3. Asset Allocation

This is part three of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part two.

At this point I was feeling pretty good.  I had just discovered an irrefutable truth about investing that not many people knew –  and it was actually going to make me money.  I was going to buy an index fund instead of a mutual fund and ride the market’s performance all the way until retirement.    Except its not quite that easy, because you can’t just buy one index fund.  One of the main points that was pounded in my head through all my research was that you can’t have have all of your retirement money in stocks.  In order to have a safe retirement portfolio, you must have your money in more than just one asset class.  An asset class is a group of securities (things you can buy on an exchange) with similar risk and rate of return characteristics.  For example, investors often refer to stocks, bonds and cash equivalents as the three main asset classes (some might also include Real Estate and Commodities).   Stocks have the highest risk and the highest return, cash equivalents are the lowest risk, but also have the lowest returns.  Bonds are somewhere in the middle.   The main reason to have different assets is to reduce the risk of your portfolio.  If you have a portfolio of all stocks, and the market crashes, you are out of luck.  But if the market crashes and you own bonds as well, your portfolio won’t lose as much value.  That is the very basic explanation of asset allocation.  Another benefit to having different asset classes (also known as diversifying your portfolio) is that when you rebalance your portfolio, you are guaranteeing that you are selling high and buying low.  More on that in Part 6.

How should I divide up my retirement money? As a young investor, the conventional wisdom says that you want 80-90% of your retirement money in stocks and the rest in bonds.  As you get closer to retirement you will want more money in bonds and in cash (the safer investments) so that you can preserve the money you saved.  There is a whole science out there about the best way to allocate your assets which I am only skimming the surface of.  In fact, most of the experts have a much more nuanced view of asset allocation.  It is not just about stocks and bonds, but about certain categories of stocks and certain kinds of bonds.   Richard Ferri’s book, The ETF Book, recommends the following asset allocation for “early savers.”

• 25% – Total US Stock Market
• 15% – Small Cap Value Stocks
• 5% – Micro-Cap Stocks
• 10% – Real Estate
• 10% – Pacific Rim Stocks
• 10% – European Stocks
• 5% – Emerging Market Stocks
• 10% – Total US Bond Market
• 5% – Inflation Protected Bonds
• 5% – High-Yield Corporate Bonds

That is 10 different asset categories!  More generally, however, it is 80% stocks (55% US, 25% International) and 20% Bonds.  Compare that allocation to Ferri’s suggestions for those who are about to retire.  The generalized allocation is 50% stocks (35% US, 15% International), 45% Bonds and 5% Cash:

• 23% – Total US Stock Market
• 7% – Small Cap Value Stocks
• 0% – Micro-Cap Stocks
• 5% – Real Estate
• 6% – Pacific Rim Stocks
• 6% – European Stocks
• 3% – Emerging Market Stocks
• 30% – Total US Bond Market
• 10% – Inflation Protected Bonds
• 5% – High-Yield Corporate Bonds
• 5% – Cash

Can I find a fund for each of these asset categories? When I first looked at this list, I thought it would be impossible to find funds for some of the more interesting categories like “Inflation Protected Bonds.”  Fortunately for us, you can buy an index fund for every one of these asset classes.  It didn’t always used to be this way.  In fact, it wasn’t until 1975 that the first index fund was created by Vanguard as a mutual fund.  And it wasn’t until 1993 and the creation of ETF’s that enabled  you to buy an index just like you would buy a stock. Check out the link for more information of how ETFs work.  Personally, I like to think of ETFs as mutual funds but with ticker symbols.

You’ll notice that index funds can be both mutual funds and ETFs.  There is a great article by the Motley Fool explaining the differences in detail.  While they perform the same function and will generate the same returns (not accounting for any fees), there are differences in their underlying mechanics and the ways in which you can buy mutual funds and ETFs.  With mutual funds, you buy your shares at the end of every day.  There also may be a minimum amount you must invest to enter the fund.  With ETFs you buy a share of the index fund just like you would buy a stock.  For example, to buy the Ishares (a brand) S&P 500 index fund, you would search for ticker symbol “IVV” and place an order, which would be subject to any commissions that you get charged for trading stocks.  Most of the index funds out there today are ETFs and because they have ticker symbols they are often more easily bought and sold than mutual funds that you may only be able to buy if you have a certain company’s brokerage account.

It is important to note that not all index funds are benchmark indexes – or indexes that are meant to track the performance of a market.  Generally, when speaking about index funds – as I have in previous sections – investors are referring to benchmark indexes.  Strategy indexes are index funds that use analysis or strategy to pick stocks in their index and are not meant to track the market.  For example, there could be a strategy index ETF that uses a screen so that only stocks of socially responsible companies are in the index.  Another strategy index may use a complex mathematical formula to constantly buy stocks that exhibit certain price trend characteristics.

Strategy index ETFs like these outnumber benchmark indexes by 2 to 1 in ETF market (according to Ferri’s The ETF Book), but from my point of view they are not something that you want in your retirement portfolio.  Because strategy indexes are attempts to beat the market, they should be treated the same way as actively managed mutual funds and should have their performance compared to the market’s performance.  While there have been no studies (that I have seen) measuring performance of strategy indexes against the market, I am willing to bet that their performance is about the same as mutual fund performances – which as you will recall from part 2, is not very good. Furthermore, if you agree that having proper asset allocation in your retirement portfolio is important, then strategy index funds will not work for you.  It will be impossible to tell if your strategy index (that is based on some computer model with stocks that change every day) will have the proper ratio of micro cap to small cap to emerging market stocks.

How do I actually buy these different asset categories? At this point, I knew I didn’t have all the specifics, but I had a general plan for how I was going to actually fund my retirement account.  As I saw it, the first step was to find an ETF benchmark index that matches the asset categories I was looking for.  Once I found an ETF for each of the 10 categories listed above (for a young investor), I would buy each of the 10 ETFs every time I put money into my retirement portfolio.  I would make sure that the amount of money I had in each ETF was equal to the percent that recommended in the preffered asset allocation.  Lets say each ETF cost $1 a share (in reality the Bond Index ETF might cost $21.63 a share and the Emerging market Stock Index might cost $84.16 a share) and I had $100 to put in my retirement portfolio.  I would buy 25 shares of the Total Stock Market ETF, 15 Shares of the Small Cap Stock ETF, 5 shares of the Micro Cap stock index and so on…  In a case where all the shares were $1, except for the Total Stock Market ETF which was $25, I would buy just 1 share of the Total Stock Market ETF.  Its not the number of shares that count, but the amount of money in each category.

My retirement plan was finally starting to come together – that was until I realized that there was more than 1 ETF for every index I was looking for.

To continue reading, follow the link to Part 4 – Expense Ratios.