Asset Allocation: Effective but not feasible?

[Hillbilly]

Help me out here folks.

I have been confused lately about asset allocation. I know on paper that it can be shown to be one of the most important decisions one makes. I can't disagree with that. And the math involved is not hard. My main issue is can it been done easily?

Here is where I'm coming from. Let's take Vanguard for example. IMHO one of the better fund companies out there with sound management of the company and funds. I have always watched the Asset Allocation fund they have to see what is going on especially the asset allocation to stocks/bonds etc and the returns generated. Today I found the following from Vanguard's web site:

Asset Allocation Fund as of 3/31/07
5 yr return = 7.84%
10 yr return = 9.18%

Wellington Fund (that I own) as of 3/31/07:
5yr return = 8.49%
10yr return = 9.87%

The Wellington fund is limited on allocation to stocks/bonds, however, the Asset Allocation fund can "asset allocate" as needed to maximize return and/or minimize risk. (I'm not trying to data mine since it has been a few years since I have compared these two funds. I must say that I do like the objective of the Asset Allocation fund better than Wellington. Please take a look at the remaining hybrid funds listed on Vanguard's site and the 5 & 10 year returns to verify and see if you have any additional notes to add. Some hybrid funds offer higher and lower returns.)

Questions: Do you feel that "asset allocation" is an effective principle but not 100% feasible to implement? If the management of the Asset Allocation fund doesn't make large advances in the returns of this fund verse say a 60/40 balanced fund, are we to believe we can? Is the performance of the Asset Allocation fund telling us maybe the pros can't asset allocate easily either. What are your conclusions on the feasibility of asset allocation?

Have a great and productive day, Hillbilly

 

[samclem]

Hillbilly,
I don't have specifics on why the Asset Allocation Fund underperformed Wellsely (slightly) over these time periods. As you'll appreciate, the "perfect" asset allocation for a particular time period can only be figured out after the fact. In advance, all that can be done is to make an estimate based on historical performance of the asset classes involved, their corelation to each other, and perhaps a guess/subjective call as to whether each is "undervalued" or "overvalued." The shortest explanation for the difference in the performance you see is that Wellsley may have exposed their shareholders to increased risk over these time periods, and that risk was rewarded.

You'll be making an "asset allocation" decision with your investment money no matter what you do. Your portfolio will be invested in various asset classes, and they will go up and down relative to each other. Some people choose relatively low-valatility asset classes that down go up ad down very much--thy are taking low risk, and will probably not get exceptionally high returns on ther money over time. Other people try to guess which asset classes will do wiell, ad put al ther money in that category--if they guess right, they'll do great. Historically, very few people have been able to choose right over a long time period. Other people select a variety of aset classes--each is risky in itself, bt they are carefully chosen to have low corelation with each other. By periodically rebalancing (taking money fromt he "winners" and moving it to the "losers"), this technques seeks to maximize overall portfolio gain while minimizing risk.

 

[unclemick]

The amateur pundit in me says that over the period selected - the 'quants' lost out to 'the value premium chasers' depending on how you label your skins and shirts. Probably would make Fama and French fans happy.

So who do you pick for next years game. I'm still cheering for the New Orleans Saints!

heh heh heh - meanwhile back at the ranch - after forty years of incredibly brilliant legend in my own mind investing - as of Jan 2006, my big dog is Target Retirement(an age related Asset thing) - after spending the bulk of my time(the successful part I'm willing to talk/brag about) in 50/50 Ben Graham to the 'classic' 60/40 which 1977 - 2005 provided the bulk of my retirement nest egg/ER. :

 

[sgeeeee]

So many difficult issues with establishing an asset allocation plan:

What is an asset? Is real estate an appropriate asset? Should you consider commercial real estate vs residential? Should you consider mortgage vs property REITs? Should you split up stock by size (small-cap to large-cap)? by value vs growth? by both? Or should you start with US vs international? etc.?

What period should you consider correlation coeficients between assets? the last 130 years? Is the last 10 years good enough? Should you look at multiple 30 year periods? If you consider a US vs international stock asset sub-division you will get different answers depending on the period of time you consider.

