I am a little hesitant even to do a post like this. Simplicity rules. For most people, a three-fund portfolio, containing a total domestic stock, total foreign stock, and total bond market fund, is all you really need. Another simple option is the four-fund portfolio, which adds domestic Real Estate Investment Trusts (REITs). (Note both REITs and bonds should be located within tax-advantaged accounts.)
On the other hand, you should carefully consider your particular investing personality. I am a “tinkerer,” and always have been, and investors who are tinkerers are prone to developing dangerous habits like actively managing investments (generally, a bad thing). John Bogle once said the normal human tendency in volatile markets is “Don’t just stand there, DO SOMETHING!” Instead, he advocated, “Don’t do something, just stand there.” For me, both are extreme positions. I need a strategy that accounts for my tinkering nature, but that keeps me from making behavioral errors. Passive investing should be, well…passive. Enter slice and dice.
You cannot predict or time markets, but you can buy, hold, and rebalance market slices to a specified allocation for each. Some have argued this degree of detailed rebalancing is “active management.” If so, then I suppose I am guilty as charged. However, I would rather call it “setting and sticking to a detailed and set allocation.” It is precisely because we cannot predict which asset categories will outperform and underperform that makes slicing allocations worthwhile.
Think about how much variation in returns all the asset classes have. A good way to do that in a visual way is to look at the Callan Periodic Table of Investment Returns. The Callan table shows from top to bottom the best to worst performing “key indices” from 1995 to 2014. It is quite a revelation. There are substantial differences in performance when looking at each asset class.
Jeremy Siegel, in Stocks for the Long Run, says, “returns can be very unstable in the short run but very stable in the long run.” The Callan table shows just how unstable the short run is. When you rebalance into (or out of) asset classes, it is because valuations have become unstable and your chosen allocation has gotten out of balance. Later, you might obtain a “rebalancing bonus” when/if that asset class reverts to its long-term (and “very stable”) value, but then you might instead obtain a “rebalancing charge” if the asset class was overvalued when you first established your allocation.
Either way, we have no idea how each asset class will perform in a given year, or for how long each will remain overvalued or undervalued. However, we know asset returns are unstable, and we know we can rebalance to manage that risk. Perhaps we may even eke out a bit more return over the long run (but don’t count on it!). Some would call this a “rebalancing bonus” – a way to capitalize on “reversion to the mean.” I try to avoid using that expression, but since I just did, I owe you a bit of explanation.
As a number of financial experts have emphasized, normal distributions rarely apply to financial markets, particularly in the short run, and sometimes this is even true during long periods. Nevertheless, in periods approaching 30 years, asset class returns are generally consistent and stable, particularly when you are considering returns for a portfolio comprised of multiple asset classes. In this context, I can agree there is a reversion to the “mean” that might be partly captured with slice and dice rebalancing. I would conclude that returns do conform closer to normal distributions, but only when using a well-diversified portfolio and only when considering portfolio-level returns.
If you slice and dice, you must commit to a long view. If this seems like a lot of work to you, I understand. Then, I would say you would be better served with a simple three or four fund approach. That might even be the smarter strategy, particularly if you are not a “tinkerer” like me. I don’t know whether a slice and dice or simple strategy will turn out to be better, so I can certainly find no fault with using a simpler three or four fund strategy.
So, let’s say you decided to slice and dice. How do you decide on the amount invested for each slice? Here is an example of how to set the portfolio weights using a “compartmentalized” approach.
We will start with REITs. You might consider REITs as different from stocks. They do behave differently than stocks (although in recent years, they have correlated highly with stocks), but they are a type of equity, and so they should be considered to be part of your domestic stock allocation. In fact, they are already included within the Total Stock Market (TSM) Index. In this example, we will be including the TSM Index Fund in the portfolio, so we need to account for the fact that part of our REIT allocation (3%) is already contained within the TSM Index. We are going to overweight with the REIT slice to improve our asset-class diversification. A good guideline is to increase it to at least 10%, but no more than 25% of the domestic equity allocation. We will use 15%. Since the TSM Index already has 3% REITs, we need 12% more via a separate REIT Index fund to reach 15%. Therefore, our domestic stock “compartment” is 88% TSM and 12% REITs.
Now, let’s add Small Cap Value (SCV) to the domestic stocks compartment. SCV is also about 3% of the TSM Index, and we will use 15% again, as we did for REITs. (By the way, SCV should not exceed 25% as well). This reduces again our allocation to the TSM Index, and so our final domestic stock compartment will be 76% TSM, 12% REITs, and 12% SCV. Note we still have not yet addressed the question of what overall percentage goes in stocks versus bonds, but next, we will consider what overall percentage of stocks goes in domestic versus foreign.
If we were not doing slice and dice, we would simply use a Total International Stock Market Index fund for our foreign stock allocation, which includes developed markets, emerging markets, and small caps. Instead, we are going to slice it by using a developed markets index and an emerging markets index. We will skip small cap here, since Vanguard announced in June 2015 that it is adding small cap exposure to its Emerging Markets Stock Index Fund and Developed Markets Index Fund at an exposure of 9-11%. For this example, we will just use developed markets 70%, emerging markets 30%.
Now that we allocated within each of the slices for domestic and foreign stocks, let’s see the ratio for each in a way that totals 100% of the “stock market level” compartment. (Remember, we still need to determine the stock/bond allocation.) We will assign a ratio of 60% domestic and 40% foreign, and then apply those to our compartment percentages determined previously. The table below summarizes the results.[table id=1 /]
Now we are ready to set the final portfolio allocation. Let’s say we decided it is 60% Stocks and 40% Bonds. Now we will multiply the 60% portfolio ratio to the stocks-level compartmental percentages we just did. See the results shown below.[table id=3 /]
Rounding to the nearest half percent, we get the below results. Here, we include very low cost Vanguard funds available for all these slices (so much for the argument that slice and dice costs more):[table id=4 /]
In summary, we calculate the portfolio-level allocation for each stock slice by multiplying the slice x domestic/foreign ratio x (the stock side of the) stock/bond ratio.
For the bond side of the portfolio, it is the same process. Simply multiply the bond slice x (the bond side of the) stock/bond ratio (using the above example, 60/40, 40%). If you decide to add a slice to foreign bonds (I would not), use the same expanded calculation used with the stock calculation: slice x domestic/foreign (bond) ratio x (the bond side of the) stock/bond ratio.
For more information on asset allocation, see this post, and if you are looking for detail, or want to learn more about asset allocation, I highly recommend Rick Ferri’s book “All About Asset Allocation.”
Whether you slice and dice or keep it simple, make it part of your Investment Policy Statement (IPS) and stick to the plan! Good luck!