potential of returns.
#3, asset allocation shifts over time. Invest aggressively when you have many working years. Once you’re drawing down from your portfolio, that’s the time to become more conservative. “More conservative” for you may mean 60%/40% stocks/bonds or the reverse! It depends on your situation and risk tolerance.
Asset allocation really is the culmination of everything we’ve talked about up until this point. It determines how everything fits together to create a plan for the future.
Business and investment writer Michael LeBoeuf thinks just as highly about the subject. I like this quote by him:
The most important key to successful investing can be summed up in just two words-asset allocation.
Michael LeBoeuf
Creating an asset allocation that fits your risk level sets you up for success. Be honest with yourself. If you would react and sell all of your funds if your investments went down beyond a certain point, then you quickly move from investing to speculation. Create a portfolio that allows you to invest for the long-term!