You can do a lot of detailed subdivision of asset classes and perform a lot of correlation analysis, but eventually you have to make a leap of faith that you believe a particular subdivision is worth maintaining in the future. Mathematics can't help you with that.

 

[Olav23]

I would personally like to see a study of how many asset classes are "enough". As the market gets more and more sliced-and-diced into smaller and more specific pieces, it'd be nice to hear that at a certain point, you've smoothed as much as you can. And that more pieces actually just increase transaction costs both for you and and the managers (plus all the time spent re-balancing).

I think someone did a study that you need to buy at least 60 stocks to be "diversified" and by that point you are just following the market. It would be nice to hear that 4, 6, 10 equity and 1, 3, 5 bond asset class holdings are as close as you can get...

 

[haha]

It would be nice to hear that 4, 6, 10 equity and 1, 3, 5 bond asset class holdings are as close as you can get...

I doubt you will hear much of that. After all, there may not be much gold in that ground, but there is sure a lot of gold in selling, explaining, administering etc -in other worlds "Sell the shovels".

So you might have to make up your own mind on this one.

Ha

 

[Olav23]

Good point, but it could come out of the academicians, ala French/Fama or one of the good guys like a Bogle. But you're very much right, follow the money....

 

[unclemick]

I would personally like to see a study of how many asset classes are "enough".

One. Stock or asset class. Go read the Postscript chapter of the 4th ed of Ben Graham's The Intelligent Investor or perhaps a copy of Monty Python's video on the Quest For The Holy Grail.

Just kidding.

Seriously - 'enough' is a subject of endless debate/pontification/college courses/books/etc. - not to mention some really yucky junk mail I've received over the years.

I personally favor Monty Python AND Bernstein's 15 Stock Diversification Myth. In spite of which me (and the Norwegian widow) have 15% individual dividend/DRIP stocks - which I blame on a hormonal imbalance.

Psst! - be very very suspicious if any of your index funds/asset classes has over 10% yearly turnover.

heh heh heh heh - I only chase performance with lagniappe funds

 

[ESRBob]

heh heh heh heh - I only chase performance with lagniappe funds

Does that mean ETFs are starting to give out toasters? 8)

 

[unclemick]

Nope - at least maybe not yet BUT:

I made somebody's list - today's mail brought four 'complimentary dinner tickets' to the 'Financial Workshop To Help Secure Your Retirement'. Oh and they are Seniors Tax Advisors and they promise "This is an educational seminar with no attempts to sell specific products and there is no cost or obligation."

Riiiight!

At least back in 92/93 during the layoffs - down in New Orleans at least they admitted who they schilling for with the free dinner to try and hustle your 401k rollover. We got several dinners that go round.

I'm too embarased for weigh in Wednesday - so I may pass.

heh heh heh - now an ETF and a free toaster - Hmmmm - for whole wheat bread only - right?

 

[Hillbilly]

As you'll appreciate, the "perfect" asset allocation for a particular time period can only be figured out after the fact.

Historically, very few people have been able to choose right over a long time period.

Very interesting reply. I think we are on the same path. I believe, since the perfect asset allocation can not be verified 100% pre-investment, we use past performance to give us some investment "comfort". To take the subject much further than that makes me want to question everything involved. Like poker, you cut the cards and play your hand.

I would personally like to see a study of how many asset classes are "enough". As the market gets more and more sliced-and-diced into smaller and more specific pieces, it'd be nice to hear that at a certain point, you've smoothed as much as you can. And that more pieces actually just increase transaction costs both for you and and the managers (plus all the time spent re-balancing).

I think someone did a study that you need to buy at least 60 stocks to be "diversified" and by that point you are just following the market. It would be nice to hear that 4, 6, 10 equity and 1, 3, 5 bond asset class holdings are as close as you can get...

You are thinking along my thoughts about the slice/dice approach. Too much work for this guy. Since the Vanguard Asset Allocation (VAA) fund would be able to "roam" through available assets and mix and match as pleased, I guess I'm still questioning if VAA can't do it much better than an old pudgy Wellington fund, why in the world would I ever think that I could do it better. If I do, it seems I'm the portfolio manager now? If so, not a good one.

