Although stock-picking is a part of my comeback plan, I use more stable asset allocation in my retirement account by using index funds. The reasons include security, costs, and results.
In the beginning, many investors think of investing as sort of a get-rich-quick program. That was my initial view. But once I started learning more about asset allocation, I liked ETFs more and more. Then I started studying into which types of funds to invest what proportion of my portfolio.
What’s is asset allocation?
Asset allocation is the art and science of diversifying an investment portfolio to optimize returns. Optimization means maximum returns with cost and risk. A certain proportion of the portfolio should be invested in different types of assets such as equities, different term bonds, precious metals, real estate, and even commodities.
Here are some examples
The Boglehead 3-Fund Portfolio
This is the asset allocation I currently use in my Vanguard Roth IRA. It is the creation of the legendary Jack Bogle. It is lauded for its simplicity, diversification, and low cost.
- U.S. Equities (VTSAX) – 64%
- International Equities (VTIAX) – 16%
- U.S. Bonds (VBTLX) – 20%
This represents an 80/20 split between equities and bonds. Within the equity section, I currently have an 80/20 split between U.S. and International stocks.
The funds listed are admiral funds ($3000 minimum investment). If you’re just starting out you may need to start with the ETF equivalents: VTI, VXUS, and BND.
Dave Ramsey
Dave Ramsey was my first exposure to asset allocation. In Step #4 (of his 7 Baby Steps), Mr. Ramsey recommends dividing the retirement portfolio equally among four fund categories:
- growth fund (e.g., VUG) – 25%
- growth and income fund (e.g., VOO) – 25%
- aggressive growth fund (e.g., VBK) – 25%
- international fund (e.g., VXUS) – 25%
Dave Ramsey’s allocation has two main criticisms. First, he recommends all equity funds. And among these categories, there can be significant overlap. For instance, the statistical correlation between some asset classes can be high. Essentially, this means some funds are essentially moving in unison. This overlap may increase risk through reduced diversification. But it’s what I first used. It’s aggressive, and was playing catch-up! I listed the ETFs I was in.
So, this allocation may not provide adequate diversification depending on your investing objectives. In addition, mutual funds can have high cost ratios. And lastly, about 80% of professionally managed funds do not even match the market. Use index funds.
David Swensen
I first read about David Swensen in Tony Robbins’s book Money: Master the Game. Mr. Swensen is the Chief Investment Officer for Yale University’s endowment fund, where he has averaged returns in the 16% range over the last few decades. In his book Unconventional Success, he advocates investing among six asset categories in the indicated proportions:
- U.S. Equities (VTI)- 30%
- International Equities (VXUS)- 15%
- Emerging Markets Equities (VWO) – 5%
- Long-term U.S. treasuries (VGLT) – 15%
- Treasury Inflation-protected securities (VTIP) – 15%
- Real Estate Investment Trusts (VNQ)- 20%
This allocation has demonstrated doing well during bull markets, while preserving wealth during bear markets. This would have been a great asset allocation if I had started investing when I “should” have. But it is the asset allocation I use for my M1 Finance pie. (This is an affiliate link) pie. This is the amount I invest above and beyond my Roth IRA.
Ray Dalio
Ray Dalio is the founder of Bridgewater Associates, which Forbes says is the world’s largest hedge fund company. He designed what he calls the All-Weather Portfolio. He recommends a somewhat more conservative approach than Mr. Swensen. Mr. Dalio was also interviewed by Tony Robbins and written about in Money: Master the Game. Recommended asset allocation for the All-Weather Portfolio looks like this:
- U.S. Equities (VTI) – 30%
- Long-term U.S. treasuries (VGLT) – 40%
- Intermediate-term U.S. treasuries (VGIT) – 30%
- Gold (GLD) – 7.5%
- Commodities (VDC) – 7.5%
Ray Dalio says balancing risk is more important than balancing funds. His asset allocation recommendations also have an outstanding record over the long-term. Again, this would have been a good mix had I started in my 20s.
So what are index funds?
The index funds (are ETFs) that could be used in each allocation are listed. Since I am partial to Vanguard, all but GLD are Vanguard funds or ETFs.
Index funds are a group of stocks (or bonds) that reflect the performance of a market (like the S&P 500) or a market segment (like consumables, energy, or health). These funds (and ETFs) ar the easiest way to diversify your investment portfolio and reduce risk.
In the end, it is important to realize that you must dollar cost average over the course of many years in order to build wealth. Remember that when the market is down, you are buying more shares for the same investment.
Email me at mark@marknoldy.com to let me know about other topics of interest to you.