I received the following query regarding my asset allocation and thought I would make a post on the subject.

How did you arrive at this allocation? I’m thinking about making a passive portfolio of index funds, but I don’t know what asset allocation I should have, and Vanguard’s Investor Questionnaire only differentiates between stocks and bonds.

First, I determined the split between cash, bonds, stocks and REITs based on my age and risk tolerance. Since my spouse and I are decades away from retirement and our risk tolerance is fairly high, we have a relatively low allocation to cash (5%-10%) and bonds (20%-25%). I don’t have a very good explanation for the split between different equities other than that it is roughly split equally between Canada, US and International (EAFE and emerging markets). I also have about 5%-10% exposed to asset classes (like REITs) that have low correlation with stocks and bonds.

Some columnists like Jonathan Clements of The Wall Street Journal think that the exact details of the asset allocation (beyond the stocks-bonds split) are relatively unimportant. What is important is having a target allocation and rebalancing the passive portfolio when it deviates too much from the target.

A very good portfolio planner is available from TD Bank and an Asset Class Allocator from iUnits provides a returns calculator for a diversified passive portfolio.

This article has 10 comments

  1. Thanks! That helps a lot. I didn’t know if there was a certain method that financial planners used for asset allocations, or if it didn’t matter so much. I also liked the TD Bank tool.

  2. Canadian Capitalist

    You are welcome Michael. Good luck with your asset allocation.

  3. According to Prof. Jeremy Siegel in “The Future for Investors,” Morgan Stanley’s Quantitative Analytics team in June 2004 concluded that in constructing global asset allocations, sectors are more important than regional representations. (Not that that ends the debate, but it’s a data point, of course)

    You mentioned that your equities are split between Canada, US and International. Are you playing the general equity markets in each region, or are you focused on specific market sectors in those regions? For instance, in Canada, are you focused on natural resource companies, such as precious metal mining companies and oil companies/trusts?

  4. Canadian Capitalist

    Suresh: My Sleepy Portfolio is my benchmark against which I measure my actual returns. The composition of my real portfolio is very different.

    I constructed the sleepy portfolio using ETFs to capture the broad market and are not sector specific.

  5. Thank you for the clarification. The Sleepy Portfolio is a bogey, correct? You had mentioned back in April that you were moving your then-current portfolio toward an asset allocation like that found in the Sleepy Portfolio. I suppose, of course, these things take time.

    So, please allow me to rephrase. Based on your readings and experience, do you anticipate better luck with geographical diversification or sector diversification? Or, given what you’ve learned, does it makes more sense to be a focused investor (a la Graham/Buffett), using the Sleepy Portfolio only as a yardstick?

    I ask because I find myself drawn toward focused investing, rather than diversification. The latter currently exposes me to three historically overvalued U.S. markets: the general equity market, the bond market, and the real estate market. I can’t avoid the real estate market bubble, as I’m not going to sell my home and rent, a rational though not practicable approach. But, I can position myself relative to risk in the other two markets.

  6. Canadian Capitalist

    I use the SP to benchmark my returns. I also use it for my smaller portfolios (like my retirement account at work and the education savings accounts for my kids). I also use selective ETFs to capture some asset classes (like international stocks).

    I have very low exposure to bonds and REITs because I think they are overvalued. I do think US large-cap equities are undervalued (and I am overweight in them). I have a fairly concentrated portfolio as I’ve noted elsewhere in the blog (my largest positions are MO, ET, TD Bank, BUD and HD).

    I am sticking with geographic diversification for my benchmark because I want it to be simple to track. I have no opinion on whether sector diversification will be superior to a geographic one.

    Sector diversification would make sense if you think that we are moving towards a single global economy and different geographies have a very high correlation that makes diversification less useful. It should be noted that correlation between markets is not static and varies over time. My opinion is economies are still different enough that geographic diversification makes sense. Also the broad markets themselves are fairly diversified among various sectors.

  7. It’s interesting that you say, “since my spouse and I are decades away from retirement and our risk tolerance is fairly high, we have a relatively low allocation to cash (5%-10%) and bonds (20%-25%),” since many people/books/advisors out there seem to recommend that people in this category should invest in a much higher percentage of equities, and in some cases 100%. This is what my advisor had originally recommended but I wasn’t comfortable with it, so my target fixed income allocation is 25%.

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  9. Canadian Capitalist

    Dave: We can debate about whether my allocation to bonds is too high or too low, but planning to have *no* allocation to bonds sounds risky to me. In many time frames, bonds would have been a superior investment to stocks. I think the actual split boils down to personal preference (the risk someone is willing to take lies somewhere between their eating well and sleeping well).

  10. An alternative approach for asset allocation is to use a good Monte Carlo model (see my website for a bunch of white papers and a free model to use). You can develop various portfolios and test their risk using various measures. Be very careful in international ETF’s that they are not high Beta–as many turn out to be. A high Beta international fund or ETF can actually increase your exposure to US markets rather than reducing it—I have a pepr on this on my site under the Retirement Planning link.