Asset Allocation & Rebalancing

This amazing book “The Intelligent Asset Allocator” by William Bernstein was an incredible read. He uses simple examples to explain a fundamental strategy if you want to win your financial future. Being Asset Allocated with your investments will not only lower your risk dramatically but also only reduce your rewards minimally.

Most people innately think that Risk and Return must be tightly correlated. High risk brings high returns. Low risk brings lower returns. This is a human bias and does not work out in real world investment situations. Bernstein points out that investing a specific way can lower your risk dramatically and only lower your return by a fraction of a percentage. You can have your cake and eat it too!

Two major investment philosophies to consider :

  1) Have investments that are loosely correlated should be a major part of your portfolio. Being loosely correlated meaning that they perform independently of each other.

  1.    US Stocks & US Bonds
  2.    Foreign Stocks & US Stocks

  2) Rebalancing every 1-2 years. What is rebalancing, you ask? Rebalancing is a strategy investors implement so that they can reduce risk. Say you have a portfolio of 60% Stock and 40% Bonds. If the stock market skyrocketed and you were now at a ratio of 70% Stock and 30% Bonds by the end of the year, you would rebalance and sell 10% of your stock to buy bonds so that your ratios are in sync again. The idea is to sell high and buy low. Rebalancing helps you enforce that idea.

  While I was reading this book, one big question kept creeping up in my head. What about the taxes? How are you to sell your stocks at a high and provoke short term gains tax? Won’t that dramatically cut your returns? Bernstein acknowledges this flaw and actually recommends not selling your stock at all. More on that later.

  Real Application. Yes yes, proving theories may be all well and good but how can this information help my sorry ass? In the last few chapters “Implementing Your Asset Allocation” is the money maker literally (hah!).

 

STOCKS

TAX SHELTERED AND TAXABLE TAX-SHELTERED ONLY TAXABLE ONLY

 

VANGUARD :

  • 500 INDEX
  • TOTAL STOCK MARKET INDEX
  • EUROPEAN STOCK INDEX
  • PACIFIC STOCK INDEX
  • EMERGING MARKETS STOCK INDEX
VANGAURD :

  • VALUE INDEX
  • EXTENDED MARKET INDEX
  • SMALL-CAP INDEX
  • SMALL-CAP VALUE INDEX
  • REIT INDEX
  • TOTAL INTERNATIONAL STOCK INDEX
VANGAURD :

  • TAX-MANAGED GROWTH AND INCOME
  • TAX-MANAGED SMALL-CAP
  • TAX-MANAGED INTERNATIONAL
DFA :

  • US LARGE COMPANY
  • LARGE-CAP INTERNATIONAL
DFA :

  • US LARGE-CAP VALUE
  • US SMALL COMPANY
  • US MICRO COMPANY
  • REAL ESTATE
  • INTERNATIONAL VALUE
  • INTERNATIONAL SMALL
  • PACFIC RIM SMALL COMPANY
  • UK SMALL COMPANY
  • CONTINENTAL SMALL COMPANY
  • JAPANESE SMALL COMPANY
  • EMERGING MARKETS
DFA :

  • TAX-MANAGED US MARKETWIDE VALUE
  • TAX-MANAGED US SMALL COMPANY
  • TAX-MANAGED INTERNATIONAL VALUE
  •   Note : He chose Vanguard for their low expense fees and their variety of Index Funds

BONDS

TAX-SHELTERED ONLY TAXABLE ONLY

 

GO WITH WHICH EVER IS THE HIGHEST RETURN

  • SHORT TERM CORPORATE FUND
  • SHORT TERM TREASURY FUND
  • LIMITED-TERM TAX EXEMPT FUND
ASSUMING YOU ARE IN THE 36% MARGINAL FEDERAL BRACKET & STATE 5% TAX,

  • SHORT TERM CORPORATE FUND (Subject to both the federal and state tax)
  • SHORT TERM TREASURY FUND (subject to federal tax, not state)
  • LIMITED-TERM TAX EXEMPT FUND (subject to state tax, not federal tax)
  • Note : We are only looking at Vanguard Bond Funds within 2-3- years of maturity. Bernstein goes through the book trying to convince the audience that Bonds any longer than 5 years will erode due to inflation and is not a good place to put your money with certain exceptions. Also, I read this book like 2 weeks ago and I’m not going to go back and review my thoughts. If you want some more details about the book, go pick it up at your local library boy!

