In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction. In this financial blog post I’m going discuss a hypothetical investing situation:
Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs. She transferred her 401K to an IRA, and has $100,000 now sitting in cash. Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K. How might she invest her IRA funds?
As a proponent of diversified index investing, I suggest the following category questions… What percent 1) Domestic vs. foreign? 2) Stock versus bond?
I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio. (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)
Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her. Working out the math that’s $80,000 for US investments and $20,000 for foreign investments. Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.
The US part is pretty easy to achieve. Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND. The foreign stock component is easy too; but $12,000 into VXUS. Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.
There you have it. A simple example of asset allocation.
My personal opinion is that an initial asset allocation process can be very simple and effective. Notice that I was able to avoid several secondary asset allocation measures such:
- Value vs Growth (stocks)
- Large-cap vs Small-cap (stocks)
- Sector allocation (stocks)
- Developed vs Emerging markets (stocks and bonds)
- Short-term vs Long-term (bonds)
- Average Maturity or Duration (bonds)
- Government vs Corporate (bonds)
- Investment-grade vs non-investment grade (bonds)
- Average credit rating (bonds)
All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above. Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe. Essentially, a total US stock fund seeks to own a piece of the whole US stock market. Similarly with a total US bond fund, etc.
In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond. [If you don’t have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]
Balhiser.com 