Why Allocations Make A Big Difference

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Bill writes in:

I keep reading tons of stuff about asset allocation and how you need to diversify your investments. Is it really that big of a deal?

In short, just starting a Roth IRA or a 401(k) or an investment account isn’t enough. If you merely open that account, pick a few default investments, and start throwing money at it, you’re doing far better than the average bear, but you’re still leaving money on the table.

The truth is that you have to put at least a bit of care into allocating your investments. Here’s why.

I’m going to use a very simple example. Let’s say your portfolio is made up of nothing but stocks and bonds. In order to represent stocks, I’ll use the very broad-based Vanguard Total Stock Market Index (VTSMX), and I’ll use the broad-based Vanguard Total Bond Market Index (VBMFX) to represent bonds.

Over the last year (September 1, 2007 to August 31, 2008), the bond index returned 5.66%, while the stock index returned -10.05%.

Over the last five years (September 1, 2003 to August 31, 2008), however, the bond index returned 4.50% annually, while the stock index returned 7.71% annually.

Let’s look at six different allocations over the last year. If you had $10,000 and invested it on September 1, 2007…

… and you put 100% of it into stocks and 0% into bonds, you’d have $8,995 in the account.
… and you put 80% of it into stocks and 20% into bonds, you’d have $9,309.20 in the account.
… and you put 60% of it into stocks and 40% into bonds, you’d have $9,623.40 in the account.
… and you put 40% of it into stocks and 60% into bonds, you’d have $9,937.60 in the account.
… and you put 20% of it into stocks and 80% into bonds, you’d have $10,251.80 in the account.
… and you put 0% of it into stocks and 100% into bonds, you’d have $10,566 in the account.

Just over the last year on a $10,000 investment, different asset allocations amounted to $1,571. That’s a lot of money to leave on the table.

Lest you think this is just an indictment of stocks, let’s look at the five year scenario. If you had $10,000 and invested it on September 1, 2003…

… and you put 100% of it into stocks and 0% into bonds, you’d have $14,497.07 in the account.
… and you put 80% of it into stocks and 20% into bonds, you’d have $14,090.02 in the account.
… and you put 60% of it into stocks and 40% into bonds, you’d have $13,692.97 in the account.
… and you put 40% of it into stocks and 60% into bonds, you’d have $13,275.92 in the account.
… and you put 20% of it into stocks and 80% into bonds, you’d have $12,868.87 in the account.
… and you put 0% of it into stocks and 100% into bonds, you’d have $12,461.82 in the account.

Over that timeframe on a $10,000 investment, different asset allocations amounted to $2,035.25. Again, that’s a lot of money to leave on the table.

This actually illustrates another point very well: the closer you get to the time when you want to cash in your investments, the safer you want to get with those investments. Traditionally, stocks are very volatile (ranging from -15% to 20% annual return), while bonds are pretty stable (returning 4-8% consistently). For example, over the short term (as shown in the first example), the stock market happened to be in the midst of a downturn, so stocks were pretty awful over that one year period. This isn’t a risk that you want to take, so if you’re getting close, you should move your investments into safer and more stable places like bonds so that you don’t lose a chunk of your investment on the home stretch.

On the other hand, if you’re a long way from your cash-in date, stocks usually return better than bonds over that longer haul, as illustrated in that five year example. While having your money in bonds would have returned you a decent return, having all of your money in stocks over that period would have earned you $2K more on a $10K investment.

Obviously, there’s a balance between these two opposing forces, and that’s asset allocation. Obviously, it can get very complex when you start throwing in other asset classes (real estate, commodities, etc.) and also include the fact that different people have different beliefs on where these markets will go.

I like to think of asset allocation as being like the rabbit hole in Alice in Wonderland – the deeper you go, the more confusing it can get.

So how do you know how to allocate? Thankfully, most retirement plans offer a series of funds with names like “Target Retirement 2035″ and “Target Retirement 2045.” These funds automatically do all of this legwork for you, so if you’re not confident with what you’re doing, such funds are a pretty reasonable bet over the long haul.

LazyIf you’re investing outside of a retirement fund, I’d strongly recommend reading The Lazy Person’s Guide to Investing by Paul Farrell, which singlehandedly taught me almost everything I know about asset allocation. As we move towards investing for our future house, I’ll be using that book as a guide in setting up a simple and easy-to-understand portfolio for myself.

In sort, asset allocation is important, but don’t let yourself get too stressed out about it. Use tools like target retirement funds in your retirement accounts to make it easy, and use excellent resources like The Lazy Person’s Guide to Investing for your other needs.

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13 thoughts on “Why Allocations Make A Big Difference

  1. I’d like to point out that you can also use the “target date retirement funds” for goals other than retirement and they work just the same.
    For example, if you plan to reite in 2040 and want to build that new house in 2025, then that 2025 target date retirement fund is an easy way to save for that new house while not risking too much of your capital so close to your goal date.
    Just because it says “retirement fund” doesn’t limit it’s possibilities of use for reaching other goals.

  2. The only caveat to that, Tyler, is tax-efficiency… some funds are (much) more tax-efficient than others, and one should be attentive to that in investing in taxable accounts. Year-targeted funds, for instance, are often less tax-efficient that others, and there might be more tax-efficient ways to invest.

  3. Good post Trent, asset allocation is one of the more important subjects in portfolio theory. 91% of a portfolio’s variability can be attributed to asset allocation, not individual securities. Unfortunately, people can go cross-eyed when when you get into the weeds of 10% in REITs, 5% is foreign small cap value, 8% in commodities… Or should I be in commodity companies?? What about currencies, ETFs or ETNs etc., etc., etc., ARGH!!!

    I kind of like the idea of target date funds. On the whole, though, I believe they underperform for some strange reason. I do think they are a great way to save us from ourselves, though.

  4. “Over the last year (September 1, 2007 to August 31, 2008), the bond index returned 5.66%, while the stock index returned -10.05%”

    If stocks returned over 77% more than bonds, how come investing 100% in bonds would have returned $1,571 more? Just when I start to think I am starting to understand investing something like this comes up.

  5. I must chime in to note, a retirement fund with a 2025 date doesn’t expect to be fully drained in 2025, the way it would be for a house. It has to support the retireee for the next many years.

    I would expect most funds still have some equities at their “date”, which you wouldn’t want for more short term goal that would be quickly depleted when the date arrives. But I haven’t checked that.

  6. The only problem with targeted retirement funds is that they assume that you will want most of your nest egg funded at the target date. However, if you are retiring at 60, you will likely live another 20 years. Since all 10 year periods of the stock market have made money, you don’t want to pull everything out of stocks at 60.

    You have to plan your investments for your post-retirement as well.

  7. Please excuse the n00b:

    When you say “move” the funds to a safer investment, you mean sell the more risky investment and by the less risky one in its place?

    If you perform this transaction within the retirement account, do you have to pay dividend taxes for the amount you have sold?

  8. I know when I reach my “target” for “retirement”, the only risk I want to have to diversify, is how to maintain FDIC insurance on my accounts !

  9. Asset allocation is important, since if you do it properly you will be diversified and won’t have all your eggs in one basket.

    The way that I approach my portfolio however is by focusing on the dividends and interest that I could earn from my investments rather than the total returns. I disagree with conventional retirement wisdom that one has to be concerned with total returns and should sell part of their stocks each year in order to live off the investments.

    If you focus on the dividend and interest portion and you try to consuct a portfolio that could generate increasing amounts of annual income to you, then the whole “risk” parameter is not as important.

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