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.

Advertisements

6. Portfolio Rebalancing

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

In a nutshell, portfolio rebalancing is when you check up on your portfolio at certain intervals of time and make sure that the percentage of each asset class in your portfolio remains close to the percentage that you originally set for it (as discussed in part 3).   Here is a quick illustration: Lets say I bought $1,000 each of two funds for my portfolio – a stock fund and a bond fund – and I want each fund to make up 50% of my portfolio at all times.  After 1 year, my stock fund went up 20% and my bond fund declined 5%.  As a result I had $1,200 in my stock fund and $950 in my bond fund.  My total portfolio value gained a little to become $2,150, but now had 55.8% (1,200/2,150) of my portfolio in stocks and 44.2% in bonds.  Because it is important for me to maintain a 50/50 split in my portfolio to reduce risk I would sell shares of my stock fund and buy shares of my bond fund so that each fund would have half of my new portfolio value which was $1,075 (2,150/2).  This is called portfolio rebalancing.

I’ll admit its not a very sexy topic, but it is one of my favorite parts about retirement investing because it takes the human element out of your decisions.  The beauty of rebalancing is that you never try to time the market, and you never have to guess about where its going.  If you choose to rebalance every year (a good strategy), then you can buy funds in january and not worry about a thing until december comes along.  Then in january you don’t even have to “research” the market, you just buy or sell funds to make sure that all the assets in your portfolio make up their proper percentage.  Why do I love taking the human element out of the equation?  Based on my own experience and plenty of data, we only get in our own way when we try and “time the market.”

Are humans really that bad at market timing? Dalbar Inc. is a Boston based research firm that publishes an annual report called the QAIB or Quantitative Analysis of Investor Behavior.  They charge $99 to see the annual report, so I haven’t seen it with my own eyes, but I did read a book called It’s Not about the Money by Brent Kessel which described a recent QAIB report.   According to the book, the report studied the actual returns of all investors in equity mutual funds from 1987 to 2006.   The report showed that the average investor would add money to their investment account when the market went up, and then take out money when the market went down.   As a result of this behavior, the typical investor grew $10,000 into $23,252 in 22 years.  Over the same time period, the S&P 500 grew $10,000 into $93,050.

In this example we are talking about people who are simply investing in mutual funds – NOT investing in individual stocks.   As I have explained above, mutual funds are essentially index funds, except they have a 1-2% smaller return.  So what this study is really saying is that the reduction in gains is not a result of picking the wrong stocks, but simply buying and selling at the wrong time.  Its just human nature to want to trade too much and  to go after the “hot fund.”  Its almost like we can’t help ourselves from selling low and buying high – and that is why portfolio rebalancing at set intervals is so successful.  You won’t worry about getting in your own way.

Investor opinions during the recent market slump in 2009 and subsequent recovery also provide an excellent example of how challenged humans are in making the correct investment decisions.   According to a Gallup poll from March 4th 2009 –  just a few days before the market bottom  – only 18 percent guessed that the stock market would recover by year end.  As it turns out, the S&P 500 gained 67 percent from its low point on March 9th until the end of the year meaning just 18% of Americans guessed right.  The poll results from the above link are posted below:

How often should I rebalance my portfolio?  I was so in love with the idea of portfolio balancing that I was ready to rebalance my portfolio once a month.  I wasn’t sure how I was going to make the numbers work – because as explained in part 5, the commissions associated with making 10 trades a month were pretty high.  As it turns out, there really is no right answer – there are studies that show monthly rebalancing to be the most effective, and other studies that show annual rebalancing to be most effective.  Still other studies suggest that its not the time period that should trigger your rebalancing but whether your original asset allocation is broken by a certain percent (like 10%).  Regardless of time period or other method you choose to trigger your rebalancing, the important thing is to come up with some way to adjust your portfolio that will take any emotion or attempt to time the market out of the equation.

