Ask The Right Questions When Designing Your Asset Allocation

So how did you decide what percentages of your money went to different investments? Could you define your process if I asked you? If these questions are a bit scary, make sure you spend some time with this blog post.

These questions are the foundation of asset allocation- any investment strategy that attempts to balance risk and reward in relation to an investor's goals, risk tolerance, and time horizon.

Determining an appropriate asset allocation is a critical step, but what might surprise you is there is no right or wrong answer. There is only better (and less better)! If there was a perfect solution, there would be one universally accepted set of portfolio models, and all investment advisors wouldn't have jobs.

Individuals can have different investing goals, so a good investment advisor can help design a custom portfolio. How much risk should you take to meet your goals? How much risk can you take before you start losing sleep whenever your portfolio dives? Do you need investment income, and should it come from interest, dividends, or selling shares? Are you in a high tax bracket, meaning you'd benefit more from tax efficient investments outside your retirement plans?

If you haven't thought about your asset allocation recently, now's a good time to work through the following five considerations.

1. The Split Between Stocks and Bonds

Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks to bonds in a given portfolio. This decision has roots in the "separation theorum", first proposed by Nobel laureate James Tobin in the late 1950's. The theorum explains the process by which investors allocate dollars to risky assets such as stocks and safer assets like bonds.

Influential in this decision is an investor's age. Over time, human capital (ability to earn & save income) decreases while financial capital ($$$ in the bank) increases. As these two sources of wealth evolve approaching retirement, many investors take less risk with their financial capital.

Be careful though. Life expectancy can stretch several decades into retirement. As such, modern portfolios usually need a high likelihood of long term survival, i.e., going too conservative can rob an investor of growth needed to both provide an income as well as outpace inflation.

A quick test is to place your portfolio on the return / volatility chart above according to the percentage of stocks in your portfolio. If you happen to be a balanced investor (60% stocks, 40% bonds), in any given year you would expect your total return to fall within a range of -2.5% and 21.5%*. Don't be fooled with those pie in the sky numbers. They are just averages. We all know that occasionally the market delivers returns outside that range. In 2008 U.S. stocks lost -36.7%, yet the very next year gained 28.8%.

2. U.S. Versus Non U.S. Stocks

Here is the global market breakdown**. When I show investors this data they start to embrace the concept of reducing their bloated U.S. domiciled investments.

The tendency to allocate more to U.S. stocks is referred to as "home bias". A large home bias has frustrated investors in the past. The decade ending 12/31/2009 saw the S&P 500 lose -0.95%. During that same time period, International stocks returned 1.58% and Emerging Markets stocks (countries such as India, China, & Brazil) produced a 7.29% return***.

If you're a growth oriented investor, I recommend a higher percentage of your stock allocation go to non U.S. stocks. Although non U.S. stocks have slightly lagged U.S. stocks in returns while experiencing a higher volatility, there is still a massive diversification benefit for investors with a long time horizon, risk appetite, or both.

3. International Developed Stocks Versus Emerging Market Stocks

Countries are classified as "emerging" based on criteria such as economic development, market size & liquidity, and even geographic politic risk.

It is reasonable that investors demand higher returns to bear the additional risks in emerging markets stocks. Investors who are willing to bear this additional risk in order to seek higher expected returns could overweight Emerging Markets relative to International developed markets stocks.

Following the same logic as #2, investors could adjust for higher percentages of Emerging Markets stocks within their stock allocation framework.

4. How To Use Bonds

For the majority of investors, bonds should be used exclusively to dilute the risk of stocks. This tends to be an easier decision than #1-#3, as bond needs are a bit easier to define and risks are easier to control.

Many investors mistakenly believe all bonds are safe. Bonds in the "floating rate" or "high yield" category definitely do not fall into the safe category. For example, floating rate as an asset class has averaged a 3.15%return, yet has experienced one-year losses as large -12.29%****. High yield bonds exhibit stock-like risk and return metrics, evidenced by the Barclays High Yield Corporate TR (USD) index -31.23% loss from December, 2007 through November, 2008.

