When I first started investing asset allocation was one of my biggest dilemmas. Having no formal training or education in investing, I was completely lost when attempting to figure out a good asset mix. It wasn’t until I found this book on diversified portfolios that I finally received the answer I had been looking for.
In case you didn’t follow link, the book is The Intelligent Asset Allocator by William Bernstein. This book contains invaluable information on good asset allocations and how a good mix across classes of stocks and bonds, both foreign and domestic, can effect your portfolio. As I’ve matured as an investor, I have become less of an ‘Asset Allocator’ and tend to focus on a small selection of valuable equities rather than “buying the market”, as they say.
Nonetheless, diversification is key to many trading strategies thus we believe this information belongs on this site as it is aimed to educate rather than force our investment beliefs onto others.
Before we start, here are some conventional descriptions of the asset classes the forthcoming portfolios. If you ware knowledgeable with common asset classes, feel free to skip this section.
Large-cap stocks are stocks that have a market capitalization of $10 billion or more
Small-cap stocks are stocks that have a market capitalization between $300 million and $2 billion
Mid-cap stocks are stocks with market capitalization between small and large-cap stocks
Fixed Income these are treasury and corporate bonds, Bernstein recommends the use of short-term (2-5 year) bonds since historically they have the same returns and less risk than longer term bonds.
Emerging Markets is a nation’s economy that is progressing towards becoming advanced as shown by liquidity in local debt and equity markets and the existence of some sort of market exchange and regulatory body.
International stocks is equity in non-U.S. companies, typically Pacific Rim, Europe, and Japan
Growth stock is stock that tends to increase in capital value rather than yield high income
Value stock are shares in a company with solid fundamentals but are priced below its peers, based on analysis of price/earnings (P/E) ratio, yield, and a few other factors (P/E is a good indicator of over/under value)
Here are a few diversified portfolios recommended by Investopedia based on risk tolerance.
Model #1: The Risk-Seeking Approach
5% Large-cap value
10% Mid-cap value
15% Small-cap value
5% Fixed income
20% Large-cap growth
25% Mid-cap growth
20% Small-cap growth
This portfolio suggests buying 50% foreign and 50% domestic equities for each asset class.
Model #2: The Risk-Tolerant Approach
10% Large-cap value
15% Mid-cap value
15% Small-cap value
10% Fixed income
15% Large-cap growth
20% Mid-cap growth
15% Small-cap growth
With a foreign / domestic split of 35% / 65%.
Model #3: The Risk-Limiting Approach
25% Large-cap value
20% Mid-cap value
15% Small-cap value
15% Fixed income
10% Large-cap growth
10% Mid-cap growth
5% Small-cap growth
With a foreign / domestic split of 25% / 75%.
The portfolios from here down will be from Bernstein’s book:
33.33% Large-cap U.S. stock
33.33% U.S. Small stocks
33.33% Foreign stocks
60% U.S. Large-cap stocks
20% U.S. Small-cap stocks
20% Foreign stocks
Bernstein does not recommend the aforementioned portfolios, however from the period 1969 to 1998 they have performed almost as well as the S&P 500, which tracks the most widely held U.S. large-cap stocks. That being said, it is perhaps just as wise to shove your money into a low-fee S&P 500 Index such as VOO, SWPPX, or VFINX.
The Madonna Portfolio
10% U.S. large-cap stocks
10% U.S. small-cap stocks
10% Real estate investment trusts
10% International large-cap stocks
10% International small-cap stocks
10% emerging market stocks
10% precious metals stocks
30% U.S. short-term bonds
The Gap Portfolio
8% U.S. large-cap growth
8% U.S. large-cap value
4% U.S. small-cap growth
4% U.S. small-cap value
4% Real estate investment trusts
4% International large-cap value
2% International small-cap growth
2% International small-cap value
1.2% Emerging markets large-cap growth
1.2% Emerging markets large-cap value
1.6% Emerging markets small-cap growth
15% One-year corporate bonds
15% Two-year global bonds
15% Five-year U.S. government bonds
15% Five-year global bonds
Some Good Ideas
Many of these asset classes are measured by some index fund, for example the S&P 500 measures U.S. Large-cap stocks and the Vanguard Emerging Markets Stock Index measures emerging markets, thus it may be wiser to buy into a few of these indexes rather than trying to make individual stock picks which can be difficult and time consuming, especially for a new investor. However, when picking index funds be sure to note the fees associated with the fund in comparison to similar index funds as these will eat away your gains, if you let them.
REBALANCE YOUR PORTFOLIO! Not too often since this will drive up taxes and trading commission fees, but approximately once per year re-construct your portfolio so that the original percentages are restored. The act of re-balancing force the investor to sell stocks that have risen in price (sell high) since they will now be a larger percent of the total portfolio and buy stocks that have fallen in price (buy low) since these stocks are now a lesser part of the portfolio.