Asset Allocation, Diversification, and Rebalancing

Asset allocation is an investing strategy for maximizing your returns while minimizing the overall risk of your investment portfolio. It involves diversifying your investments among the major asset classes, such as equities, fixed income, real estate, commodities, and cash. Different asset classes have different levels of correlation, i.e., some will go up or down more than others. The different price movements will balance out your overall portfolio, and also give you the opportunities to BUY LOW and SELL HIGH.

How Asset Allocation Works

The underlying mechanic that makes asset allocation work is the idea that you spread out your investments into different asset classes with low asset correlation.

As your portfolio diverges from the original allocation target, the better-performing assets grow larger relative to poor performing ones. When the diverged amount is big enough, you rebalance the portfolio to restore the original percentage. This involves selling some of the better-performing assets to buy some of the underperforming assets — this is “buy low, sell high” at its best.

Five Major Asset Classes

If you look around, there are many different ways to categorize the different asset classes. For our purpose, I am using these five major asset classes:

Stocks
Bonds
Commodities
Real Estate
Cash

Asset Correlation

The power of asset allocation depends on having a combination of investments that have low asset correlation. The concept that best-performing asset varies from year to year (i.e., asset correlation) and is not easily predictable. For instance, your stocks may do well for several years, but you will eventually run into a market where other assets will outperform stocks. This means your entire portfolio won’t tank at the same time, and you’ll be able to rebalance to buy low, sell high.

Graphic from Stock Market Cook Book

Let’s take a look at the table above. You can see that Large Stocks has a correlation coefficient of -0.02 compare to Treasury Bills. This means that when Large Stocks go up in value, Treasury Bills go down. On the other hand, Large Stocks and Small Stocks with a correlation coefficient of 0.79 will track each other well but not perfectly.

In other words, you can think of Bonds and Treasury Bills as an insurance policy against your stock investments.

Asset Allocation by Age

Traditionally, the 100 Minus Age Rule is thrown around a lot when people discuss asset allocation. It is a quick way to determine your stocks vs. bonds split. For example, if you’re 40 years old, you should have 60% stocks (100-40) and 40% bonds.

I think it is an okay place to start, but you should not follow it blindly. For example, a 20% Bonds allocation is probably too high for a 20 years old investor, and a 40% Stocks allocation might be too high for a 60 years old investor.

I feel the following percentage in the table below is about right FOR ME…NOT FOR YOU. You have to take individual risk tolerance level, the amount invested, and their financial objectives into account — so there is no right allocation that fits everyone.

Age	Stocks	Bonds	Comm	Real Estate	Cash
20	100
30	90	3	3	3	1
40	80	6	6	6	2
50	65	14	6	12	3
60	50	24	6	15	5
70	30	40	6	15	9

For example, this is my current allocation at age 45 using Morningstar’s Portfolio X-Ray Tool. The benchmark number shows a typical Target Retirement 2040.

To make this process easier, I aggregate all my accounts in Personal Capital, then enter the data into the X-Ray Tool. Personal Capital also offers a view of your allocation by Asset Classes and by US Sectors.

Asset Allocation Models

The traditional method of asset allocation breaks down your investment into four broad categories:

Domestic Large-Cap Stocks
Domestic Small-Cap Stocks
Bond
Foreign Stocks

A pie chart is normally used to represent an allocation. Three popular asset allocation models are Aggressive, Moderate, and Conservative based on investor’s risk tolerance and time horizon.

Aggressive — This type of portfolio is appropriate for investors with high risk tolerance and/or long investment time horizon. This portfolio has a higher percentage of stocks relative to bonds.
Moderate — This type of portfolio is appropriate for investors with medium risk-tolerance and/or medium investment time horizon. This portfolio has a lower percentage of stocks relative to bonds.
Conservative — This type of portfolio is appropriate for investors with low risk tolerance and/or short investment time horizon. This portfolio has the lowest percentage of stocks relative to bonds

Graphics from CNN Asset Allocator

Your goal is to choose the right balance between asset classes based on your risk tolerance and investment time horizon. You can try the CNN Asset Allocator to see what a recommended portfolio looks like.

How to Determine Your Ideal Asset Allocation

Figuring out your ideal asset allocation is a very personal thing, and there is no right answer. When determining your asset allocation, the two most important factors are your risk tolerance and your investment time horizon.

