Sunday, February 05, 2006

Asset allocation basics: Part III Asset mix

The asset mix is the primary determinant of the portfolio risk and return. It is normally determined by the investor’s risk capacity and investment goals. The old rule of thumb “100 – your age” as the percentage of equities is a quick and simple way to determine your asset mix and may be a good starting point. A more scientific way is to quantify the investor’s investment horizon and risk tolerance such as this detailed online survey from Index Fund Advisors: http://www.ifa.com/SurveyNET/index.aspx. In the next post, I'll include a list of asset allocation (AA) plans around the web that may be of further help.

Starting Point

I settled on a 30% bond 70% equities weighting as mentioned before. My wife and I are in our early thirties. My appetite for risk tolerance is rather high, but it's more than adequately satisfied with the actively managed portion of my portfolio. When constructing my own asset allocation portfolio, I was heavily influenced by Paul Merriman’s website FundAdvice.com. This is his ideal recommendation for allocating the equities portion:

Two Morning Star style boxes were used to demonstrate Merriman’s asset mix which is a modified “four corners” approach. As the name suggests, the “four corners” approach calls for allocations in large growth, large value, small growth and small value to take advantage of the lack of correlation between large and small cap, growth and value (Recall from Part II that lack of correlation of assets in the portfolio enhances the risk adjusted return.). Merriman’s plan introduces a value bias as the large and small blend replaces the large and small growth components. This bias was justified by another seminal work called the “Fama-French three factor model” that quantified additional contributions to portfolio return from value stocks and small cap stocks. Merriman assigns equal weighting to each of the four boxes in his model portfolios and I saw no reason to deviate.

The same style box is applied to international equities, although note that Merriman is referring only to the developed foreign markets above. There is actually a fifth element: emerging markets, so that in his model portfolio 1/5 of the weighting in international equities is assigned to each of the four checked boxes plus emerging markets.

In the fixed income arena, Merriman’s advice can be summed up as, “keep it short”. Here “it” here refers to bond maturity. He used the following figure to show that "the longest maturity you needed in order to achieve high bond returns was five years. And it shows you that in this 40-year period, one-year Treasury bills gave investors nearly 95 percent of the return of five-year Treasury notes, with much less volatility."

Numerous model portfolios can be found on this page from FundAdvice.com. In Part IV, I'll discuss specific sectors the Merriman portfolio lacks/omits. I'll also include a list of other asset allocation plans found around the web.

< Part II Part IV >