Hi sports fans. You might have stopped by today because alliteration is your bag and you just couldn’t walk away from that title. (Hey, we understand.) Or maybe you’ve heardt our #1 smash hit podcast series on 401Ks and you want an answer for the million dollar question:
What’s the right asset mix (stocks, bonds, REITs, EFTs, etc etc.) to hold inside my investment accounts?
Well, you’re not going to believe this, but that’s EXACTLY the question I’m going to answer today. That’s not coincidence, folks: I PLANNED it that way!
The secret to successful investing is not (not NOT NOT) picking the right stocks. In fact, picking individual stocks has been repeatedly proven to produce worse returns over long periods of time than investing in a well diversified portfolio of stocks (and bonds! And more!). Because you’re no dum-dum, cowboy, I’m going to proceed with this article assuming that you’d like to maximize returns on your invested money, whether that be in a workplace 401k, an individual retirement account or even a taxable investment account – anywhere where YOU have to make choices about which investments you’ll own.
So let’s start riiiiiight at the beginning, with some definitions. I mean, you can’t decide how to allocate your money amongst different types of assets if you don’t know what those different assets are. As we’ve discussed in the past, there are many, many different asset classes – many of which are hard to put into your 401k account (think artwork, raw land, exotic pets, bitcoin and sneakers). For the purposes of this article, I’m going to cover a few of the most common assets that you can readily utilize in most investment accounts.
Here’s 12 large and common categories:
- Large Cap Growth Stocks: These are large companies (worth more than $10B) whose primary goal is growth – so when they make money, they reinvest it into the company and don’t hand it back to investors. They may even lose money on a regular basis due to investing in growth, but they are growing fast enough to be valued based on their ability to earn lots of money in the future. Facebook is an example of a large cap growth stock.
- Large Cap Value Stocks: Large companies who are primarily focused on returning capital to their investors. These stocks will generally provide some growth, but they also produce taxable income in the form of dividend payouts to investors. Proctor and Gamble is a good example of a large cap value stock.
- Mid-Cap Stocks: These are shares of ownership in companies that range in total valuation from $2B to $10B. Mid cap stocks have underperformed others since the 90s, but many believe they are positioned well to lead in times of recovery from an economic downturn.
- Small Cap Stocks: This asset class is defined as stock in companies worth between $300M and $2B. These shares tend to be more volatile than those of larger companies, but earn a slightly higher return over the long run when compared to mid and large cap stocks because of it. I like to sprinkle a fair dose of small cap stocks into my model portfolios.
- International Stocks: Stocks in companies outside of the U.S. in developed countries, such as those in the European and Asian markets. Developed international stocks can be correlated to US stocks, but provide diversification for specific geopolitical risks or risks related to the domestic economy.
- Emerging Market Stocks: Stocks in developing countries like China, India, Brazil, etc. These tend to be very volatile, but can produce great returns… when they’re doing well.
- REITs: Short for Real Estate Investment Trust, these are companies that hold real estate or real estate loans. Investing in REITs can be a great way to get the financial benefits of real estate ownership without the pain of fixing a leaky faucet at 3am!
- Commodities: These are raw materials or primary agricultural products that can be bought and sold. Things like gold, coffee and sorghum. You can buy funds that track the entire commodities market, or you can specify “I want to own a position in copper”. Some commodities, particularly gold, are considered a good hedge against inflation.
- Government Bonds: You may not have heard, but our government isn’t exactly sitting on a surplus of funds. So when they pass a $3 trillion dollar spending bill, they have to borrow money to pay for that spending. They do this in part by writing bonds. A bond is just an IOU that says “we’ll pay you back on this date and we’ll pay you interest payments between now and then for the privilege of using your money”. Because there are so many types of bonds with different maturities, owning bonds through a fund that tracks them all is a good alternative to picking individual bonds. These are considered among the safest of investments.
- Commercial Bonds: Just like governments, companies also sometimes choose to finance operations through writing bonds. These can vary from highly safe to very risky. Thankfully there are credit rating agencies that analyse bonds when they are issued and provide a rating that is meant to give investors an idea of how risky that bond is.