Determining Your Precise Allocation

Everyone has their own allocation. Here’s a few questions you want to ask yourself.

  • What goals do you want to accomplish? Do you want a home in 5-10 years? Saving for your kid’s college education? You want to stop working like the rest of us?
  • What time range do you want to accomplish each of those goals? If you have more time, you have the ability to be more risky with your money. But you still have to think about…
  • Your pain tolerance. Most people won’t like to admit this but they can not stomach if we had another recession. I know some millionaries that are great at making money and saving money but once they’ve invested into stocks and saw half a million dollars drop in their investments.. Guess what they did? That’s dam right, they sold it for a lost and never invested in the market again. We want to make sure that you are at a pain tolerance level that you can stand so that we stay in the market. Because if you aren’t in the market, and most of your money is in cash, then you’re just losing because of inflation.

This is my investment plan for now. I might change it throughout the years but this is what I’m striving for.

  • To meet these goals, my fiance and I have set aside money weekly, monthly, whatever we can so that we can get this allocation. When it comes to taxes, we do not believe in selling to provoke a short term gains tax.
  • To try to minimize rebalancing, we have plans to take the dividends in cash and buy bonds from that. We will also continue to add monthly into our investments so if our portfolio is heavily stacked with stocks, we will just have to add monthly to our bonds and hope it will balance out. If it doesn’t, well that’s life. We are also going to rebalance annually in May. I’ve read some stuff about how May is a good month on financial forums and I can dig that.
  • My allocation was also inspired by both of Tony Robbin’s financial books “Money:  Master the Game” & “Unshakable : Your Financial Freedom Playbook” Great reads. Highly recommended.
TAXABLE INVESTMENT PLAN
US LARGE CAP STOCK 45
TIPS 15
MUNIS 15
JAPAN LARGE CAP STOCK 10
EUROPEAN STOCK INDEX 15
TAX-SHELTERED INVESTMENT PLAN
MID-CAP INDEX [VIMSX] 12.5
SMALL CAP GROWTH INDEX [VISGX] 12.5
TOTAL INTERNATIONAL STOCK INDEX FUND 15
INFLATION-PROTECTED SECURITIES FUND 10
FTSE ALL WORLD EX-US SMALL CAP 15
INTERMEDIATE-TERM TREASURY FUND 15
EMERGING MARKETS STOCK INDEX ADMIRAL [VEMAX] 2.5
GNMA 7.5
REITS 7.5
ENERGY 2.5

 

You can see here that a good rule of thumb is to invest in large cap stock in your taxable accounts since most likely (these are less at risk of failing and you can potentially buy and hold them till you freakin die). Companies that have been around for a hundred years will probably be around for the next hundred. Think Coca Cola. I highly recommend reading Buffettology. It goes through the different companies that are great to buy and hold. We invest in riskier things in our tax-advantage accounts (401ks, IRAs and such) so we can buy and sell quickly without tax consequences. We also rather buy an index than just 1 small stock because it’s less risky, more diversified and I’m too lazy to do the research on smaller companies that have less financial reports.

  • Note : Vangaurd is a great company to invest with. You have to make sure that  whichever company you decide to go with has LOW FEES. This is key. But the con with Vangaurd is that you will have to have 3k+ to start investing. It may seem daunting to have to save up 3k but if you can just start with something small on a monthly basis. Say 300/mo, or even smaller, then you will get there before you know it. The biggest impact you can have on your financial future is ADDING MONTHLY to an investment and being CONSISTENT. Good luck and I hope this helped!

 

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