In Search of the “Holy Grail” Portfolio Asset Allocation

Searching for that idea asset allocation is a never ending challenge. Particularly if one does not want an overly complicated portfolio. Below is a slight variation of a Strategic Asset Allocation plan laid out earlier this week. While the projected return meets the goal of exceeding the projected return for the S&P 500 by more than 100 basis points (1.0%), the projected uncertainty is a little high at 15.85% or rounded to 15.9%.  In addition, the Diversification Metric is too low at 24%.  Our goal is to push that percentage over 40%.  Over the next few weeks I want to improve on this basic asset allocation and look at some technical indicators that will help investors know when it is time to hunker down and go into protective mode.

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Portfolio Performance: 26 August 2011

The August 26th performance data was lost during the blog migration from Host A to Host B.  I'm re-posting the data table so this information is available. All portfolios tracked using the Captool software are now updated, something that was not complete last weekend.

The August statements should be available this weekend so I will likely not post another performance table until I have that information.

Portfolio Performance - 08/26/2011

Portfolio Last Update Launch Date Tracking Tool Port. IRR ITA Index Diff Port. vs. ITA Index VTSMX IRR Diff. Port. vs. VTSMX Index IR SR RR
AA-Mosaic 07/29/2011 07/21/1999 Captool 2.76% NA NA 1.61% 1.15% 0.05 NA NA
Curie 08/19/2011 12/26/2007 TLH SS 2.4% -2.3% 4.7% -3.0% 5.4% NA 17.1 -10.0
Mosaic2 07/29/2011 07/19/1999 Captool 4.95% NA NA 1.43% 3.52% 0.16 NA NA
Newton 08/19/2011 06/02/2008 TLH SS 6.7% 2.3% 4.4% 1.6% 5.1% NA 3.5 -0.6
Passive Port. 07/29/2011 12/01/2000 Captool 5.21% NA NA 2.02% 3.19% 0.71 NA NA
Schrodinger 08/19/2011 12/01/2000 TLH SS 3.9% 2.2% 1.6% 1.4% 2.4% NA 19.5 -5.6
Jane 07/29/2011 02/14/1997 Captool 9.11% NA NA 4.89% 4.22% 0.55 NA NA
Einstein 08/19//2011 06/30/2008 TLH SS 8.3% 5.6% 2.4% 4.1% 4.2% NA 6.5 4.2
Gauss 07/29/2011 02/19/1997 Captool 9.24% NA NA 4.86% 4.38% 0.23 NA NA
Kepler 08/19/2011 11/01/2008 TLH SS 11.8% 11.5% 0.3% 10.6% 1.2% NA 0.73 0.73
Scrappy 07/29/2011 08/14/2008 Captool 12.02% NA NA -0.99% 13.01% NA NA NA
Bohr 08/19/2011 08/14/2008 TLH SS 7.0% 6.5% 0.5% -0.4% 7.4% NA 10.3 -0.8
Kenilworth 08/19/2011 08/18/2010 TLH SS -9.7% -10.8% 1.1% -12.0% 2.4% NA 0.01 -0.1
Franklin 08/19/2011 05/6/2011 TLH SS -25.7% -34.4% 8.7% -46.7% 21.0% NA 0.11* -0.17*
Projects 07/29/2011 12/01/2000 Captool 5.47% NA NA 0.02% 5.45% 1.33 NA NA
Washington 07/29/2011 06/18/1999 Captool 3.23% NA NA 1.82% 1.41% 0.28 NA NA
Maxwell 08/19/2011 12/25/2000 TLH SS 0.2% 3.9% -3.7% 2.0% -1.8% NA -0.06 -0.22
Adams 07/29/2011 06/18/1999 Captool 3.64% NA NA 1.82% 1.82% 0.72 NA NA
Euclid 08/19/2011 06/30/1999 TLH SS 1.1% 8.4% -7.3% 1.8% -0.7% NA -0.03 -0.2
Jefferson 07/29/2011 06/13/2006 Captool 5.96% NA NA -0.76% 6.72% NA NA NA
Madison 08/19/2011 03/13/2008 TLH SS 4.3% 2.1% 2.3% 1.3% 3.0% NA 0.12 -0.05

Asset Allocation for Small Global Portfolios

If your portfolio is small and yet you want global diversification, this portfolio is one to consider.  This six asset class portfolio is built around asset allocation guidelines laid out by David Swensen in his book, "Unconventional Success."  Thirty percent of the portfolio is allocated to U.S. Treasury Bonds (TLT) and TIPs (TIP).  Domestic REITs are covered with the VNQ ETF.  Unlike many portfolios tracked here at ITA Wealth Management, this portfolio does not include international REITs, commodities, or international bonds.  In addition, U.S. Equities are not sub-divided into smaller asset classes.  This portfolio sticks to the basics and its appeal is simplicity. 

The following Quantext Portfolio Planner (QPP) analysis portrays a positive outlook.  Assuming a four-year historical period that includes the last bear market and a 7.0% future projection for the S&P 500, this portfolio is projected to outperform the S&P 500 by 70 basis points.  We prefer a 100 basis point cushion, but that requires additional diversification.  The projected risk or uncertainty comes in below 15% or a value of 13.9%.  Scroll down the page and one observes a rather low (27%) Diversification Metric (DM).  The goal is to hold DM below 40% and this portfolio does very well with this metric.

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Portfolio Construction the ITA Way

David Swensen writes in his “Unconventional Success” book, “Construction of a financial-asset portfolio involves full measures of science and art.  The science encompasses the application of basic investment principles to the problem of combining core asset classes in an efficient, cost-effective manner.  The art concerns the use of common-sense judgment in the challenge of incorporating individual characteristics into the asset-allocation process.” Long-time readers of ITA Wealth Management have the basics of investing drilled into them.

If you are a beginning investor and have saved money to start a portfolio, then this blog post is for you.  In this initial portfolio construction process, think diversity.  At the very least, broaden your asset class horizons to include six basic asset classes. Just to iterate one more time, don’t build your portfolio around sectors as you will miss too much of the global market.  Think in terms of asset classes and for the Fundamental Six I’ll list them as I see it.

  1. United States equities markets. I actually break this large asset class into six to nine sub-asset classes, but that can wait till later. Search this blog for “Big Six” and “Big Nine” and you will run into reasons why I think it is important to sub-divide U.S. equities into smaller asset classes.
  2. Developed international equities markets.
  3. Emerging markets or countries that do not qualify as a developed country.
  4. Domestic REITs.  Later we will expand this to include another asset class, international REITs.
  5. Domestic bonds.  Again, we will expand to include international bonds.
  6. U.S. TIPs.  In the Dashboard worksheet of the TLH Spreadsheet we combine TIPs with bonds into one asset class.  For this discussion I split them into two asset classes so as to emphasize the inclusion of the TIP ETF.  Every investor should hold a certain percentage of TIP in a portfolio.

Now that you have the basic asset classes in mind, what percentage should be invested in each.  This is one of the most, if not the most, difficult decision an investor makes.  This is a personal decision as each of us has different needs and aversion to taking risks.  For this reason, I prefer to recommend percentage bands for each of the six fundamental asset classes.  Even these band recommendations are made to be broken.

  • U.S. or domestic equities                               30% +/- 15%
  • Developed international equities                     15% +/- 5%
  • Emerging equity markets                                15% +/- 5%
  • Real Estate (REITs)                                        15% +/- 10%
  • Bonds                                                              10% +/- 10%
  • U.S. Treasury Inflation Protecte Securities      15% +/- 10%

Note the allocation bands permit one to go as high as 45% with bonds and TIPs.  Some investors will likely want to push this as high as 60% so use these percentages as general guidelines.  Most of the portfolios I track are growth rather than income oriented so they are skewed toward the first four asset classes listed above.

For example portfolio asset allocation plans, seek out one or more of the portfolios tracked on this blog.  Questions are welcome and highly encouraged. The focus of ITA Wealth Management is to educate the individual investor.

Kepler Portfolio Review: 29 August 2011

If there is one portfolio that is hitting the sweet spot when it comes to meeting the asset allocation plan, the Kepler Portfolio is the master.  Check out the Dashboard from the TLH Spreadsheet below.  Since this is not a large portfolio, I decided to hold the Threshold to 25%.  Moving the percentage down to 20% would have pushed emerging markets into an underweight position, but I can easily see that without making a percentage change.

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ITA Asset Allocation Philosophy

Do you ever ask why ITA Wealth Management is such a strong advocate for developing an asset allocation (AA) plan?  While academic studies of the late 1980s placed more importance on asset allocation than more recent studies, there still does not appear to be any portfolio models that outshine broad diversification through asset allocation. Further, complete and in depth studies as to the importance of asset allocation are still wanting. I have yet to see a detailed analysis of portfolios that use asset allocation as we do here at ITA.  Below are a few reasons for standing behind the AA model for portfolio construction.

Platinum membership is available for a mere $5.00 per month.

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Winter’s Bone: Music From the Motion Picture

While a music recommendation this weekend should include, "Goodnight Irene," I'll pass on that recommendation.  We do trust all our friends on the East Coast are safe as it has been a rough weekend for millions.

The CD recommendation for the week is from the motion picture, Winter's Bone.  Marideth Sisco does an amazing job with "Angel Band."  "High On the Mountain" is another favorite from this CD.

