Asset Allocation

How many asset classes?

September 7, 2008


There is a larger question that must be asked in discussing the recent introduction of new Claymore funds tracking global real estate and infrastructure: just how many asset classes does a portfolio need? How much more diversification benefits can real estate, infrastructure, commodities, or even more exotic asset classes provide? In Unconventional Success, David Swensen discusses asset allocation is great detail and provides some guidelines:

  • A strong equity orientation.
  • Sufficient diversification through many asset classes.
  • At least 5 to 10 percent should be allocated to any individual asset class — enough to have an impact on the overall portfolio.
  • An asset class should not dominate a portfolio — allocate no more than 25 to 30 percent to a single asset class.
  • The asset allocation decision should be infrequently revisited.

Mr. Swensen’s reasonable guidelines suggest a portfolio composed of no less than 4 and no more than 20 asset classes. A strong equity bias means that the maximum number of asset classes should be far less than 20. The Sleepy Portfolio, for instance, has only eight asset classes — cash, short-term bonds, real-return bonds, REITs, Canadian equities, US equities, EAFE equities and emerging market equities — but the bulk of it (70%) is in equities. The other 30% is already divided between four asset classes; there is simply no room for new ones.

It seems to me (I don’t know of any studies to back up my claim) that once a certain level of diversification is achieved, adding more asset classes is likely to fall prey to the law of diminishing returns. So, as far as the Sleepy Portfolio is concerned, eight asset classes should be plenty enough.

Are you comfortable with your portfolio?

May 6, 2008


Stocks have staged a significant recovery after falling sharply in the first quarter of 2008. The TSX Composite is up about 19% from its low in January and the S&P 500 is up about 11% from its mid-March swoon. If the lows reached in the first quarter was indeed the market bottom, we can classify the plunge as a severe correction – the TSX was down 18% from its 52-week high and the S&P 500 tiptoed into bear market territory when it was down 20.25% briefly. During the market storm, diversification within stocks wouldn’t have helped; cash and government bonds provided the only refuge.

While the reasonable course of action when markets are correcting is not panicking and staying the course, now may be the time to revisit your asset allocation in light of your reaction to falling stock prices. At times of market turmoil three options are available: (a) sell enough to reach your comfort level (b) stay the course or (c) scrounge every nickel you can find and invest it in stocks. If your inclination was to sell some stocks, your risk tolerance may be less than you originally believed and you may want to increase your allocation to bonds and cash (Now may not be the ideal time to buy bonds either as Government of Canada 5-year bonds are barely yielding 3%).

YTD 2008 chart comparing XSB with XIC, VTI, VEA and VWO

How Much in Equities?

February 11, 2008


The portion of your portfolio that should be allocated to equities depends on your ability, willingness and need to take risk. One of the factors affecting the ability to take risk is time horizon: investors with a long time horizon can allocate a greater percentage to equities than investors with a shorter time horizon. Larry Swedroe in Rational Investing in Irrational Times provides the following guidelines for the maximum equity exposure depending on time horizon:

0 to 3 years – 0%
4 years – 10%
5 years – 20%
6 years – 30%
7 years – 40%
8 years – 50%
9 years – 60%
10 years – 70%
11 to 14 years – 80%
15 to 19 years – 90%
20 years or longer – 100%

Note that other factors such as your willingness and need to take risk will determine how much you actually allocate to equities. I found this table interesting because it provides a rough guideline of how much could be allocated to equities.