Allocating new money: Snowball vs. AA method?

[Urchina]

Just curious as to how folks on this forum allocated new money when they were starting out in their accumulation phase. In the reading I've been doing there seem to be two schools of thought, and I can see advantages/disadvantages to both. I'm wondering what others think and do.

School 1: Snowball method. An investor selects an AA, then prioritizes the positions in it, setting arbitrary $$ amounts in each position as a goal. Then, all new money is channeled to the first position -- when the goal there is reached, new money is channeled to the second position, etc. Benefits: a more rapid buildup of assets in a given asset class, and quicker goal achievement for those who are goal-oriented. May save on brokerage fees since you'll only be buying one asset class at a time (assuming you use funds and not individual equities / bonds). Disadvantage: During the time you're building up assets in a class, you're missing out on diversification, and if you set a high goal in asset classes you miss out on diversification for an extended period of time.

School 2: Set your AA percentages, and then divide new money to each asset class accordingly. Advantages: you get the benefits of diversification as you go. Disadvantages: potentially higher brokerage fees, depending on number of asset classes; slower goal achievement (for those who need short-term goals to stay focused).

We're using a hybrid of this model, channeling new money to asset classes that are lagging according to our AA (how we currently rebalance) and then sending new money in accordance with our AA once our AA is back in shape. It's working so far, but we're still fleshing out our AA and streamlining our investments.

 

[samclem]

I guess I recommend a variant of school 2. With the products available now (especially target retirement funds), a young investor can take a small amount and invest monthly in a single widely diversified product. As assets grow, they can use the time to learn about investing and decide if they need to fine-tune their portfolio by adding a small amount to another fund or two, or segregating their funds into those most suited to tax-defered and those best put into non-tax favored accounts, etc.

This method has four advantages:
1) Diversification from the get-go
2) No dabbling with market/asset sector timing (there's time later to experiment with bad habits!)
3) Reduced costs (compared to launching in to many funds/etfs with a very small stake in each).
4) Available capital grows along with investment understanding.

 

[WM]

When we were starting out we didn't know much about AA, so we put everything into an S&P fund for a long time. Then we learned a little bit and started also directing some new money to small cap and international. Then we learned some more and we're now putting new $ into bonds, in 2009 it will be REITs and emerging markets, and when those are full, international bonds. So I guess we're doing a few at a time.

 

[W2R]

I try to keep my percentage of equity funds (vs cash/bonds/fixed) consistent with the percentages I have decided upon in my investment plan, always.

Overall, I believe that I follow a variety of your method #2, except for Wellesley. I DCA monthly into my taxable equity funds and into my TSP bond funds and contribute once a year to my Roth IRA, but bought Wellesley (a balanced fund) outright as soon as possible.

By now I am very nearly fully invested and planning to retire next year, so each month I will just add to those funds that are lagging behind their allocated percentages more than others due to recent market declines.

 

[GoodSense]

I basically do #2, through my 401(k) account, although when it comes to starting a new fund at Vanguard you need to do a little of #1 to get started.

It still gives me the satisfaction of meeting my goal, since I look at the total number, not what's in each fund.

 

[Nords]

We're using a hybrid of this model, channeling new money to asset classes that are lagging according to our AA (how we currently rebalance) and then sending new money in accordance with our AA once our AA is back in shape. It's working so far, but we're still fleshing out our AA and streamlining our investments.

I think you're describing value-cost averaging, which tends to buy shares at a lower cost than DCA. It's a bit more complex than "set & forget" DCA but you're rewarded for the extra effort.

In a world of $4-$8 trading commissions it's hard to see the advantage of method #1. It may make the saver feel better, especially if they happen to be buying an asset class that's temporarily outperforming its long-term average. But it's almost as likely that they'll get discouraged by buying a class just before it begins underperforming, which I would expect to wipe out any satisfaction from achieving an AA.

I suspect #1 is only applicable for minimum balances (as already mentioned) or "just because it makes me feel better".

 

[Urchina]

I think you're describing value-cost averaging, which tends to buy shares at a lower cost than DCA. It's a bit more complex than "set & forget" DCA but you're rewarded for the extra effort.

I've read about value-cost averaging (in the four pillars, maybe?) but we aren't actively working the numbers out. Maybe what we're doing is the "lazy" version of VCA. We just buy what's lagging, because we don't like selling equities that are doing well to buy those that are tanking. (We don't have a problem buying equities that aren't doing well -- we just really like a buy-and-hold-forever strategy).

 

[Urchina]

Overall, I believe that I follow a variety of your method #2, except for Wellesley. I DCA monthly into my taxable equity funds and into my TSP bond funds and contribute once a year to my Roth IRA, but bought Wellesley (a balanced fund) outright as soon as possible.

Want2retire, I'm considering Wellesley/Wellington for part of our portfolio. When you say that you bought it outright, did you have a goal to acquire a certain dollar/share amount and work toward that? Your post indicated that you didn't DCA into Wellesley. Since the minimum for Wellesley is only $3k -- I'm assuming you did the former.

If so, how did you calculate in advance how much to buy?

Finally, do you hold Wellesley in a tax-advantaged or taxable account? I like the income it throws off, and we're thinking about building an income stream earlier rather than later, but (per my education in the high-yield bond thread here) am curious as to how others handle this. Thanks!

 

[W2R]

Urchina, my financial plan has 30% in Wellesley. So, I have kept it at that percentage, without intentionally holding back on investing up to that limit. That is similar to your "snowball" method for Wellesley, I suppose. Since my tax-advantaged accounts are already full of bond funds, I have Wellesley in taxable - - however, I would recommend putting it in tax advantaged accounts if you have room.

 

[Urchina]

Want2Retire, thank you. I was raised to never really discuss money with others, so I always feel a little awkward asking (and I'm at the beginning of the learning curve, so there's some ignorance/uncertainty awkwardness compounding it). I appreciate your willingness to share!

 

[chinaco]

I think #2 is less risky... but it really depends on the assets and the level of diversification.

IMHO - for most people simple is better. Diversify across classes (including bonds) and balance every couple of years or yearly (or when certain limits are crossed). During accumulation this helps to implement the buy low/sell high technique and lock-in gains... over 30 years it adds up.

 

[jIMOh]

I did #1 and 2009 will be the last year I need to do #1 until all positions in AA are at normal percentages.