Imagine this: You’re baking a cake for your Aunt Edna’s birthday under rather unusual circumstances. You know that when you’re finished mixing everything, your cousin Eddie will come along and add anywhere from 1-3 eggs and 1-2 cups of sugar to the mix before you bake it.
How do you account for that?
Naturally, you use a recipe that would be appropriate for 2 eggs and 1.5 cups of sugar so as to minimize the problems in either direction. But your cake is unlikely to be perfect–that’s just the nature of the game.
Asset allocation is kind of like that.
You have control over what you put in your portfolio. But you have to make the decision without knowing what returns each asset class will provide, so there’s no way to determine the “perfect” asset allocation ahead of time.
We have lots of historical data, but we don’t know how well future results will conform to past results. The end result is that we can be pretty confident in the most basic of asset allocation concepts:
- Stocks have higher expected returns than bonds, but at the cost of higher short-term volatility, and
- Bonds have higher expected returns than cash, but at the cost of higher short-term volatility.
But the further we move beyond that, the less clear things become. Trying to determine, for example, whether 20% or 25% of your portfolio should be in international stocks is a bit silly. It’s draping a thin sheet of precision over a mountain of guesses.
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Interesting post! I agree that we have no way of knowing the “perfect” asset allocation and that arguments about small optimizations in portfolio weights are not productive. Instead, we aim for a reasonable asset allocation that will hopefully withstand most scenarios that “cousin Eddie” might throw at us.
I think this post goes along well with your earlier post of financial simulation. The value of simulation is not to predict what will happen so that we can optimize for that scenario…this is impossible. Instead, the value of simulation is to provide a sense of how a particular portfolio will perform over a range of outcomes that might happen. Used in this way, a good simulation can help us to construct a diverse portfolio that can protect us from a variety of surprises….but it is still a sloppy science.
I agree completely. Once you’ve educated yourself on the attributes of the various asset classes, styles, etc., you’ve just got to make an informed call and move on. It helps to write down your reasons. For example, I have reasons for keeping half of my equity holdings in foreign equity, and for limiting my fixed income investing to short-term treasuries and TIPS. Those decisions are actually the meaningful ones that are based on knowable attributes of the asset classes. Whether I should be at 70/30 or 75/25 should not be keeping me up at night.
Another problem is that correlations change over time (not to mention returns and variability).
I simply like to rely on Life Cycle Funds. It transfers the guessing game from me, the non “expert”, to the real “expert.”
@Romeo: I’d love to rely on Life Cycle funds, and in principle they could fit the bill very well, but in practice the allocation decisions they make are hard to love. I recommend Vanguard target date funds to certain people at certain times, but in my opinion there are obvious and significant flaws in their allocation, even for Joe Average, which is who they are built for. I would love to see a strong fund family or a broker offer a build-your-own option that managed all the allocation, rebalancing and lifecycle shift automatically based on the decisions you made when setting it up. That is the killer personal investing product, and I’m sure we’ll see it someday.
Ethan: Folio Investing offers something very much like that.
John Gay (a CFP who reads this blog occasionally) wrote a review about them here. Some of their “folios” are age-based, and I think you can create your own.
Mike, good column. Just thought I’d add that the reason stocks tend to do better than other asset classes is they represent ownership. Bonds represent debt. It’s basic, but with interest rates at very historic lows, important to remember bond returns (other than interest payments) are primarily driven by changes in interest rates. Rates go up, bond prices go down. Most investors need bond funds, since most can’t buy $100,000 bonds and commissions on individual bonds in small amounts are high. You can’t hold a fund to maturity, so caution is wise on intermediate and long-term bonds.
When you think about it, asset allocation simply means “don’t put all your eggs in one basket”. Kudos to all for referencing the importance of making an asset allocation decision, and as Ethan put it, “then move on”.
Oh, as a bit of a foodie, I’ve got to quibble with your choice of baking metaphor Mike.
If you try to make a cake and you get your ratios out of whack, there’s a good chance your cake will be a complete flop. That’s how baking is.
Perhaps investing is more like making a Thai stir fry. You might be a little short of ginger, or you might slightly over do the garlic and the capsicums, but if you get the big stuff right it’s still going to do the trick!
Totally agree with the big picture point though. I was reading those example portfolios for ages that floated around the Web a week or two ago, and idea that somebody who is in their 20s needs 96.34% in stocks but then that drops to 94.98% in their 30s (note to readers: or whatever — I am making up those figures, but they’re ballpark) is just silly!
I have used the same asset allocation mix for over the past 15 years. My 401 has gone up with the market and it has gone down with the market. Now, as I turn 50, I continue to use the same mix, it is now that I want to reduce the downturns. My approach is the same. I continue to add new monies every two week (with the employer match) and at the end of the year, I take a portion of the annual gains and move it into a “safe” investment vehicle so that I have something when I retire. So as it is, I have about 60% in stocks and 40% in bonds. My wife, who is 10 years younger, has 70% in stocks and 30% in bonds.
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