- High-Yield Bonds: If a bond has a very low credit rating signifying risk of the investor not getting repaid, they generally have to pay a much higher rate of interest than companies or government entities who issue high-quality bonds. These are also known as “junk bonds”, but they can have a place in a well-designed portfolio.
- International Bonds: These are bonds written by foreign governments or companies and they can span the full spectrum of risk and return from very safe to very risky.
Sigh- I know you think that was a lot… but trust me, there are more categories than that. But now that you at least know what the biggest asset classes are, I want to introduce you to three key principles of asset allocation (this is a big deal, class! So don’t be impatient. LEARN. LEARN!)…
Diversification
It sounds as corporate nonsense-speak as “synergy” or how everyone misuses the word “agnostic”… but diversification is a real thing (and useful, too). A stock portfolio can be said to be well diversified if it contains at least 20 different stocks that are different enough to move independently of each other.
You could just pick 20 stocks of companies in all different industries, then, and you’d be diversified. For a lot of folks, that number is probably much lower than you might have guessed. However, we don’t recommend this path, because diversification is not the only path to generating good returns.
You see, a stock does not have a 50/50 shot at beating the market. Looking back 10 years, 2/3rds of all stocks underperformed a broad index of similar stocks. That means you could EASILY pick 20 losers if you were just picking stocks and planning to hold them for a long time. In that case, you’d have a well diversified portfolio (win!) of losers (shucks!). It also means that the gains driven by the broader stock market are generally not driven by most companies rising at a similar pace. No, they are driven by a few companies that blow up and pull the rest of the market index up with them. We hope you’re starting to feel a sneaking suspicion that you miiiiiight should just own the whole market. …Pat that still, small voice on the head; we’re going to get to him in just a moment.
The point is that diversification is sorely needed in your allocation game. Statistics say with outrageous certainty that you can’t, and won’t, pick the magical Perfect Stocks For Next Year, and, as stated above, that most stocks will perform poorly in the next year. But the market itself, on the whole, will rise! Because SOME stocks WILL do super good (remember- you won’t pick them). Got me? Okay, let’s proceed:
Efficient Market Hypothesis
Stock picking is a losing game, if I didn’t make that clear enough already. For instance, if we look at professional mutual fund managers at large-cap funds who are actively researching companies and trying to pick winners (that means their whole career is understanding and selecting stocks- it’s what they do all day every day. HINT: that is NOT your career; you are not as good at this as these guys), 85% of them did not outperform the S&P 500 (which is an index that tracks 500 of the largest companies in the US). Did you hear that!? The significant majority of them didn’t beat the most common index out there! How could this be?
One thing that we here at Abraham’s Wallet subscribe to (but rarely discuss, because it’s so very inside baseball. BTW, that phrase makes it sound like knowing stuff about baseball isn’t cool. We believe that knowing stuff about baseball can actually be kind of cool.) is called Efficient Market Hypothesis (EMH). In a nutshell, this is a body of research showing that, as long as a market is free enough, all of the information that can be known about a company is already priced into the stock for that company. That means that NOBODY (least of all an individual investor hanging around the internet), can get a hot drop on a stock that is “undervalued”. If it’s trading at a particular price, that price has been decided by a free market and is the best reflection of all information available. Rather than pick stocks that you think are a bargain, the EMH devotee would rather just own the entire market and trust that he’ll capture the market’s probable increase. We’ll say it again: although most companies underperform the market, the broader stock markets themselves have always gone up over long periods of time.
At this point, I hope you’re starting to think, “Well gee Wally… can I just buy into the whole market?”. As César Chávez would say, “¡Sí se puede!” By buying the S&P 500 index, you’d be eliminating diversification risk! Wiping it out! But… you can also buy lots of different indices that track different markets. Those could be small companies in the US, companies in emerging markets like Brazil or India, or even indices that track specific types of bonds instead of stocks. By diversifying across all of these options, you’d be not only protecting against a big drop in one particular country’s economy, you’d also be spreading your investments across all sorts of assets so that if stocks across the globe didn’t perform you’d be enjoying the returns on your real-estate or bond investments while you waited for stock markets to heat back up.
HOLY CRAP WE MADE IT.
Ok. We are finally at the part you have all been salivating over. You’re probably saying ENOUGH WITH THE EDUCATION TALK HOSER- WHAT DOES A GOOD, DIVERSIFIED PORTFOLIO LOOK LIKE!?! And I’m like, okay, you don’t have to go caps lock on me… sheesh. I’m not going to tell you any specific stocks, mutual funds or ETFs to buy. But I will give you a few examples of simple asset allocations that spread you across a variety of asset classes (domestic stocks, international stocks, bonds, real estate, commodities, etc.). How you divide up your own portfolio will depend on your own risk tolerance and how much time you have to invest, so please consult with a professional if you have any questions about doing this on your own. Ok, here are four solid allocation options:
- The two-fund portfolio: In this allocation, you pick a total stock market fund (generally an ETF that tracks every stock in the whole world – they do exist) and a total bond market fund. You then just divide up your portfolio between these two, based on your risk tolerance and your investment timeline. If you’re comfortable with lots of ups and downs and you have plenty of time to leave your money in the market, you’d likely use lots of stocks and less bonds. One popular approach is to use 100 minus your age to get to the right mix of stocks (so if you’re 20, you’d be 80% stocks and 20% bonds). Personally, I feel like that formula is a bit conservative, but you could do a lot worse. If you wanted to use a two-fund portfolio with an 80/20 mix, it would look like this:
- Total Stock Market: 80%
- Total Bond Market: 20%
- The three-fund portfolio: If you don’t want to screw with the hassle of figuring out what percentage of stocks and bonds you should own, you could just say, “To heck with it – I’m going to put 1/3rd of my money in US stocks, 1/3rd in international stocks and 1/3rd in bonds”. Not super precise, but we already knew that about you, and to be frank, you’d have a nicely diversified portfolio here as long as you chose low-fee ETFs that tracked the total U.S. stock market, the total international stock market, and the total global bond market. Here what that would look like:
- Total US Stock Market: 33%
- Total International Stock Market: 33%
- Total Bond Market: 33%
- Tax-Focused Bonds: We didn’t talk about it above, but there is a type of bond issued by state and local governments which is generally exempt from federal taxes. Since bonds, you remember, pay you an interest payment (usually twice per year), if you’re holding bonds in a taxable account and you’re in a high tax bracket, that tax bite can really eat into your returns. Municipal bonds (“munis” for the lingo lovers) are a good option if that’s your situation, and you might substitute them for other bonds in an allocation like this:
- Total US Stock Market: 33%
- Total International Stock Market: 33%
- Municipal Bonds: 33%
IMPORTANT NOTE! Because interest on these puppies is tax-free, they pay a bit less interest. So you’d never want to hold these bonds in a 401k or IRA, where you’re not paying taxes on the interest payments for your bonds. Muni bonds only go in taxable accounts, and the best way to hold them is in a diversified fund of lots of different bonds, since it’s very very very hard for the retail investor (that’s you and me) to figure out which individual bonds are a good investment.
- Small Cap Conviction: Let’s say you’d like to dial in the allocation amongst the asset allocations we discussed above with more precision versus just owning the entire market in proportion to the size of each security. That would open you up to endless possibilities, but just for the sake of example, here’s what a mix might look like for someone who wants to tilt their portfolio a bit towards small cap stocks and include some REITs into the mix:
- US Large Cap Stocks: 35%
- US Small Cap stocks: 10%
- REITs: 5%
- Total Bond Market: 20%
- International Stocks: 20%
- Emerging Markets Stocks: 10%
Of course, you could tweak this if you felt conviction about mid-cap stocks, wanted to divide up your bond position between government, international and corporates, or make any other changes to the portfolio based on an opinion you have about a specific asset class over the long term.