Be sure you order the soundtrack, not the book or DVD unless that is what you want.

Newton Portfolio Review: 25 August 2011

Over the last month, numerous limit orders were struck when the market dipped into buy zones.  Shares of RWX, VBK, VOT, and ELD were added in an effort to bring many under target asset classes back into balance.  We are still holding considerable cash in this portfolio and there are many limit orders still in place.  The expectation was that the market would drop even further.  Perhaps we got too greedy.

International bonds is a new asset class.  ELD as a new addition to this portfolio and we are looking at other ETFs to use to populate this addition.

Performance data is shown in the following screen shot.

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Portfolio Risk: Why is Standard Deviation Important?

Questions surrounding standard deviation (SD) keep cropping up.  Why is SD important when it comes to developing a Strategic Asset Allocation plan for a portfolio? Anyone who has worked with portfolio building software knows how projected return and uncertainty or risk are intimately connected.

When I was teaching, I would analyze the scores of my students as I wanted to see if all numerical grades fell within one standard deviation of the class average. Students who fell outside of 1 SD (to the downside) were of concern. Questions came to mind. Did they not study? Was the test a fair examination of the material taught? Was I not clear in what was expected? Examinations are not only a test of how well a student learns the material, but it is also a self-test for the instructor to know how well they presented and explained the material. Statistical analysis of test results help to answer some of these questions. We do the same for our portfolios.

Let’s take a crack at using a simple example to explain how SD works. In this example, I will use data on the average height of the U.S adult male, now listed as approximately 70 inches. The standard deviation is around 2 inches. This means that within one SD, all U.S. adult males fall within a range of 68 inches to 72 inches. That means that 68 percent (think 2/3 to make it easy to remember) of all U.S. adult males will fall within one standard deviation. When we move to two SD, 95 percent fall between 66 and 74 inches; 98 percent (3 SD) between 64 and 76 inches. Now we see how unusual it is to find a seven footer (84 inches) among the general population. Small people are also rare.

When working with the statistics of the height of adult U.S. males, we can count on the above results if we were to run a test by going into a large city and randomly pulling males aside for measurement. The results are not as clear cut when working with the projections I show when conducting a QPP analysis on a portfolio. For example, the projected return is impacted by a setting used to project the return of the S&P 500. The default setting assigns a return for the S&P 500 to be 8.3%. Some of us think that assumption is too high so we adjust it down one percentage point to 7.3%. When that adjustment is made, our portfolio also shows a decline of 1% point in the projected return.  Recently, I’ve been using a projection of 7.0% instead of the default, 8.3%.

In addition to the uncertainty surrounding the setting for the S&P 500 projection, we need to make a decision as to what time frame to use for our analysis. The author of the QPP software, Geoff Considine, recommends using three years. That is less than one business cycle, known to be five years. Why not use four, five or more years for the analysis? Think about how the three-year period will impact analysis over the next 1.5 years. Our starting dates will be in 2008 or the year when the S&P 500 was crashing. 2011 is the year to consider using four- and five-year intervals instead of the recommended three-year period for QPP analysis.

Platinum membership available for $5.00 month. Proceeds go to fund businesses for the disadvantaged through MEDA Trust.


Trading Is Hazardous To Your Wealth

Portfolio turnover is a problem for investors. It is a much larger problem than most realize. Swensen writes in “Unconventional Success,” “In an industry characterized by a long litany of shockingly dysfunctional behaviours the frenetic churning of mutual-fund portfolios stands near the top of the list. In 2002, the weighted-average turnover of equity mutual-fund portfolios registered at a staggering 67 percent, representing a level consistent with an average holding period for security positions of 1.5 years.

Odean and Barber put some numbers to over-trading in two studies. In “Are Investors Reluctant to Realize Their Losses?” Odean examined 10,000 random discount brokerage accounts and found that stocks investors purchased underperformed securities they sold! In a follow-up study titled “Trading is Hazardous to Wealth: The Common Investment Performance of Individual Investors,” Hebner writes, “Odean analyzed 66,465 individual trading accounts. [How did he ever gain access to this many accounts?] They found that from 1991 to 1996, investors that traded the most earned an annual return of 11.4%. In the same time period, the market returned 17.9%. The simple conclusion: Active investment strategies will underperform passive or indexed investment strategies.”

Obviously, the title of Odean’s second paper gave rise to the title for this entry. We avoid trading by going the passive route, although we are not completely passive investors. We only need to buy and sell if rebalancing of asset classes is appropriate or if we deem it necessary to make a change in the asset allocation. In a number of portfolios, we are reducing the exposure to the bond asset class as we see a high probability of interest rates going up in the future. We don't know when this might happen, but we want to prepare for the inevitable.