Asset Allocation Disclosed

Every finance forum has discussion after discussion related to asset allocation.  The Vanguard Total Stock Market Fund is generally accepted as a solid be-all, end-all option for people pursuing early retirement. I unfortunately did not start with the “basics”. My degree is in finance and I studied for a CFA, so that combined with a naturally high opinion of myself set me off on a mission to pick stocks. Hundreds of hours were spent analyzing companies, listening to investment podcasts, and trying to find that company that’ll beat the market.

The results are a whopping 1.24% higher return on the S&P 500 over a five year period, but I am humbly trailing the market YTD.  We are slowly transitioning our holdings into index funds and in hindsight, it would have been much better to focus on a side hustle or just devote more time to sales in the regular job than all the work and effort put in for a marginal improvement over the index.

Part of this transitioning from individual stocks was establishing a target asset allocation that would fit our return needs and risk profile.  My investment belief is that the world is in for “lower for longer” returns.   The wonderful returns stock market run we’ve seen over the last two generations have come from an increase in market participation and an aging population accumulating more wealth.   This has led to more capital available for deployment at the same time there are less producers generating value for shareholders.  I am also a believer in the Efficient Frontier and Modern Portfolio Theory, where each asset class provides a given level of return relative to risk. A diversified portfolio of riskier assets will provide a higher return over time, but will generate higher volatility during that time period.

The general consensus is with equities is the larger the company, the lower the risk. The large cap index will provide a lower, less volatile return than the small cap index. Its also general consensus that developed economies provider lower and less volatile returns than developing economies (ie the US and Europe are safer than Africa/South America) and that debt investments (bonds) are a safer investment than stocks. The image below is a great example on the volatility in returns of each asset class.

We are planning for a portfolio to support us for a fifty year retirement, therefore there are two major risks for its sustainability:

• Absorbing a large market crash in the first five years (Sequence of Return Risk)
• Achieving a high enough return for the portfolio to survive for fifty years

With those thoughts, I’ve diversified from VTSAX in two ways:

• Adding a Bond/REIT/Cash allocation to absorb short-term portfolio shocks
• Supplementing the Total Stock Market Fund with Mid-cap, Small-cap, and International Index Mutual Funds/ETFs

As a note, Real Estate Investment Trusts (REITs) are an interesting asset class and don’t fit into any “box”. REITs are not a one size fits all, as the individual companies have different debt loads and a different portfolio of assets. Some carry the same risk as a bond portfolio, like a REIT that has no debt and only owns real estate with long term leases from investment grate companies. Others take on large sums of debt and invest in high risk assets (think about a Hospitality REIT with a high debt ratio). If you’re going to invest in REITs, my recommendation is to pick individual companies. These companies have diversified portfolios of hundreds of properties and you already pay a management fee to the leadership of that company. Buying an index or a mutual fund layers a second level of management expense you can just bypass by making a decision on property type and debt load you’re comfortable with. Due to the complications, REITs should be generally avoided unless you are willing to do due diligence on the company.

Now for the reveal:

Large Cap Equity: 35%. Primary holdings include VTI, VOO, ITOT, and IVV

US Mid Cap Equity: 15%. Primary holdings include VO, IJH

US Small Cap Equity: 15%. Primary holdings include VB, IJR

International Equity: 15%. Primary holdings include VXUS, IXUS

REITs: 10%. Primary holdings include STAG, EPR

Bonds: 7.5%. Primary holdings are VWINX, VWELX*

Cash: 2.5%.

* We have made the personal preference to hold my bond allocation inside two actively managed funds by Vanguard.  Bonds are a tricky investment, they provide a fixed return but carry the risk of principal loss. There are also times where a stock investment can provide a better risk adjusted return for a fixed income investor and I’ve chosen to turn those decisions over to fund managers at Vanguard for 0.16% and 0.15% expense ratios respectively.   The Vanguard Wellington Fund and Wellesley Income Fund are long time favorites from the members of the low cost investing movement.   The Vanguard Admiral Shares Bond Index carry a 0.05% expense ratio, while the actively managed funds carry at 0.15% to 0.16% expense ratio.  We are making the conscious decision to pay an additional $10-$11 per $10,000 invested to have a professional between us and the fixed income market.   We’ve been very satisfied with the performance.

At the time of the writing, we are anywhere from eight to eighteen months away from declaring early retirement.  Our current allocations are weighted a little heavier towards stocks than Bonds/REITs/Cash, but are building the other allocations towards target between now and retirement.

What is your asset allocation? What do you think of our plan? Please share your feedback below