You can do a lot of detailed subdivision of asset classes and perform a lot of correlation analysis, but eventually you have to make a leap of faith that you believe a particular subdivision is worth maintaining in the future. Mathematics can't help you with that.

Exactly....one must move on based upon faith. I guess most of my post comes from growing tired reading all the books that tell me that asset allocation is the most important decision I can make. But to this date, I can't tell you the 100% best way to do it. One doesn't see much about having to take the "leap of faith" but you are exactly right. Typically one sees a reference to a large study or some number crunching activity that proves X amount of bonds along with Y amount of stocks gives you Z amount of return on average per year. Enough to make one :

So who do you pick for next years game. I'm still cheering for the New Orleans Saints!

.......

Since the Saints just got Robert Meachem in the draft today, I would not be surprised to the Saints move closer to the Super Bowl. He should develop into a great player.


To all, thanks for giving me your ideas and time on this feasibility question. Please feel free to add as needed.

 

[rmark]

I think someone did a study that you need to buy at least 60 stocks to be "diversified" and by that point you are just following the market.

This is mostly true only for volatility, the actual final wealth you end up with could be very different compared to the total markets return.

 

[Alan]

Here is where I'm coming from. Let's take Vanguard for example. IMHO one of the better fund companies out there with sound management of the company and funds. I have always watched the Asset Allocation fund they have to see what is going on especially the asset allocation to stocks/bonds etc and the returns generated. Today I found the following from Vanguard's web site:

Asset Allocation Fund as of 3/31/07
5 yr return = 7.84%
10 yr return = 9.18%

Wellington Fund (that I own) as of 3/31/07:
5yr return = 8.49%
10yr return = 9.87%

The Wellington fund is limited on allocation to stocks/bonds, however, the Asset Allocation fund can "asset allocate" as needed to maximize return and/or minimize risk. (I'm not trying to data mine since it has been a few years since I have compared these two funds. I must say that I do like the objective of the Asset Allocation fund better than Wellington. Please take a look at the remaining hybrid funds listed on Vanguard's site and the 5 & 10 year returns to verify and see if you have any additional notes to add. Some hybrid funds offer higher and lower returns.)

Questions: Do you feel that "asset allocation" is an effective principle but not 100% feasible to implement?

In the early days of my investing my 401(k) used to have a very few limited options and VAA was one of them. It was the only place in my 401(k) I could get access to bonds. VAA did very well and once I was contributing the max I started an IRA and again used VAA, howver within a year I got a letter with a voting card to change the rules of the fund so instead of limiteing the amount of stocks, the fund manger(s) could allocate a 100% to stocks to chase better returns. I did vote against but lost of course, and switched my IRA from VAA to Wellington because at the time I was after an overall AA of 70/30. My 401(k) also started adding a lot more funds so I got out of VAA altogether so I could control my AA to the split I wanted. Of course come the stock market bust and VAA had negative returns for several years in a row.

It does not surprise me to see that Wellington is a little better than VAA in recent years as the VAA fund is going to regularly change its AA to try and maximise returns which is not for me. I have an AA target which I keep to based on my time horizon and tolerance for risk.

 

[Alan]

I think someone did a study that you need to buy at least 60 stocks to be "diversified" and by that point you are just following the market.

Diversifying is something do within your asset allocation. e.g. if your AA is 70% stocks then you need to hold a diversity of domestic and international stocks in various market segments etc.

 

[Hillbilly]

My 401(k) also started adding a lot more funds so I got out of VAA altogether so I could control my AA to the split I wanted. Of course come the stock market bust and VAA had negative returns for several years in a row.

I have an AA target which I keep to based on my time horizon and tolerance for risk.

Alan: you seem to be a person that has been there, done that. You indicate you wanted to to control your AA. Nothing personal but could you explain why you did and felt that way?

Also, how or what reference did you use to set your AA based upon your time horizon and tolerance for risk? Past returns? Other?

Thanks for the reply. Hillbilly

 

[rmark]

In crude terms, the global public market is equally divided into
- u.s. stock, international stock, real estate, u.s. bonds, international bonds
Just five total market index funds hypothetically match the world market weights.