Risk Tolerance is your willingness to bear the risk of potentially losing some or all of your money in exchange for higher potential returns. For example, an aggressive investor, or one with high risk tolerance, is more likely to risk losing money to get better results. It’s essential to be truthful to yourself when considering your risk tolerance level. The last thing you want to do is prematurely sell your investments in a panic.
Investment Time Horizon is the expected number of years you will be investing to achieve a particular financial goal. For example, if you are investing for a retirement that is 35 years away, you could afford to take more risk because you can ride out the down periods. On the other hand, you want less risk if you are a retiree or if you are saving for a short-term goal.

Balancing Risk and Reward

One way to help you determine your ideal asset allocation is to first look at how much you need to have and how soon. Also, you need to decide whether you could afford to wait a few more years if you don’t achieve your goal within the target deadline.

For example, let’s assume you need to save $100,000 for a down payment in 5 years and can afford to save $1,200 a month for the next 60 months. If you calculate these numbers, your investments must have a combined average annual return of 12% per year. This requires an aggressive portfolio, but 5 years is a short time, and you could lose some or all of your money.

Your possible alternatives are:

Extend your time horizon. For example, you can save $100,000 by adding $1,200 per month to an investment portfolio that has a combined average annual return of 5% in 6 years.
Increase your monthly contribution. For example, you save $100,000 by adding $1,500 per month to an investment portfolio that has a combined average annual return of 5% in 5 years.

Now that you understand what portfolio rate of return needs to be at, you could more realistically decide your asset allocation. For example, if you are shooting for a 5% rate of return, you could construct a conservative portfolio. However, if you are shooting for a 12% rate of return, you will have to be more aggressive.

Diversification

Now that you figured out your high-level asset allocation, you need to ensure that your investment is well-diversified.

1. Morningstar Style Box Diversification

The first way to diversify is to spread your investments based on the Morningstar Style Box, which divides your portfolio into nine categories according to the market capitalization and valuation.

Graphic from Morningstar’s Portfolio X-Ray Tool

Diversify by market capitalization ensures that you invest in both large companies and small ones. The Value vs. Growth components further diversify as follow:

Growth Stocks are shares of companies whose earnings are expected to grow at an above-average rate relative to the market. The company is growing earnings and/or revenue faster than its industry or the overall market.
Value Stocks are shares of companies that tend to trade at a lower price relative to its fundamentals (i.e., dividends, earnings, sales, etc.) and thus considered undervalued. Common characteristics of such stocks include high dividend yield, low price-to-book ratio, and low price-to-earnings ratio.

It’s crucial that you do not mistake “growth” for a higher return on investment. Based on the Efficient Market Hypothesis, the market already took the higher growth rate into account, and the price already reflects this. A “value” stock could very well turnaround, become favorable, and outperform a “growth” stock. Just like before, it’s not possible to predict if value stocks will outperform growth stocks for any given year. There’s a good article called, Value Versus Growth Monthly Returns that illustrate this concept and explains the image below:

Your goal is to diversify and balance growth versus value so that you are not over-invested in one area or another.

2. Stock Sectors Diversification

The next method deals with sectors (or industries) that your investments belong to. The top five sectors based on the Target Retirement 2040 are Information Technology (16.38%), Financial Services (14.60%), Healthcare (11.97%), Consumer Discretionary (10.41%), and Industrial Materials (10.27%).

Note: Personal Capital will only track US Sectors but the X-Ray tool will break down your entire portfolio into sectors.

Graphic from Morningstar’s Portfolio X-Ray Tool

Your goal is to spread your investments across many sectors so that you are not over invested in any one sector. This is how you protect your portfolio against catastrophic events, such as the collapse of the Dot-com Bubble of the early 2000s and the Subprime Mortgage Crisis of 2007/2008.

3. World Regions Diversification

The method deals with the geographical region of your investments. The top geographic markets include:

North America
Europe Developed
Japan
UK
Asia Emerging

Graphic from Morningstar’s Portfolio X-Ray Tool

How Much Should We Invest Internationally? I think the traditional view of limiting foreign investments below 20% of your total assets is too conservative.

