Asset allocation evaluation requested, please

[Urchina]

Hi, all. Midlife is officially upon us and we are re-evaluating our aa. I'd love some outside opinions.

DH and I are now both in our early 40s with about 20 years until retirement. We have a very high risk tolerance and have had no trouble staying the course over the past decade. We anticipate relatively high expenses in early retirement due to the combo of kids in college and parents possibly needing assistance. We are indexers and would like a fairly simple aa. Our proposed aa looks like this:
50% large cap index (black rock s&p 500 index)
20% intl index (mdiix and veu)
5% small cap index (vb)
5% REIT (vnq)
20% total us bond index (bnd)

All currently held in tax-advantaged accounts.

The black rock funds are what is available in DH's 401k. If we had things our way, we would invest 55% in a vanguard total stock market index instead. The small cap index is in this proposed aa to help make up for that.

Particular questions I'd appreciate input on:
1. Does anyone see any advantage to reducing our fixed-income exposure?
We would probably be perfectly happy going 90% equities for the next decade or so, but I am not convinced that doing so would appreciably boost our returns, or at least not enough to make up for the additional risk. It's possible that at 80% we are already out of the risk-return sweet spot. Thoughts?
2. Does 5% in the small cap index do enough? I had a hard time figuring out what percent of the total market index was small cap. Anyone have info they could point me to, there?
3. The REIT. I like the exposure to commercial real estate it gives us. DH doesn't seem to care much one way or the other and would be happy putting that money into the large or small cap index funds. Does 5% of a portfolio give us reasonable diversification into this sector?

I should also mention that this aa is for our investable assets. We also have residential real estate (primary residence plus a rental condo), a solid and growing cash emergency fund, a new 529 plan, and stock in a privately-held company in the tech sector.

Thanks for any and all ideas and comments!

 

[LOL!]

My preference is for more small-cap than market weights and way more than you have written. For what market weights are please see: Approximating total stock market - Bogleheads

If you wish to increase risk, keep the fixed income, but tilt more to small-caps and value. So add lots of VBR (US small-cap value) and VSS (foreign small-caps), up to 50% of your equities.

 

[Totoro]

If you like simple consider that allocating 5% to something will only have very limited impact on your overall return in the longer term.

So you might to think about simplifying even more, as you indicate yourself

 

[eytonxav]

My preference is for more small-cap than market weights and way more than you have written. For what market weights are please see: Approximating total stock market - Bogleheads

If you wish to increase risk, keep the fixed income, but tilt more to small-caps and value. So add lots of VBR (US small-cap value) and VSS (foreign small-caps), up to 50% of your equities.

+1 bump the small cap, decrease your large cap

 

[BTravlin]

No advice on the AA but I would suggest saving some outside of tax advantaged accounts so that you have more flexibility once retired. I am now retired and am 90% tax advantaged and wish I had put more aside in a ROTH account for that very reason.

 

[Urchina]

My preference is for more small-cap than market weights and way more than you have written. For what market weights are please see: Approximating total stock market - Bogleheads

Thank you all for the responses!


Thanks for the link, LOL. It looks like an 80/20 large cap/small cap split approximates VTSMX.

As part of this, I am evaluating whether or not a small-cap tilt is worth the additional risk. I need to find a good back-tester to see what, historically, has happened to portfolios weighted in small caps.

Totoro, yes, 5% in the REIT is pretty small. The second question for me to research, then, is what is the smallest percentage of a portfolio that actually provides meaningful diversification. I don't want the REIT to be the main counterbalance to the large cap fund. The small cap, international and bond fund have that role. The REIT is more of a... condiment, shall we say. But if it's in there I'd like it to earn its keep. I'll see if I can determine a threshold for that criteria.

BTravelin, isn't a Roth tax-advantaged in that earnings compound and can be withdrawn tax-free? We have Roths and about 20% of our portfolio is in them.

 

[BTravlin]

My preference is for more small-cap than market weights and way more than you have written. For what market weights are please see: Approximating total stock market - Bogleheads


BTravelin, isn't a Roth tax-advantaged in that earnings compound and can be withdrawn tax-free? We have Roths and about 20% of our portfolio is in them.

Yes, the Roth is tax advantaged and I guess I mistakenly took that to mean tax deferred like 401k's and IRA's. Having a decent portion of your savings outside of tax deferred is what I meant and you have that. Sorry for the confusion.

 

[LOL!]

Thanks for the link, LOL. It looks like an 80/20 large cap/small cap split approximates VTSMX. ?

If you want to replicate VTSMX, then do not use VB nor VBR. Use the extended market index fund, VXF instead.

Backtesting, eh? I'm slightly amused that you wanted to reduce fixed income and then are worried about small-caps adding too much risk. Are you going to calculate Sharpe ratios and all that other stuff, too? In any event, a small-cap and value tilted portfolio has back-tested so well that lots of books have been written by Rick Ferri, Larry Swedroe, Bill Bernstein, and so on. See also: Bogleheads • View topic - Ultimate Buy and Hold - 8 slices vs 4

 

[dallas27]

I cant imagine a future where holding bnd is a great idea right now, at least not one that is reasonable.

Dump bnd, up small cap and reit. Will bounce around. Even retired, you would want a fair amount in thise higher risks. Retired, you should still have 20+ year horizons on a lot of your assets.


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[pb4uski]

....
1. Does anyone see any advantage to reducing our fixed-income exposure?
....Thoughts?
2. Does 5% in the small cap index do enough? I had a hard time figuring out what percent of the total market index was small cap. Anyone have info they could point me to, there?
3. The REIT. I like the exposure to commercial real estate it gives us. DH doesn't seem to care much one way or the other and would be happy putting that money into the large or small cap index funds. Does 5% of a portfolio give us reasonable diversification into this sector?...

Does DH's 401k offer a stable value fund paying a decent return? If so, I would consider using that for fixed income since it would reduce your interest rate risk and you can't get a SV fund outside a 401k. Other than that, I think 80-90% equities would be fine at your age. Unless there is a SV fund you can use you could just let the current FI investments ride and put contributions to equities and you'll slowly increase the 80% to 90%. And then in your 50s you can start putting contributions to fixed income to increase your FI allocation in preparation for retiring.

According to Vanguard Portfolio Watch, the US stock market is 65% large cap, 28% mid-cap and 7% small-cap. So you can back into the proportions of Mid-Cap Index and Small-Cap index you would need to supplement the S&P 500 available to you in DH's 401k. Additionally, you can then tilt things a bit to mid and/or small cap if you wish to.

I actually don't have REITs but if you want to allocate 5% to that would seem fine to me.

 

[target2019]

Dump bond and put 10 percent additional into small cap and 10 into international.
5 - 10 percent in REIT is common. Maybe go 7.5.

 

[Animorph]

I use 5% VNQ and 5% RWX for domestic and foreign RE. I think it has been worthwhile.

I agree with most of the others on the small caps. That 20% sounds much better. I do pretty much a 50/50 split for large/small. 20% just kind of gets you even with the total market.

I believe it was William Bernstein I read that showed 15% bonds actually gave slightly better performance (gain versus volatility) than 0% bonds. Not that I listened to that, since I'm close to 0%. That worked for equities too, 15% equities was better than 0%. 20% bonds might be a little high, but not enough to concern me.

 

[Urchina]

If you want to replicate VTSMX, then do not use VB nor VBR. Use the extended market index fund, VXF instead.

Because....?

Backtesting, eh? I'm slightly amused that you wanted to reduce fixed income and then are worried about small-caps adding too much risk.

The small caps are going up against the alternative of the S&P 500 index fund. I need to justify the risk vis-a-vis the large caps. If we decided to reduce the bond fund, that money would go into equities, and I'm assessing whether or not small caps is worth the risk based on the alternative, which is large caps or international stocks.

Are you going to calculate Sharpe ratios and all that other stuff, too?

Probably not. I'm not planning on making this a hobby or a career.

See also: Bogleheads • View topic - Ultimate Buy and Hold - 8 slices vs 4

Again, thanks for the link. I'll spend some more time on that wiki and forum, too.

 

[Urchina]

Does DH's 401k offer a stable value fund paying a decent return?

Sadly, no. They had to fight tooth and claw to get the BlackRock index funds, and the expense ratios on those range from 0.48 to 1.16. Compared to the Vanguard and Fidelity Spartan funds, that's highway robbery, especially on an index fund.

Of course, the bulk of our investable assets are in DH's 401(k), and it has our worst options.

 

[LOL!]

Because....?

Because the extended market index fund has ALL the missing pieces not in the S&P500 index fund needed to re-constitute Total Stock Market index.

A small cap fund plus S&P500 index fund would be missing all the large-caps not in the S&P500 and mid-caps, too.

 

[dallas27]

I

I believe it was William Bernstein I read that showed 15% bonds actually gave slightly better performance (gain versus volatility) than 0% bonds. Not that I listened to that, since I'm close to 0%. That worked for equities too, 15% equities was better than 0%. 20% bonds might be a little high, but not enough to concern me.

The problem with all those studies is they were completed on a timeline where bond rates were trending toward zero for the last hundred years. Now we have approached 0 percent return and indeed in Europe the fed has a NEGATIVE interest rate policy.

So while i dont know if holding bonds is still bad, I am certain studies have limited value until rates are above 0.

To me, either 0ish is the new normal, or some economic calamity is next. Either way, its equities all the way, baby!

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[Urchina]

Final update: DH and I settled on an AA last night, taking into account the choices in his 401(k) (which are pretty appalling, really -- can the plan administrator catch a clue, please?).

We decided to lower our bond exposure. We transferred some of the allocation we had earmarked for bonds to international and mid-cap stocks, and then took the rest of the bond allocation and will put it into Wellington (which we had wanted to do for a while, anyway). That fund will give us some bond exposure and some growth, but the index funds will still do the heavy lifting.

The final lineup looks like this:
US Large Cap (S&P 500 index): 41%
US Small & Mid Cap (VXF): 25%
Int'l large cap: 18%
REIT: 5%
Vanguard Wellington: 11% (which, when folded into the above categories, adds 5% to US equities, 1% to international, 3% to bonds and some miscellaneous)

We are happy with the plan, can make it work with the selections available to us in our deferred comp plans, and are looking forward to it.

Thanks for all the help here!

 

[LOL!]

Ah, you pulled the ol' deferred compensation trick out of the hat. Presumably those plans have some fixed income in them.

 

[dvalley]

Good discussion in this thread. I noticed a few suggestions for VBR (small cap). All my after tax investment is in VTSAX (Total Market); I figure it's the entire market so it already includes mid and small caps too does it not?

 

[Totoro]

dvalley: correct. The reason it is mentioned is because small caps are a small portion of the total market (5% or so).

Small caps in general are deemed to be more risky with a higher potential reward.

Since OP is thinking about increasing risk => might make sense to increase small cap exposure.

 

[target2019]

OP may want to consider the extended market index rather than just mid cap. Over a long run of investing, small cap exposure helps significantly. If the investor is conservative minded, then avoiding small caps makes sense.

 

[dvalley]

Thanks for clarifying. I'll add VBR to my after-tax portfolio (50/50 VTSAX/VIMAX ). I don't need this money for at least 8-11 years.

 

[LOL!]

OP may want to consider the extended market index rather than just mid cap. Over a long run of investing, small cap exposure helps significantly. If the investor is conservative minded, then avoiding small caps makes sense.

A quick read of the thread shows that the OP picked the extended market index.

 

[target2019]

The paragraph and bullets do not agree. Mentions midcap in paragraph and VXF in the allocation.

 

[LOL!]

VXF (extended market index fund) is classified as a US mid/small cap fund which is the same as a "US Small & Mid Cap" fund.