Based on my research it seems like rebalancing your portfolio annually is a safe approach.  But just because you rebalance annually, it doesn’t mean you should be putting money into your retirement portfolio only once a year.   As I explained at the end of Part 5, once a year investing reduces your return because your money wasn’t in the market getting 8% a year, and is risky because you are not paying yourself first.  So in the end, even after taking into account annual rebalancing, it is still important to put money into retirement once a month – which means there is really no way to avoid paying large amounts of money just in trade commissions.  With this realization I decided to revisit target date funds.

To continue reading, follow the link to Part 7 – The Solution.

7. The Solution: Target Date Funds

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

So what exactly are target date funds (TDFs)?  At their core, TDFs are mutual funds.  But unlike mutual funds which might own individual stocks, TDFs are “funds made up of other mutual funds.”  In other words, TDFs do not directly own individual stocks but instead they own index funds, or a bunch of mutual funds in order to provide the investor an appropriate asset mix for retirement (like the asset allocation strategies mentioned in part 3).  In general, TDFs are composed of four primary asset types: 1. US Equity (Stocks and Real Estate) 2. International Equity, 3. Bonds, and 4. Cash Reserves.   The percentage of the fund’s money in each asset depends on the fund’s target retirement date.

For example, Vanguard has a “2020” fund, a “2025” fund, a “2030” fund…. all the way up to a “2055” fund.  If you plan to retire in the year 2055, you should buy the 2055 fund.  The 2055 fund will have more of its assets in stocks than the 2020 fund because more risk is acceptable with retirement that far off.  But the asset allocation of the 2055 fund will not always remain the same.  An important feature of target date funds is that the asset allocation will change (and become more conservative) as you get closer to retirement without you having to buy  a different fund.  So while the 2055 fund may have 90% of its assets in stocks and 10% in bonds today, in the year 2045, your “2055 fund” will have something like 60% stocks and 40% bonds.

Target date funds were created to be a one stop shop for investors.   You start putting money in to one fund in your 20s, and you will continue to put money in that same fund all the way into retirement.  You don’t have to worry about buying different funds to make sure you have the appropriate asset allocation in your portfolio because your target date fund is automatically diversified and rebalanced every year.  Further more, like mutual funds, you don’t have to pay a trade commission every time you put money into it.  So when I first read about TDFs at my HR orientation, it all sounded too good to be true, and I wrote them off because I figured they would have high expense ratios – just like most other mutual funds.  But after months of research on how to be a do-it-yourself investor using index ETFs, I finally concluded it was impossible to overcome the high costs of making online trades – even if it were as few as 3 trades a month.  If I invested $6,000 a year with my ETF strategy, my retirement portfolio would have an effective expense ratio of 6.92%, meaning I would be better off buying mutual funds.  So as much as I had tried to avoid it, it was finally time to reconsider Target Date Funds.

What are my options?  From what I could find there are three major players in the Target Date Fund world: Vanguard, Fidelity and T. Rowe Price.    Here are links to each fund (that is appropriate for my target retirement) along with their expense ratios:

  • Vanguard’s 2050 Fund (VFIFX): 0.19%
  • Fidelity’s 2050 Fund (FFFHX): 0.84%
  • T. Rowe Price’s 2050 Fund (TRRMX): 0.77%

0.19%!  Needless to say I was shocked at how low Vanguard’s expense ratio was, and honestly a little skeptical.  Just for reference, the weighted average expense ratio of all 10 index funds in my preferred asset allocation (described in part 3) was also 0.19%.  By that I mean if you multiplied the expense ratio of each index fund in your portfolio by its allocation percentage you would get your portfolio’s weighted average expense ratio.  For example, the cheapest Vanguard index fund (I’m using vanguard instead of Schwab because overall having a Vanguard account is the cheaper option) for the “Total Stock Market” is VTI with a 0.07% expense ratio.  The cheapest fund for High Yield Corporate Bonds is HYG with a 0.50% expense ratio.  To get the weighted average you would multiply VTI’s 0.07% by VTI’s allocation percentage (25%), add the product of  HYG’s 0.50% ratio and HYG’s allocation percentage (5%), and on and on for each asset.