The US GDP is $21.41 trillion (2019) vs. World GDP at about $88.08 trillion (projected 2019) — only about 24.3% (source: Worldpopulationreview.com)! I think we should be aiming for a 30-50% mark.

Our expert, Larry Swedroe, concurred with this assessment:

“I believe investors should consider having 50 percent of their equities in international stocks and have at least 30 percent.” — Larry Swedroe

Your goal is to spread your investments across geopolitical boundaries. Position your portfolio to capture the growth potential of developing markets, while balancing it with the relative security of matured markets.

4. Diversification Within Asset Class

In addition to the methods above, you can also further diversify each class, as shown below.

Stocks
- Company size (e.g., large-cap, mid-cap, and small-cap)
- Sectors
- US vs. International equities,
Bonds
- Government Bonds vs. Corporate Bonds
- Investment Grade Bonds
- Inflation-Protected Bonds
- etc.
Real Estate
- Residential vs. Commercial
- Equity vs. Mortgage
Commodities
- Metals (e.g., gold, silver, copper, etc.)
- Energy (e.g., crude oil, natural gas, gasoline, etc.)
- Livestock and Meat (e.g., hogs, pork bellies, live cattle, etc.)
- Agricultural (e.g., corn, soybeans, rice, etc.)
Cash

Aside from Berkshire Hathaway, it would be difficult and not very cost-effective to build a diversified portfolio with individual stocks. A more effective way to construct a diversified portfolio is through the use of passively managed mutual funds and ETFs. Passively managed investments are better because the underlying assets are more predictable and their lower expenses.

Rebalancing

This is where the magic happens with asset allocation. When your allocation shifted from its original percentage, you sell some shares of the better-performing assets and buy more shares of assets that have been underperforming to restore the original percentages. This is basically a “buy low, sell high” technique.

Rebalancing Frequency

However, you don’t want to rebalance your portfolio too often because you’ll have to deal with transactional expenses and taxes — although, the M1 Finance platform has completely eliminated this problem.

Traditionally, it is recommended that you rebalance your portfolio at least once a year and no more than once a quarter. However, instead of rebalancing based on time period, I think a better strategy is to rebalance when the portfolio has changed from the original allocation by some percentages.

The Larry Swedroe 5/25 Rule for Portfolio Rebalancing

From his book Think, Act, and Invest Like Warren Buffett, Larry Swedroe suggests that an investor should rebalance the portfolio whenever the allocation changed by an absolute amount of 5% (e.g., from 40% to 45%) or by a relative amount of 25% (e.g., from 6% to 4.5%).

For example, any of these situations would trigger a rebalancing:

A 35% allocation drops below 30%
A 40% allocation increased above 45%
A 5% allocation dropped below 3.75%
A 10% allocation increased above 12.5%

Another strategy that you can use to reduce trading costs and tax consequences is to slowly adjust your portfolio using new funds to buy more of the underperforming assets. This should bring things back into the proper allocation for a smaller portfolio, but may not be adequate for a larger portfolio.

Other Considerations

Portfolio Realignment

Depending on your goal, you could have a portfolio that will last for several decades. As you grow older, your risk tolerance and investment time horizon will change. Every few years, you should carefully reconsider your asset allocation against your financial goal to make sure they are still in agreement. Often, you’ll find that investors shift toward a more conservative portfolio as they grow older.

Tax Consequences

Another factor is the tax consequences of your investment activities. How you manage your portfolio, the types of investment, and the nature of the account (i.e., taxable versus tax-sheltered) could have an impact on your investment performance.

Some strategies to consider concerning taxes include:

Tax-loss Harvesting your taxable account
Put bonds and high-dividend yielding investments in a tax-sheltered account
Minimize Buy and Sell activities to reduce capital gains tax liabilities

Target Retirement Funds

If all these asset allocation ideas are giving you a headache, you may be a good candidate for a target retirement fund. With a target retirement fund, all you have to do is pick the one that has a target date closest to your financial goal

A Free Tool to Help Manage Your Investments

You can use Personal Capital to link to your investment accounts and use their Investment Checkup feature to analyze your asset allocation. It will provide you with valuable information, such as recommends your target allocation, shows where you are overweight and/or underweight, allows you to drill down and see how each investment is contributing toward different asset classes. Here’s is a screenshot of what it looks like: