Monday, December 27, 2010

Developing an Asset Allocation Model (Part VI)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider, two posts on various asset subclasses and the previous post, which revealed my personal asset allocation policy. This final post in the series will discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

As a reminder, here’s the policy I have in place as of 24 December 2010:

Bonds: 44.0%
Short-term Balancing Item
Medium-term 0.0%
Long-term 0.0%
Inflation-protected 15.5%
Pension Actual%

Equities 50.0%
US Large-cap 23.0%
US Small-cap 10.5%
Europe 7.5%
Pacific 3.5%
Emerging Markets 5.5%

Real Estate 3.0%
Commodities 3.0%

Total 100%

I based the overall allocation between stocks and bonds on my risk profile. As we discussed in the first part of this series [link1], each of us has different risk parameters. In my case I (hopefully) have a large number of years still in retirement. While I have hopes of income from my writing, realistic expectations indicate I should discount those hopes and assume I am relying on my current assets to fund my retirement.

Consequently, I need sufficient cash flow to fund each year’s expenses and a mix of securities to provide a real rate of return over and above inflation. The biggest risks to my financial security are (1) longevity, (2) significant declines in asset values and (3) inflation. Given those, I started with a 50/50 allocation between bonds and equities. I then added the two additional classes of Real Estate (REITs in my case) and Commodities (precious metal coins and ETFs.)

I chose to carve the Other category out of the Bond allocation because current rates of returns on bonds are significantly below my long-term expectations. If real rates of returns on bonds were higher than my long-term expectation, I might well be fully invested in the bonds and carve the Other category out of the Equities, or be someplace in between.

Turning to the Bonds: I determine the present value of my defined benefit pension plan annuity. (If you don’t have the wherewithal to do that yourself, send me a note and I’ll send you an excel file with instructions.) I convert the present value into a percentage of my total assets.

Other than the pension, my main bond category is the Inflation-protected bonds. These bonds do a good job of addressing all three of my major risks. I have two different assets included within this subclass: Series I Savings Bonds and TIPs (Treasury Inflation-protection bonds). The target percentage I use varies based on the real rate of return on TIPs. The higher the real rate, the higher the target percentage. For example, at a 2.5% real rate of return, the target percentage is 28%. The minimum and maximum of the target range are 14% and 42%. (If I reach the higher end of the range, I would be cutting into my equity allocation, but I would be happy to do that with an inflation-protected real rate of return of 3.25% or higher.)

When I first started investing in this category, my preferred approach was to utilize Series I savings bonds [link to description of Series I bonds]. Their real rates of return were in excess of 3% at the time and I bought as much as the government allowed. With their current real rate of return at 0%, they are very unattractive. I cherish the Series I bonds I have and probably won’t cash them in until they mature. Consequently, all my purchases and sales now involve TIPs. Real rates have been creeping up recently and I will probably soon increase my target percentage.

With the Federal Reserve actively pushing down interest rates, I do not want to invest in standard medium or long-term bonds. I believe the low interest rates are much too low to compensate for the risk of increasing rates because (1) the Fed stops buying bonds, (2) inflation starts to kick up again or (3) foreign creditors stop purchasing the United States’ ballooning debt. Because of the Fed’s actions, the remainder of my bond allocation is sitting in short-term securities. This consists of money market funds paying almost no interest and short-term CDs and corporate bonds with maturities of less than three years. These will fund much of my spending over the next two-three years.

If real rates of return increase, I may gradually lengthen the duration of my bond purchases and increase TIP holdings, otherwise I’m concerned bonds are the next minor bubble with losses ahead of them. See for example Vanguard’s warning to its investors.

Let’s turn now to Equities. Within the equity allocation I found two issues to address. The first question revolves around US equities: how much to allocate between large-cap and small-cap stocks. The actual market percentage varies depending on the flavor-of-the-year. Sometimes the masses like big stocks; sometimes they go gaga over the little stuff. (The tech boom is an example of this.) I’ve settled on roughly 2/3rds of my US allocation going to large-cap stocks and the remainder to small-cap.

The other question is what percentage of equities should be allocated to US, Europe, Pacific and Emerging Markets? Search the internet and you can come up with widely different views of the market capitalization of the various markets. Vanguard, for example uses: North America 44.0%, Europe 26.7%, Pacific 13.5% and Emerging Markets 15.8%. That would imply that of the non-North American markets, 48% belongs to Europe, 24% to Pacific and 28% to Emerging Markets.

If one were a world denizen, an allocation such as Vanguard’s might make sense, but I mostly spend dollars in the United States, so it makes sense to me to overweight my home country for two reasons. Large-cap US corporations have considerable international operations, but because they are US based, they tend to think in dollar terms and hedge some of their currency risk. Thus large-cap US corporations give me access to foreign markets on a hedged basis. Pure plays in the foreign markets subject me to currency risk. I like some currency risk because it tends to provide diversification and so stabilize asset values. However, at the end of the day I am spending dollars not euros or yen.

So I’ve taken the position that US corporations will account for roughly 2/3rds of my equity allocation. Of the remainder allocated to foreign markets, I have again taken a position that 1/3rd will go to emerging markets with the remaining split between Europe and Pacific more or less based on their relative world allocations.

To summarize, I am overweighting the US by increasing its allocation by about 50% and underweighting the rest of the world by 40%. Within the foreign allocation I overweight emerging markets by almost 20% while underweighting Europe by about 5% and Pacific by about 10%.

I’ve tweaked these percentages over the last decade or so. It is interesting to me that for the longest time most of the investment advice I received or read suggested I should have lower allocations for foreign securities than I had. Recently I have seen a number of articles suggesting larger foreign allocations than I hold—which might be the reason we’ve been seeing net outflows from US domestic stock funds and into foreign stock funds. I have to admit it makes me a little nervous when the world starts agreeing with me.

Any Other subclass that I choose to track needs to be sufficiently substantial to have a measurable effect on diversification and risk/return. I’ve set that minimum as 2% of total assets. Originally I had two subclasses: Real Estate and Precious Metals. This year gold skyrocketed past the point where I thought holding the bullion made sense, so I sold out that position and moved into a couple of commodity indexes as an inflation hedge. We’ll see how that works out. I could argue for higher percentages for each of these two subclasses and in fact moved the precious metals from 2% up to 3% over time—mostly through inertia of price increases and a reluctance to sell, until I did.

If something in this analysis struck you as not making sense or it made you feel a bit uncomfortable as you read it, I suggest you try to understand the basis of your feeling. Perhaps I’ve introduced a different way of looking at something that you might want to consider; or perhaps my approach isn’t right for you and that explains your discomfort. The whole point is to make good decisions for yourself. After all, I have to live with my choices; you get to live with yours.

In the next post I plan to talk about the when and hows of reallocating your portfolio.

~ Jim

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