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Asset Allocation, Diversification, and Rebalancing

Asset Allocation, Diversification, and Rebalancing

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Asset Allocation, Diversification, and Rebalancing 1

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. Since different asset classes performs differently, i.e., some will go up or down more than others, they will balance each other out and also give you the opportunity to BUY LOW and SELL HIGH.

How Asset Allocation Works

The underlying mechanic that makes asset allocation a powerful tool, is the idea you spread out your investments into different asset classes that have low asset correlation. As your portfolio diverges from the original allocation target over time — because better performing assets grow larger relative to poor performing ones — 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:

  • Equities
  • Fixed Income
  • 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 stock investments 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.

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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 word, you can think of Bonds and Treasury Bills as insurance policy against declining stock market condition for your stock investments.

Asset Allocation by Age

Traditionally, the “100 Minus Age” Rule is thrown around a lot when people discusses asset allocation. Basically, 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 it should not be followed blindly. For example, 20% bonds is probably too high for a 20 years old investor and 40% stocks might be too high for a 60 years old investor.

Personally, I feel the following percentage in the table below is about right FOR ME…NOT FOR YOU. Each person have to take into account their own risk tolerance, how much they have invested, how much they will need at any given time…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.

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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

The allocation is usually represented as a pie chart, which is further classified as aggressive, moderate, or 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

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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 a high risk tolerance, is more likely to risk losing money in order to get better results. It’s important to be truthful to yourself when considering your risk tolerance level because the last thing you want to do is prematurely sell your investments in a panic.
  • Investment Time Horizon is the expected number of months or years you will be investing to achieve a particular financial goal. For example, if you are investing for 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 determine if 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 need 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 our 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.

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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 a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

It’s important that you do not mistaken “growth” for higher return on investment.  Based on the Efficient Market Hypothesis, the market already taken the higher growth rate into account and it is already reflected in the price.  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:

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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 that Personal Capital will only track US Sectors (which is what I have been using for my asset allocation) and the X-Ray tool will break down your entire portfolio into sectors. 

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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 Dot-com Bubble of early 2000s and Subprime Mortgage Crisis of 2007/2008.

3. World Regions Diversification

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

  • North America
  • Europe Developed
  • Japan
  • UK
  • Asia Emerging

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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 given that the US GDP is $21.41 trillion (2019) vs World GDP at about $88.08 trillion (projected 2019), or the US is only about 24.3% (source: Worldpopulationreview.com)!   I think we should be aiming for 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 and 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.

  • Equities
    • Company size (e.g., large cap, mid cap, and small cap)
    • Sectors
    • US vs International equities,
  • Fixed Income
  • 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 of construct a diversified portfolio is through the use of mutual funds and ETFs; preferably passively managed ones 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 it’s original percentage, you are selling some of the assets that have been doing well and use that proceed to 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.  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 is a fixed percentages different from the original allocation.

A 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 with regard to taxes include:

Target Retirement Funds

If all these asset allocation ideas are giving you a headache, you may be a good candidate for target retirement fund.  With 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 screen shot of what it looks like:

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Other Resources

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Steve
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Steve

Very good post. One little thing I would add regarding individual stocks vs. ETFs. Individual stocks, since they are far more volatile than a broad ETFs introduce a variance drag on investor returns, which greatly reduces compound growth rates. So while something like GE may have an average annual return of 10%, the compound growth rate that you actually see in your holding will absolutely be lower, probably on the order of 6%. Compare that to an ETF that holds GE and many other large caps, and you will still see an average annual return of 10%, but the lower… Read more »

Mr. ToughMoneyLove
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Excellent article. I would suggest that readers also consider commodity, currency protection, and inflation protection components of a proper long term asset allocation because these components are non-correlated in unique ways. Scott Burns and Craig Israelson have written on and researched this extensively.

Kyle
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Kyle

I wish I had found that nifty correlation graph. I’m always irrationally wary of putting images up for fear somebody will try to sue me for copyright violation or something like that.

Ray
Guest

Great links here. The whole concept of diversification is one everyone needs to understand the value of. I have learned a lot just looking at the portfolios of the great investors. I don’t hold any more than 4% in any one position. Last time I looked at George Soros portfolio he didn’t have more than 1 1/2% in any one position.

Great post!

Bertilak
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Bertilak

Nice writeup. One thing I noticed was the following statement: “ETFs – If you are investing large amount of money, ETFs may be better than mutual funds because of their lower expense ratios.” Some mutual funds have different share classes for larger investments. These have lower expense ratios. I know this is true for Vanguard and think it is true for several other fund companies. With Vanguard the ETFs are just different share classes of some of their mutual funds, and that share class and the corresponding ETF have the same expense ratio. So in this case the ETF does… Read more »

Jonathan
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Jonathan

This is an amazing detailed and incredibly insightful article. I especially enjoyed your comments about adopting an approach of diversification. Too many times people put everything in one basket and then wonder why it all went wrong.

Asset Allocation, Diversification, and Rebalancing

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