These can be further broken down into
- small stocks, value stocks, emerging markets, corporate bonds, treasury bonds, etc.
The value of ‘slice and dice’ is in allowing an investor to overweight the sections of the market they feel are under priced. They have non-average returns – good or bad - from holding a non-average portfolio. I suspect the tactical allocation funds would suffer from high turnover costs, but I haven’t done any detailed reading on them.

 

[Alan]

Alan: you seem to be a person that has been there, done that. You indicate you wanted to to control your AA. Nothing personal but could you explain why you did and felt that way?

Also, how or what reference did you use to set your AA based upon your time horizon and tolerance for risk? Past returns? Other?

Thanks for the reply. Hillbilly

some 14 years back (age 38) I realized that I was counting too heavily on company pensions and really had little idea how to go about building a nest egg. I was 38 and had just switched jobs for the 4th time. This job also came with a 401(k) which was a whole new concept to me. I asked a couple of guys at work and didn't like the answers I got as they were all for owning individual stocks and chasing returns. I picked up a copy of Money magazine that contained a free book called a Guide to a Secure Retirement. It explained about allocations and diversification etc. as well as all sorts of good stuff for a complete novice like myself. It suggested specific allocations based on number of years from retirement. It also held a questionaire to gauge my tolerannce for risk, plus a calculator for me to set cash targets so i would have any idea of what sort of returns I needed to achieve my target.

These days there are many on-line questionaires, and and tools to recommend suitable AA's for your personal circumstances.

I am now 3 years away from RE, the calculators such as FIRECALC say I don't need to save any more so I have a conservative mix of 40% stocks, 505% bonds and 5% cash.

 

[Alan]

HB,

Vanguard Planning and education section has some good stuff on how to choose an asset allocation including an AA questionaire.

https://flagship.vanguard.com/VGApp...geducation/retirement/PEdRetSaveOVContent.jsp

 

[Hillbilly]

I suspect the tactical allocation funds would suffer from high turnover costs, but I haven’t done any detailed reading on them.

Can't disagree but one wonders if that it (high turnover costs) would not apply to one's portfolio if you are picking the AA.

HB,

Vanguard Planning and education section has some good stuff on how to choose an asset allocation including an AA questionaire.

https://flagship.vanguard.com/VGApp...geducation/retirement/PEdRetSaveOVContent.jsp

Thanks Alan. Have not loooked at what VG has to offer lately. As you can tell, I'm a novice investor that just pass through FI this year. This AA stuff still gets me going in a circle at times. You would think VAA would have this figured out by now but hope goes on.

Hillbilly

 

[Alan]

Thanks Alan. Have not loooked at what VG has to offer lately. As you can tell, I'm a novice investor that just pass through FI this year. This AA stuff still gets me going in a circle at times. You would think VAA would have this figured out by now but hope goes on.

When we sold our house 4 years back we wanted to invest the money ( >$200K) in a stable account with a decent return. We chose Wellesley (fom Vanguard) that has an AA of 35/65 and re-balances within the fund to maintain that. Wellesley has a 30 yr history of stable but not huge returns. Our personal return in this fund is now 12.4% last 12 months and 7.5% over the last 3 years. I am perfectly happy at my stage in life and finances to have those sorts of returns plus I don't worry about the AA swinging all over the place. Wellington is similar but 65/35 (I use it for saving towards LTC instead of taking out an LTC policy and therefore have a much longer time horizion for when or if I should need the money)

I'm a pretty boring investor really but I keep good records and have an effect ROI over the past 10 years of almost 8% on my whole portfolio. Which is all I need to sleep well at night.

 

[Hillbilly]

I'm a pretty boring investor really but I keep good records and have an effect ROI over the past 10 years of almost 8% on my whole portfolio. Which is all I need to sleep well at night.

The more I look at investing, the more I think "boring" is best. Over 10 years, 8% is nothing to laugh at. I bet more than a few investors would like to have that return. Matter of fact, if I can get that today, sign me up on that asset allocation plan.....