Musings on Asset allocation
Musings on Asset allocation
My stance on the asset allocation
I’ve often seen people ask for advice or feedback on their portfolio allocations over the internet, and for the most part I’ve always been a bit puzzled as to their preconceptions and ideas.
For the most part I’ve always asked the same questions, gotten the same answers, and as such given the same advice.
That said, the constant questions leads me to believe that there is a need to discuss and outline what the “Default Portfolio” should look like, and what circumstances might justify moving away from it.
The usual example
Here’s a common example of a new investor looking feedback:
hey question guys
25% jepi/jepq
and 75% schd
is that a valid dividend portfolio as basic as it can get right?
I’m not joking about it being a common example, I literally copy pasted that from a discord chat with a dozen other comments and questions that are quite similar.
There’s nothing wrong with asking questions, and broadening our knowledge, and it’s a good thing that this person asked this question because it’s clear that they didn’t really think through what they were doing!
What everyone should do
As a general rule if you’re looking to start up (or maintain) an investment portfolio, there is really no need to overcomplicate things.
All you need to do is to own a widely diversified low cost tax efficient market capitalization weighted index fund.
Let me make that clearer:
You should own one and only one fund that has the following characteristics:
Low cost (with a Total Expense Ratio under 0.3% of AUM)
Tax efficient (depending on your tax residency)
Widely Diversified (with at least 500 companies and operating worldwide)
Market Capitalization Weighted (the higher the market cap, the higher the allocation in the fund)
Index fund (with only a handful of updates and changes throughout the year)
That’s it!
No individual stocks.
No multiple funds.
No Bonds, real estate or alternative assets.
Keep it simple.
If you’re in Europe you’ll probably be best served with a fund such as $VWCE or similar.
If you’re in the US, something like VT 0.00%↑ should be your best option (particularly inside a tax advantaged account).
When should you do something else?
Generally speaking? Never.
That said there might be reasons why you might want to change your allocations, or perhaps introduce a bias to your investment portfolios.
Keep in mind though, that this is not something for everyone, and indeed 99% of people would be better off if they didn’t try doing this.
Even for the 1% that might be able to benefit from this sort of deviation, it’s important to note that there are tradeoffs to this, and that it will still most likely result in lower risk-adjusted wealth than they otherwise would have.
So, what are the circumstances in which it makes sense to do something else?
You have a need to begin withdrawing cash in the near term (<5 years)
You have a particularly heavy exposure to a particular factor in the index and would like to diversify it away
You have a psychological need that the index is not able to fullfill
You’re a professional and have good reasons to believe the index is not the optimal allocation for you
You have certain tax benefits (or similar) as a result of diverging from the index
These 5 reasons generally cover the most common cases in which it may make some financial sense to consider diverging from the index for a specific investor.
It’s important to note that even if those circumstances do exist, it doesn’t mean you should automatically diverge from the index!
What it means is that with careful consideration and research you might be able to justify doing so.
Sticking with the index is still likely a good idea, even if it isn’t the theoretically optimal action!
So, how likely are these circumstances to occurr?
Pretty likely I’d say, since most people with fall under at leaast one of these at some point in their lives.
The most common is point 1, since when we start hitting retirement age, we have to start to prepare to begin withdrawing our investments (at least partially!).
Point 2 is also quite common, and can range from something as simple as “The index is highly concentrated in a single country from which i already derive the majority of my income” to more complex geopolitical or financial concerns.
Point 3 is probably the most interesting to me, because it is actually part of the reason I do what I do here!
At the end of the day there are some psychological benefits to seeing dividends coming in to my account, and to tracking specific individual companies.
These are things that I enjoy doing, and which keep me motivated to stay invested and to keep investing!
In those cases the underperformanced related to this divergence more than pays for itself by the fact that i would likely be investing a lot less if i wasn’t doing them!
Point 4 is self-explanatory, if you’re a professional and you know what you’re doing, it might make sense for you to diverge from the index.
Finally point 5 is something that we discussed before, and which I hope to discuss in greater detail in a future post, tax benefits!
Some countries do provide tax benefits to investing in local companies or funds, and even some employers will provide some “Discounts” when making use of an Employee Stock Purchase Plan.
I know that the company that I work for gives a 25% discount if we enroll in that program, and so it makes some financial sense for me to take advantage of it.
Summary
In short if you’re looking for a decent portfolio, you should just stick to an index fund.
If (and only if) you match one of the exceptions mentioned above, then you may consider diverging from the index.
It’s still probably a bad idea though.
Let me know what you think in the comments below!