Asset allocation
Maximizing returns and minimizing your risks is the magic to achieving your investment goals and getting a good night's sleep. You can achieve these seemingly opposed aims by distributing you investments in different assets this is asset allocation.
According to studies by Nobel laureate William Sharpe and researchers like Brinson, Hood and Beebower (1986), asset allocation accounts for more than 95% of all variance in quarterly returns. (for purposes of this discussion I will restrict myself to non real estate assets). Using Ibbotson's data from the past 70 years on expected returns and standard deviations (geek speak for reward and risk), I ran some excel magic and came up with what I think is an ideal asset allocation for your non real estate investments.
If you are a US resident below 35 years of age
US bonds 15%
US Mid Cap 15%
US Small cap 10%
International 25%
Commodities 5%
REITÂs 5%
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6 Comments:
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Very nice post. A few comments based on my minimal research/reading: There's no such thing as an "ideal" asset allocation - different people have different needs. Furthermore, the location of funds (taxable versus tax-exempt accounts) determines your asset allocation almost as much as risk/return factors. For instance, if you don't have space or tools in a tax-exempt account for REITS, it's almost not worth having them (depending on other factors ofcourse). Thus it is a highly personalized thing, this asset allocation thing.
Also, it has been shown that for purposes of asset correlation and risk/return - midcap is not worth holding at all. The returns aren't as good as small cap and the risk is way more than large cap. Better diversification is afforded by overweighting value versus blend (you want to eschew "growth" as an asset class since "blend" is often mostly growth due to cap weighting). "Value" has over the long run beaten growth and punched small holes in the efficient market hypothesis (read Robert Haugen, for instance). It seems paradoxically, in the long run, good companies are bad stocks and bad companies are good stocks. So, then, using the same model as yours, but taking value stocks into account, the following would have a better return/risk characteristic for someone just starting out:
US bonds 15%
US large market 15%
US large value 10%
US small market 10%
US small value 10%
International market 15%
International value 10%
REITS 10%
Commodities 5%
These should ideally be implemented using low cost index funds that are appropriately tax-managed if held in taxable accounts. There aren't any great low cost commodities index funds so you may want to wait a while before giving commodities weightage considering how incredibly speculative that market is.
-kurra
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