Here is how High Yield bonds (blue line) have compared to a mix of intermediate duration corporate and government bonds (green line) since the Great Recession of 2008. If we're managing for risk, it's pretty obvious which type of bonds are preferred. Proper risk management comes in especially handy in times like 2008.

Chart Source: Morningstar, ticker: JNK, January 12th, 2015.

There are some advantages to using more exotic bonds, like if an investor heavily relies on their portfolio for income. Additionally, a strong case can be made for substituting corporate and government bonds for tax free municipal bonds, especially when the investor is in a higher tax bracket.

I recommend investors stick with short to medium duration bonds, with roughly equal allocations to both corporate and government varieties. Keeping the duration low reduces bond pricing sensitivity to changes in interest rates. A split between corporate and government bonds has historically delivered a diversification benefit.

We should never feel surprised by our bond holdings. This is why I control for risk as best as possible by limiting duration as well as focusing on high quality issues.

5. Should You Use "Alternative" Investments

There are several types of alternatives; gold, real estate, commodities, long/short equity, hedged strategies, etc. Diversification can be thought of as the only "free lunch" in investing, but often these exotic strategies take it too far. More than once investors have been disappointed with lower returns and higher risk after investing in alternatives.

Alternatives have caused a rift in financial circles. There are hundreds of articles promoting the asset class within your portfolio. There are just as many cautioning against it.

In the May, 2013 study Asset Allocation: Risk Models For Alternative Investments, authors Pedersen, Page, and He determined a big challenge for investors is the disappearance of the diversification benefit of alternatives exactly when investors need it. The Yale Endowment Fund, a heavy investor in alternatives, found this out the hard way in 2008. When stocks decline, investors flock to quality, like treasury bonds. Since many alternatives invest in distressed and illiquid assets, they can decline just as quick as stocks during these flights to quality. In many cases, you can't even sell if you wanted to.

My advice is to ignore alternatives. If you still decide to include them, my question is how do you incorporate them in your portfolio? Do you reduce your stock, bond, or both allocations to make room for alternative assets? Lopping off 10 to 20% of your stock allocation is way different than carving out the same amount from your bond allocation. I've yet to find a valid methodology for making this decision.

Hopefully #1-#5 gave you a educated framework to think about your allocation. If you don't have a clear idea of how your portfolio has been constructed, ask your financial advisor. Inquire about their specific approach. If you receive any answer outside of a simple, succinct explanation, you'll want a 2nd opinion. If you're a DIY investor, I hope I helped you gain clarity on your own investment design. Perhaps you now have an opportunity to Simply Your Portfolio a bit!

One of the greatest exercises I ever executed as a financial advisor is spending a few weeks working through questions #1-#5. My responses are the chassis I built my company's portfolio models upon.

If you'd like some guidance, don't be scared of reaching out to me in the Shoot Us An Email form down in the website footer. I can help you customize your allocation whether you want to do it in your own 401(k) or hire us to help you out.

* Source: Equities are represented by the MSCI World Index until 1987 and the MSCI All Country World Index from 1988 to 2013. Indices are not available for direct investment; therefore, their performance does not re ect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Source: MSCI data.

** As of December 31st, 2014. Market cap data is free-float adjusted from Bloomberg securities data. China market capitalization excludes A-shares, which are generally only available to mainland China investors. Data courtesy Dimensional Fund Advisors LP.

*** Asset classes represented by the following indices; S&P 500 (Large caps), MSCI EAFE Index gross dividends (International stocks), MSCI Emerging Markets Index price only. Indices are not available for direct investment; therefore, their performance does not re ect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

**** BofAML ABS Auto Floating Rate TR USD (USD) average return 12/31/1996 to 12/31/2015. One year greatest loss is February, 2008 through January, 2009.

#assetallocation