Catch a Gideon

Asset Allocation: The Cornerstone of Successful Investing - ch 8 Bogleheads Series

November 9th, 2006 by digerati

This is Chapter 8 in the Bogleheads series here at Successful Personal Finance. We are going through each chapter in the book and letting you know what we learned from reading it. You should buy the Bogleheads Guide to Investing. It has more examples and more depth than I’m giving here, and is overall an excellent investment book.

Your most important portfolio decision can be summed up in two works: asset allocation.

First off, what is “asset allocation?” It is similar to diversification, but different. Diversifying means buying a variety of a single type of investment (you buy GE and MS stock to diversify). Asset allocation means buying a variety of types of investments. For instance, you may purchase a combination of large cap stocks, small cap stocks, international stocks, bonds, and commodities.

The remaining questions to ask yourself are: what types of investments should I get, and what percentage of each should make up my portfolio?

The book then discusses “Efficient Market Theory” and “Modern Portfolio Theory” to some detail. I won’t bore you. Basically, EMT says that its is next to impossible to “beat the market” because share prices reflect all the information available. When you add transaction costs to the mix you always lose.

Modern Portfolio Theory (MPT) says that given the choice an investor will take the highest return / lowest risk investment. If you have two options and one is a steady increase while the other is up and down (though with the same final return) MPT says you will choose the steady increasing option. (I disagree that this is the option people take since it is apparently not the case very often.)Some studies back it up. One study separated the final return on pension plans into 4 parts:

• Investment policy (asset allocation) between bonds, stocks and cash.
• Individual securities selection
• Market timing
• Costs

They determined that 93% of the variability in return came down to the investment policy. They also found that attempts to actively manage the fund usually resulted in a decreased return of 1+% annually.

That being said, there are four questions to answer when designing your portfolio:

1. What are your goals?
2. What is your time frame?
3. What is your risk tolerance?
4. What is your personal financial situation?

What are your goals?

What do you want to invest for? Do you want more money to buy cars? Are you purchasing a home? Saving for college or retirement? It is necessary to know how much you need to save before you start.

What is your time frame?

Different options are better give your time frame. On average stocks are a bad investment for under 5 years. If you are planning to purchase a home with your invested money in 3 years, stocks are likely not the best choice.

What is your risk tolerance?

Studies find that investors are more fearful of a loss than happy with a gain. (I’ve dubbed this the Pack rat syndrome.) Too many investors put money in “safe” investments like CDs because they know they won’t lose money. They don’t realize that they have an opportunity cost of doing so. Others (read Casey Sarin) invest wildly in the hope that their calculations work out and they become very rich quickly.

To determine your risk tolerance try asking yourself if “you will sell during the next bear market?” If the answer is yes, you are more risk adverse and should create a “safer” portfolio. And don’t just say “no of course not.” It’s much easier to say you won’t than look at a rapidly declining market and want out.

The Bogleheads suggest adding 10-20% more bonds in your portfolio than you think you need. I’ve seen the rule that the percentage of bonds should match your age.

Your personal finance situation?

Other factors matter too. If you have a pension or plan to get social security payments that reduces the amount of money you need to make from investing. Remember when you decided how much you needed (in step one). Well subtract from it the payments for social security and pension that you will receive.

How to choose your investments

So you know you’re going to choose a combination of types of investments. Most people can worry about a mix between stocks, bonds, and cash (T-bills) only. More advanced investors may choose to add commodities (like gold), hedge funds, and real estate (REITs) to their portfolios.

Let me add a couple other random pieces from the book. The rest of the chapter is mainly examples of how difference age groups should invest, including the Vanguard funds associated with the recommendations.

Mix large cap and small cap stocks. Small cap (growth) stocks are more volatile and thus less stable. Have a mix of 2:1 between large and small cap stocks.

High risk bonds are not for the long term investor. The reason the longterm investor adds bonds to the portfolio is for safety. Purchasing junk bonds is more speculative and less safe.

That’s it for Chapter 8. You should read more from the Bogleheads Series at Catch a Gideon.  You should go out and buy The Bogleheads Guide to Investing. It is a great book and well worth the price.

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