We could go on forever with examples of asset allocations. If you’d really like to nerd out on specific portfolio options, there is a great review of many, many more possibilities at this blog post. But for now I’m happy if you understand the basic principles:
- There are different assets that I can hold in an investment account.
- I should diversify my investment within each asset class and among the different asset classes.
- Equities (stocks) tend to earn higher returns over time, but are more risky in the short term than fixed income securities (bonds).
- Typically I’m comfortable with more risk and volatility in my investments when I have lots of time before I’ll need to access the funds I’ve invested.
Once you nail those four ideas down, you’re almost ready to go build yourself an asset allocation. You just need ooooooone more tip to get allocation juuuuust right:
Rebalancing
Let’s say you went with the most basic portfolio we recommended up there, the two fund portfolio. And let’s say you played it pretty safe, with a 50/50 mix of stocks and bonds. But what if stocks go to the moon over the next year and bonds have a terrible year? Well after that year, you might have 70% stocks and only 30% bonds. Now your 50/50 allocation is shot… and you need to get it back. That describes the need to rebalance your portfolio.
Rebalancing just means selling the things that have done really well, and buying the things that have not done so well in order to return your asset allocation to the original mix. By doing this, you’re forcing yourself to “sell high, buy low” – which is a great mantra for investing.
Rebalancing can also create better returns in your portfolio over time: This is because different asset classes tend to do well at different times. For example, if you had invested $100 in shares of Apple in 1994, you’d have about $166k today. If you had invested that $100 in Starbucks, you’d have $23k today. But, believe it or not, if you had invested $50 into each company and rebalanced your portfolio every time it got more than 5% out of the 50/50 mix, you’d have almost twice as much money as you would have from investing in Apple alone. That’s because in the past those companies have experienced big surges in growth at different times, and by owning both and keeping your mix even, you’d participate equally in both growth periods.
Smart, right?
Creating a two-fund portfolio and rebalancing it a couple of times per year is pretty straightforward. If you’re just getting started and setting up a 401k account, that might be a totally reasonable starting point for you. Of course, as your assets grow over time (and they will, homeboy. THEY WILL), it does make sense to add additional precision to the allocation you choose, and the strategy you have for rebalancing.
SO THAT’S IT.
Diversify, find an allocation balance that fits your risk tolerance, don’t try to pick stocks, and rebalance regularly. I’ll admit, all this is a bit beyond the big, simple principles of finance like “get out of dumb debt, live below your income, save some for the future, etc.” It’s a little technical, a little chewy, and a little daunting. And as you enter these waters, it can get even more specific–and challenging.
You may have a variety of account types – a 401k, a taxable account, and a Roth IRA. Being smart about asset allocation means that you might choose to keep certain assets in specific accounts for the present or future tax benefits of doing so. And a two fund allocation might no longer be the most appropriate way to maximize your long term wealth. As you make that transition, I do think it’s wise to pull in outside expertise unless you have a lot of time and energy to give to all of the components of managing, tweaking, rebalancing and monitoring a larger investment portfolio. My day job, for instance, consists of directly managing these types of investments for many clients, and helping them make the best choices for the accounts we don’t directly manage, like their workplace 401k plans. (So, just an FYI, if you’re thinking about whether this type of help would fit your situation, book some time with my firm and we’ll always give you an honest assessment!)
For lots of people, this level of financial management is where they say, “Okay look, we need professional help, here.” Totally understand. If that’s you, find help and utilize them to your benefit. We certainly believe in that route.
But if you just wanted a primer on asset allocation, amigos- you got it! Now get out there, and enjoy some taco diversification. (You MUST allocate space in your tummy for all the major taco groups to capture maximum returns on deliciousness. Professional help is available. Meaning: I’ll join you if you insist.)
*Mark Parrett is one of the founders of Abraham’s Wallet. When not blogging for you here, he’s raising a family in Salt Lake City, UT and working as a financial planner at Outpost Advisors.
