How much money should I put in each asset class? This is arguably the most important investing question for a successful portfolio. Yet, it can be one of the hardest questions to answer. Asset allocation is a fundamental question with many different variables. When I was 20, I’d put all of my money in a single stock. My thought was I had to risk big in order make big gains. There’s some truth to that but it was the wrong way to go. Most investment professionals agree that being diversified is the only way to invest. Everything else is speculation. Diversification really is the only free lunch in investing. In fact, you can make more money by being diversified on the efficient frontier curve than just hoping you’re properly diversified. But first, you should consider your investment objective when figuring out your asset allocation strategy.
What’s Your Investment Objective? (i.e. the fundamental reason you’re investing)
1. Capital Preservation – Keeping your war chest – investments keep up with inflation but are considered low risk. You might fit into this category if you’re older and need your money for living expenses or you believe we’re at the top of some epic bull market. Ironically, if you’re older and have huge portfolio (more than you will every spend in your lifetime), a growth & income or balanced portfolio might be better suited for you.
2. Capital Accumulation – Building your war chest – Long-term capital appreciation. There are a lot of benefits to capital accumulation, one of which is tax deferral. If you hold onto a portfolio that consists of appreciating assets, you’ll only be taxed when you sell for a gain. You could hold a stock that doesn’t pay dividends, yet continues grow hundreds of percentage points over a 20-year period. The tax man will stay off your back until the investment is sold. And here’s a cool twist: you can leave stocks like these to your children and they receive the cost basis at the time they receive them, not the original cost basis. This is great for your kids and will save a ton on taxes.
3. Income – Capital preservation with a focus on current income. I love getting dividend checks every quarter from some of the biggest companies in the world like AT&T. However, high dividends come at a cost. That cost is usually lower growth in the underlying business which translates into lower capital appreciation (e.g. you could hold onto a 5% dividend payer where the stock price never rises). On a different note, don’t forget about bonds here. Corporate bonds are my favorite and provide a lot of protection when stocks are at record highs.
4. Growth & Income – A mix of growth and income with a focus on growth. The focus here is on building a growth portfolio that also generates some sort of income. The income might b 1.5 – 3 % annually, which is generally on the low side. You’d expect the growth side to generate 6 – 10 % returns depending on the risk of the overall portfolio.
5. Balanced – A mix of long-term capital appreciation and income with a focus on current income. This is one of my favorite objectives for folks in their early 50’s because it provides a good amount of current income and the portfolio will also increase in value due to capital appreciation.
6. Speculation – Swing trading – going for the long shot. Using a higher degree of risk. I’d recommend having a separate smaller account that is strictly for this if you’re into speculation. This way you can compartmentalize your investments and you won’t risk your entire life savings. For example, holding an account with $2,000 where you trade put and call options on a few securities is fine. Just realize that you could lose everything in a week or make tens of thousands in a week.
Your investment objective will change over time. Just like mine went from a speculative trader when I was 20 to a growth & income investor now. Maybe when I’m 60, I’ll be more in the capital preservation camp.
Asset Categories versus Asset Class Segments
In order to get the proper allocation for your portfolio, you have to think about both asset categories and asset class segments. Asset categories are broken down into three types based on my Triad Portfolio allocation model:
1.) Risk-free Assets – Cash and cash equivalents, short-term Treasuries
2.) Core Assets – Stocks & Bonds
3.) Alternative Assets – Options, Real Estate, Venture Debt
Asset class segments are the sub-categories underneath the overarching category. For example, stocks (equities) are a core asset class. There are many segments that fall under stocks. You can invest in large-cap growth, large-cap value, emerging markets, developed international, small cap, etc. You may have seen a chart like this when pick your 401(k) investments.
I took this chart from Vanguard’s Portfolio & Management section of their site. You can see the Vanguard Growth and Income Fund is a stock fund that falls under the large-cap blended asset class segment. This means that there may be growth stocks and income stocks in the portfolio. Now if we look at the main stocks that make up this fund, we’ll see some of the biggest companies in the world:
Some of the above stocks are focused more on growth (Facebook, Alphabet, Amazon) while others provide income in the form of dividends (Microsoft, J&J, AT&T). Notice too that the top ten stocks in this portfolio make up only 21% of all the holdings. This fund is a mix of big name stocks. This one fund might satisfy your allocation to stocks. That’s it! One fund. It doesn’t get much easier than that.
Investors will make more money with fewer headaches with a simple approach. When I tell people that one stock fund is all they need to hold some push back. “What about being diversified into many things?” Well, if you own Vanguard’s Growth and Income mutual fund, you’ll be invested in over 100 stocks of some of the best companies in the world. What more do you need than that? If you added a bunch of mutual funds, you’d likely just overlap your holdings and further complicate your life.
How Much Do I Need in Each Category?
I currently have about 40% risk-free, 40% core, and 20% in alternatives. Your allocation will depend on your specific situation. Maybe your investment objective is capital preservation. If that’s the case, you’d might have even more in risk-free investments like short-term treasuries. Maybe you you’re young and need to grow your wealth as quickly as possible. You might be invested more in core and alternative assets if that’s the case. You have to figure out your risk budget / risk profile as well as your investment objective prior to knowing your allocation.
Once you’ve figured out the risks you’re willing to take and your investment objective, it’s time to get to work. The framework starts at the asset category level. Let’s start with my scenario at 40/40/20.
Money market funds
Individual stocks – I buy individual growth and income stocks giving the core part of my portfolio a balanced approach. I stay well-diversified by investing in 15 stocks on average. I own big names everyone knows and some smaller companies in a lower percentage allocation. An alternative would be to invest in Vanguard’s Growth and Income Fund.
Oil options – I go to old faithful when it comes to my alternatives. I own oil through USO and trade options around the position to create income. I’ll do this on other stocks too but I like oil the best. I wrote an entire post about this method so feel free to read more about that here. I lot of people have turned to crowdsourced real estate investing as well in order to diversify away from Wall Street investments.
The percentage of your assets that you should have in each asset category and asset class segment depends on your investment objective and risk tolerance. You should use a software to figure out where your portfolio lies on the efficient frontier curve or enlist the help of a good fee-based financial planner to determine your allocation mix. I bet you’d be surprised by your current allocation mix versus how your portfolio should be allocated. I was. Check out my allocation below. I made a conscious decision to divest from utilities but was surprised by my weighting in consumer defensive stocks.