Archives for January 2008

Over the last year or so, I’ve learned a lot of new things about investing and asset allocation. At the same time, I know that changing your asset allocation too frequently is often a response to recent market activity (aka performance chasing, or market timing). In addition, I’m a highly analytical person and I love for things to have a correct answer to 5 significant figures before committing… which is pretty much impossible here. But at some point I know I just need to take action if I truly believe it is an improvement.

Previous Asset Allocation
In April 2006, I moved from the all-in-one Vanguard Target Retirement 2045 Fund (VTIVX) to a portfolio with more asset classes in an attempt to better optimize risk/reward factors based on historical data. You can see the asset allocation breakdown here. This asset allocation is pretty much what I have right now, except that I added a Micro-Cap stock fund and we moved money into a 401k with limited investment options.

Interim Asset Allocation

I’m still continuing my series on building my portfolio, so I won’t explain all my actions here, but here are some quick summaries:

1. Stocks/bonds allocation. I am shifting to a age-based formula for my stocks percentage. Using 115 minus my age, I am at 86% stocks and 14% bonds.
2. Domestic/international allocation. I am increasing my international allocation to better match the world market. It’s essentially 50/50 if you think REITs are a separate asset class.
3. Small/Value/Emerging Markets. These sub-classes are riskier than their overall market, but have been shown to have diversification benefits. Even if they don’t in the future, I am okay with them simply being more risky along with higher returns. Essentially, I am taking the total markets, and increasing the portion of one additional asset class which I think has the highest diversification benefits. For example, Small Value is a subset of Total US market, and Emerging Markets is a subset of the Total International market.
4. Real Estate. I’m still holding REITs, as they are a way to invest in commercial real estate, and have also been shown to provide diversification benefits. Will give more references later.
5. Micro-Cap, International Value, and Large Value. I think all of these potentially good asset classes to hold, but I think they are of lesser overall importance than the others. So in an effort to simplify, I am dropping them as separate funds. I still continue to have exposure the asset classes within other funds.
6. New Bonds Allocation. I’ve been meaning to this for a while. I’ve been holding an intermediate-term corporate bond fund because it used to have a lower expense ratio after various fees. Inflation-protected bonds are still pretty new, but I’ve been convinced of their utility. I’ve also been convinced that bond ratings agencies just aren’t that good at their jobs, so I’m sticking with the highest quality bonds (Treasuries). The book Unconventional Success was a big influence here.

I call this my interim asset allocation because while I’m very confident this new setup fits my needs and preferences better than my previous asset allocation, I know that I will continue to learn and read. But just like with football coaches, this interim asset allocation might just become my permanent one.

In addition to all the books that I have read (and am still reading), I’d also like to say thanks to the many smart and helpful folks over at the Diehards.org forums for all the indirect and direct help. (I post anonymously at both forums.) Even though they sometimes feed my tendency towards complexity, I love the wealth of information that is available.

I am a proponent and investor in low-cost, passive-managed mutual funds, but even within that philosophy there can be a dizzying array of choices. Although this has been taking a lot longer than I had hoped, but here is an updated compilation of posts about my thought process when re-building my portfolio.

Section 1: Simplified Theoretical Stuff

1. Disclaimer and General Philosophy
2. Consider Simply Buying The Entire Market
3. Efficient Frontier and Modern Portfolio Theory

Section 2: Choosing An Asset Allocation

1. Deciding On The Stocks/Bonds Ratio
2. Deciding On The Domestic/International Ratio
3. Considering The Diversification Benefits Of Small and Value Stocks
4. Equity Asset Allocation: Comparison of 8 Model Portfolios

Recent Transactions
In the last quarter of the year, we ended up putting in the maximum $15,500 salary deferral in both of our 401k/403b’s. I had already put in $12,500 already in my Solo 401k, so I sent in a last-minute check for $3,000. For my wife’s 401k, it was done in big salary deferrals in October, November, and December. We were lucky that the company allows almost 100% salary deferrals.

Summary and Performance
My last portfolio update was back in September, but I figured with the end of 2007 it was definitely time for an update. It was a late decision to go ahead and contribute a lot to our tax-deferred accounts and taking away a bit from our cash hoard, so I was more concerned with getting them in on time than what I was actually investing in. Lots of changes to come soon, so I’m just posting a snapshot of what we have for now.

I did go back and track the cash inflows, and calculated our time-weighted rate of return, which ended up being 2.49% annualized for 2007. For a very rough comparison, the S&P 500 via Vanguard 500 (VFINX) returned 6.13% YTD. Part of this low performance was just due to timing, as the latter half of 2007 was a lot worse than the 1st half, and that was when we invested a lot more money. (Remember, this is the exact performance of our money, not just the averaged returns of all the funds we hold.) In 2006, our portfolio return was calculated at 24.9%. How did you do in 2007?