Though both Vanguard’s Target Date Fund and my ETF portfolio would have the same expense ratio, it is clear that the Vanguard TDF is a much better deal because I wouldn’t have to pay any money on trade commissions (though I still would have to pay the $20 annual account fee).  Even with the obvious solution in front of me, I was curious to know why there was such a difference in expense ratios for funds that were supposed to do the same thing.

Why do similar target date funds have different expense ratios? If you do a little digging you can find out the composition of each fund.  Each fund is slightly different in how much it allocates to US Equity, International Equity, and Bonds, and each fund shows small differences in how that allocation changes over the years.  I’ve include a table below to show the small differences in each funds asset allocation strategy:

What is more intersting, however, is how each fund accomplishes this broad asset allocation.  As mentioned above, each of these target date funds is essentially a fund of funds.  Take the Vanguard Fund.  It is comprised of just 3 funds: The Vanguard Total Stock Market index, the Vanguard Total International Stock index and the Vanguard Total Bond index.  On the other hand, T. Rowe Price’s and Fidelity’s funds are composed of 17 and 20 different funds, respectively.  The extra funds essentially further divide each of the major categories – like US equities – into sub categories.  For example, Fidelity has 10 different funds that make up its “US Equity” allocation and they are shown in the screen shot below:

I suppose that what you are paying for in the extra expense ratio is having your TDF be EXTRA diversified.  The question then is simply this: Is a three fund portfolio properly diversified?  That is probably a question better debated by academics than myself, but I know I feel pretty comfortable with it, especially when considering the drawbacks of the other two funds.

Both the Fidelity and T. Rowe Price funds are made up of actively managed mutual funds – NOT index funds like the Vanguard TDF.  Take Fidelity’s “Small Cap Value Fund” (shown above) for example.  Its investment strategy is to invest “at least 80% of assets in securities of companies with small market capitalizations,”  and to invest in “securities of companies that [the manager] believes are undervalued in the marketplace.”  This is taken straight from Fidelity’s website.  In other words, some guy is picking and choosing what stocks to be in that fund, and as discussed in Part 2, actively managed funds generally do not beat their relevant indexes.  Furthermore, you’ll note that the “Small Cap Value Fund” is part of the US Equity assets, yet it says in the fund’s prospectus that it holds 5% of its assets in international companies!  It’s hard to feel comfortable with a fund whose real asset allocation is almost impossible to compute, much less decided by active management strategies.

The Decision:  In case it is not completely obvious by now, I decided to take my talents, or my money rather, to Vanguard’s target date fund.  Admittedly, I gave up a few things in making the decision.  First, I gave up on the idea that appropriate diversification meant having 10 different funds in your portfolio.  I could have bought one of the other target date funds with a more nuanced diversification – but as I said, I was not comfortable with buying a fund that was composed of actively managed funds.  The second thing I gave up was approximately $2,100 over 30 years.  As it turns out, I can buy the same three funds used in the Vanguard TDF for free with a vanguard account which would result in a weighted average expense ratio of 0.11% percent, compared to the TDF’s expense ratio of 0.19%.  That 0.08% difference adds up to about $2,100 in 30 years.  The way I justify this expense is that I am essentially paying $70 a year to have someone rebalance my portfolio and automatically change my portfolio’s asset allocation as I get older.  To me, having absolutely no stress and no responsibility for my retirement portfolio is worth $70 a year – it may not be for you.

So thats it.  I went from scoffing at target date funds to being a proud owner of Vanguard’s VFIFX fund – and not because I wanted to, but because that was the smartest (and easiest) thing to do.  Hopefully, I’ve convinced you to do the same, but if not, at the very least I hope that you’ll agree that the logic I used to make that decision is sound.