Covering your Asset Allocation

Somewhere along the way someone has told you; “Don’t put all your eggs in one basket.” What does that mean? It’s a metaphor for reducing risk, right? Let’s take a look…

Time & asset allocation will be the 2 most determining factors of your investing success. Both factors serve to manage risk in your portfolio. Over time you have a greater chance of building bigger returns and riding out large market swings. With asset allocation you have a greater chance of making those returns more consistent on a year over year basis.

Take a look at the chart of above. This is asset allocation across 10 asset classes. The very first thing you’ll notice is inconsistency. In this patchwork pattern you’ll see different asset classes bouncing around all over the place. One year an asset class may be at the top of heap, and then next year it has fallen way back down. 

Some notes on the chart, which covers 11 years from 2008-2018:

  • US equities outperformed all asset classes over these 11 years, as is to be expected in most time horizons of 10 years or more. Small cap, mid cap, and large cap ranked 1, 2, 3 in that order. (see 11 year average)
  • TIPs averaged 2.9% which is probably a pretty good indicator of the inflation rate over 11 years. Four asset classes lost ground to inflation, with commodities losing money period. (see 11 year average)
  • Consider both 2008 and 2018 where bonds & cash reigned supreme. In 2009 and 2012 they were bottom feeders. (light grey and dark grey panels)
  • Bonds saw only 1 year of negative returns, in 2013. That was the only year US stocks ranked #1, 2, 3. Bonds historically have a negative correlation to stocks.
  • Emerging Markets is a highly volatile asset classes. In ’09, ’12, and ’17 they performed very well. In ’08, ’11, ’15, and ’18 they got crushed. (yellow panels)
  • Commodities have had a dismal run. (teal green panels)
  • On a year by year basis, allocation is hopeless. It’s extremely difficult to pick the best asset class from one year to the next.
  • Across a long time frame (11 years in this case, longer in most investing scenarios) asset allocation clearly serves to reduce risk. It provides a consistency that can protect against large market swings.

Weighting:

It’s almost impossible to talk about asset allocation without talking about weighting. I don’t think anyone would recommend taking $1,000 and putting $100 into each of the 10 asset classes represented in the chart and claim you are properly allocated. If they do, run screaming for the closest exit with your $1,000 firmly in hand. With that being said, how do you weight these asset classes in your portfolio?

You can read a dozen books by a dozen really good financial wizards and get a dozen different answers. This is for 2 reasons, 1 – there is no right answer and 2 – everyone has a different risk tolerance, timeline, goal, and expectation for their portfolio. This is not a “one size fits all” proposition. In fact, The Oracle himself recommends only two asset classes in a 90% / 10% mix – large cap stocks (SPY) and cash/short-term bonds (BIL).

Mr. Roboto, revisited:

As we take a look at allocation, the easiest way is to look at a “Robo Fund”. This is what they are made for, simple “one click” investing across a broad spectrum of investments. When you answer a few questions at your Robo Advisor to establish a “risk profile” and combine that with your timeline and goals for your money… boom! The Robo will spit out an asset allocation mix based on the algorithms built by the quants who work at your Robo firm of choice.

Purely as an example I grabbed what looks to be a somewhat conservative portfolio from Schwab’s Robo Advisor. It serves as a good picture of what a real-life asset allocation mix may look like, and it covers all of the asset classes in my example chart.

For illustration purposes only, not necessarily a recommended allocation

From a bird’s eye view it holds 65% stocks, 21% bonds, 9% cash, and 5% commodities. If we drill down further we can match it up to the asset classes in my chart above:

US stocks (the large cap, mid cap, small cap asset classes) = 30%

International stocks  = 21%

Emerging Markets = 9%

REITs = 5%

Bonds (and for simplicity sake TIPs) = 21%

Commodities = 5%

Cash = 9%

The performance of a broad portfolio like this would never be at the top in terms of the #1 performer, but it will never be at the bottom either. My guess is it would cut a line through the “middle” of my spreadsheet above, and not jump around much from top to bottom on a year to year basis. What you’re going for here is consistency – returns you can “stomach” on a year to year basis.

Risk vs. Reward:

If you are retired and allocating your nest egg, mitigating risk by way of minimizing large fluctuations is important. You don’t want to suffer a huge downward swing as you are drawing money off your investments to live on.

If you have a longer timespan you’d ideally tilt your allocation more toward stock than bonds. With a longer time horizon you can ride out the volatility a portfolio with a higher stock allocation will experience.

Either way you’ll still enjoy more consistent performance with the comfort of knowing that no matter what next year may bring, you will own the top performing asset class at some level.

That’s all for now, thanks for reading!

My chart came was derived from a fantastic Ben Carlson blog post. I built my own spreadsheet and verified the data. Always consult the services of a reputable, fee-based professional should you have any question about your investing.

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