For our second book club book, I asked Small Investor readers to read The Bogleheads' Guide to Investing
. This was really a great book. If you have not done so already, pick up a copy from Amazon using the link below - you'll be glad you did. For many people, the information within this book would be all they really needed to know to invest successfully. It also has some great information about insurance and a little on money management. I've made several posts about sections of this book since there is so much great information.
Today I would like to cover chapter eight, which is on Asset Allocation. In addition to investing early and regularly and being aware of taxes and fees, asset allocation is key to maximizing your total investment returns. There are two main reasons for asset allocation: 1) ensuring that you are invested in the areas of the market that are doing well at any given time and 2) reducing the level of fluctuations in your overall portfolio by buying assets that zig when the others zag, and thereby reducing the risk of a significant loss.
If you have ever looked through your mutual fund statement, you may have noticed that some of your funds have performed much better than others during a given 1, 3, or 10-year period. You may think to yourself, "I wish I had invested it all in that small-cap fund that made 20%, instead of havign some money in that large-cap fund that only made 8% over the last year. In a worst-case scenario, you might decide to sell the shares of the large-cap fund and put it all into the small-cap. Do this and you'll be making 5% returns while the markets are making 12% returns.
The thing to realize is that you'll never be able to predict which sectors of the markets are going to do well over any given period. Efficient market theory says that all information that is known is already priced into the markets, so it is just as likely that the large-caps will do better than the small-caps over the next period as it is that the converse will occur. By buying into both segments of the market, you'll be sure to have some of your money in what is doing well next time. While your whole portfolio will not be making as good a return as the best performing mutual fund in the mix, you'll do better over time than you would if you were trying to jump from fund to fund and pick the one that will do well next. The times that you pick the fund that makes 1% or declines while another one goes up 10% will more than offset any times you are lucky enough to actually pick the fund that makes 18% instead of 12%.
By moving into a fund that has done well, you are also buying shares that have already appreciated, meaning you are buying high. While there is no reason that they cannot go higher for a period of time, which is why you should also not sell everything just because shares have gone up, on average shares that have been beaten down will do better than those that have shot up. If anything, you'd do better buying the fund that did poorly since you'd be buying low instead of high. Unfortunately, many people find the fund that has done the best during the last year and buy shares of that one, holding while it treads water or even declines, then sell just when they should be buying it because they are then trying to chase the next fund that did well. It is better to invest in everything, then rebalance periodically to sell some of the shares in the funds that have done well and buy more of the shares in funds that have done less well.
Asset Allocation Reduces Risk
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A second reason to spread your money around is that it decreases the level of fluctuations in your overall portfolio, which means it reduces the amount of risk you are taking. This risk includes not only the risk of losing money, but also the risk of not getting as good a return on your money as you should. Different assets will do different things at any given time. During the early 2000's, you would want to be in stocks since they were increasing rapidly. In 2008, you would want to be in bonds since they increased a little, plus paid interest, while a portfolio of all stocks declined by 40%.
When diversifying for stability, you want to pick assets that are as uncorrelated as possible, which means buying stocks, bonds, and real estate. Stocks should also include companies of all sizes in both US and foreign markets, since sometimes the US is where to be and other times other countries do better. Owning both a total US stock fund and a total foreign stock fund will cover all of the bases. Bonds should be both US and foreign as well, and also have different maturity dates, ranging from short-term, which are safer but have lower returns, and long-term, which pay a better interest rate but fluctuate in price more. You can get exposure to both of these markets with a total bond market fund. Real estate should include your home, along with either rental properties or Real-Estate Investment Trusts (REITs) if you don't want to be a landlord. You could also throw things such as art or collectibles into the mix, but that really takes some knowledge (and some space), so that is better left as a hobby if that is what you like to do than as an asset allocation plan.
The Boglehead's provide suggested asset allocations for people of different ages and risk tolerances at the end of Chapter 8. They even provide suggestions of combinations of Vanguard funds that you could use, doing all of the work for you. If you haven't done so already, be sure to buy a copy of The Bogleheads' Guide to Investing
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
