Basic Asset Allocation Models – Forbes Advisor


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Asset allocation refers to the combination of investments in a portfolio. It describes the proportion of stocks, bonds and cash that make up a given portfolio – and maintaining the right asset allocation is arguably the most important decision long-term investors can make.

As Vanguard founder Jack Bogle said, “The most fundamental decision in investing is your asset allocation: how much stock should you hold? How much should you hold in bonds? How much should you have in cash reserve? »

Stocks and bonds have contrasting advantages and disadvantages. History teaches us that over the long term, stocks have a higher rate of return than bonds. Since 1926, stocks have enjoyed an average annual return almost twice that of bonds. At the same time, stocks are more volatile. Bonds in a portfolio reduce volatility, but at the cost of lower expected returns.

This dynamic can make the decision between stock and bond allocations difficult. In this article, we’ll look at asset allocation models from two angles: First, we’ll look at stock/bond allocation and its effect on a portfolio’s volatility and returns. Second, we’ll look at specific investment portfolios that any investor can use to implement whatever asset allocation they ultimately choose.

Keep in mind that an asset allocation plan involves more than stocks and bonds. In stock allocation, for example, one can consider geography (US stocks vs. international stocks), market capitalization (small companies vs. large companies) and alternatives (eg, real estate and commodities). We’ll look at some of these asset classes in our model portfolios below.

Basic asset allocation models

As noted above, the most important decision an investor can make is the allocation between stocks and bonds. Based on a large amount of historical data, we know how the different allocations between stocks and bonds behave over long periods of time.

100% bond portfolio

Avant-garde offers data on the historical risk and return of various portfolio allocation models based on data from 1926 to 2018. For example, a portfolio comprised of 100% bonds experienced an average annual return of 5.3%. Its best year, 1982, saw a return of 32.6%. It fell 8.1% in its worst year, 1969. Of the 93 years of historical data cited by Vanguard, a 100% bond portfolio lost value in 14 of those years.

100% equity portfolio

At the other extreme, a 100% equity portfolio had an average annual return of 10.1%. Its best year, 1933, saw a return of 54.2%. Its worst year, just two years earlier in 1931, was down 43.1%. The portfolio has lost value in 26 of the 93 years covered by Vanguard’s analysis.

Comparing these two extreme portfolios highlights the pros and cons of investing in stocks and bonds. Long-term stocks have a much higher return, but the stock-only portfolio has seen much higher volatility. The decision investors must make is how much volatility they can afford, while considering the returns they need to achieve their financial goals.

Asset allocation models focused on income, balance and growth

We can divide asset allocation models into three broad groups:

• Income portfolio: 70% to 100% in bonds.

• Balanced portfolio: 40% to 60% in shares.

• Growth portfolio: 70% to 100% in shares.

For long-term retirement investors, a growth portfolio is generally recommended. Whichever asset allocation model you choose, you need to decide how to implement it. Next, we’ll look at three simple asset allocation portfolios you can use to set up an income, balanced, or growth portfolio.

3 Easy Asset Allocation Portfolios

There are a number of asset allocation portfolios that one could create to implement an investment plan. Here, we’ll keep it simple and look at three basic approaches. Although they are increasing in complexity, all are very easy to implement.

The single-fund portfolio

You can implement an asset allocation model using a single target date fund. Most 401(k) plans offer target date retirement funds, which do two important things.

First, they take an investor’s money and distribute it among a number of diversified mutual funds. These funds include both bond and equity investments. They generally include investments in national and international stocks and bonds, as well as in small and large companies.

Second, as an investor nears retirement, the target date retirement fund gradually shifts the asset allocation in favor of fixed income investments like bonds. This reduces portfolio volatility as the investor approaches the time when they will need to start relying on the portfolio to cover living expenses in retirement.

Target date funds are generally categorized by the year in which the investor plans to retire. For example, an investor planning to retire in about 35 years might choose the Vanguard Target Retirement 2055 fund (VFFVX). This fund invests in both US and international equity mutual funds, as well as US and international bond funds. Its asset allocation model now consists of around 90% equities and 10% bonds and short-term reserves. Of course, this allocation will start to shift in favor of bonds as we get closer to 2055.

Keep these three points in mind when considering target date funds:

• Target date fund fees can be high. Although Vanguard’s target date retirement funds are reasonably priced, some mutual fund companies charge upwards of 50 basis points.

• Target date funds may not be suitable for a taxable account. Because target maturity retirement funds include bonds and other fixed income investments, they may not be suitable for a taxable investment account.

• There is no obligation to invest in a fund with a maturity corresponding to the year in which you plan to retire. If you prefer a different asset allocation model, you might find a target date retirement fund that matches the model of your choice, regardless of when you retire.

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The 2-fund portfolio

If you want more control over your asset allocation, consider a two-fund portfolio. With just two well-diversified index funds, you can create an excellent investment portfolio.

For example, you can place your stock allocation in a total market index fund covering both US and international companies. You could then invest the portion allocated to bonds in a total bond index fund. This portfolio makes it much easier to implement the stock/bond allocation you prefer.

Using Vanguard Mutual Funds as an example, here are two funds one could use to set up a two-fund portfolio:

Vanguard Total World Stock Index Fund (VTWAX)

Vanguard Total Bond Market Index Fund (VBTLX)

At first glance, such a portfolio may not seem to offer sufficient diversification. The Vanguard Total World Stock Index Fund, however, invests in over 8,400 companies. Moreover, these companies have their headquarters all over the world. Similarly, the Vanguard Total Bond Market Index Fund invests in over 9,000 bonds. In short, even this portfolio of two funds is well diversified.

The 3-fund portfolio

For even more control over your allocation, check out a three-fund portfolio. With this model portfolio, the equity allocation is split between two mutual funds, one covering US equities and the other covering international equities. This provides additional control over how much of the equity allocation goes to US companies and how much goes to foreign companies.

Using Vanguard mutual funds, the three-fund portfolio could be implemented with the following mutual funds:

Vanguard Total Stock Market Index Fund (VTSAX)

Vanguard Total International Stock Index Fund (VTIAX)

Vanguard Total Bond Market Index Fund (VBTLX)

Other mutual fund providers offer similar index funds that can be used to implement the three-fund portfolio. Loyalty, for example:

Fidelity Zero Total Market Index Fund (FZROX)

Fidelity Zero International Index Fund (FZILX)

Fidelity U.S. Bond Index Fund (FXNAX)

Most major mutual fund companies offer index funds and similar target date retirement funds that one could use to implement any of the three portfolios above.

Keep an eye on the fees

When deciding on your asset allocation model and implementing that model, keep in mind the importance of investment costs. Even a 50 basis point fee could reduce your returns over a lifetime of investment. As a general rule, aim to keep your investment expenses to no more than 25 basis points, and less than 10 basis points is best.

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