Revisiting my asset allocation

Asset allocation matters when it comes to long term returns. It serves as a guidepost to stick to when times are bad and also gives me the opportunity to balance the risk and rewards of investing according to my own goals and risk tolerance.

There is no simple formula for figuring out what asset allocation is right for an individual. There are simple ones like the three-fund portfolio which includes three total market funds that cover domestic and international stocks as well as bonds weighted in a way that matches the risk tolerance of the investor.

There are also more complicated ones that slice and dice the various asset classes with various goals like increasing return, increasing income or decreasing risk.

In some of my initial posts which you can read here, I went into detail about my investment strategies and my own asset allocation.

The asset allocation I use right now was something I developed in 2008 right after graduating college and I think it has worked well for my needs. I didn’t spend a lot of time on it back then so when I started this blog, I wanted to make sure it was still something I was comfortable with and also something that showed favorable results against a simple three-fund portfolio or even the S&P 500.

The back testing I did in 2015 showed favorable results for that portfolio in terms of risk/reward when compared to a standard three-fund portfolio as well as the S&P 500.

We’ve got another two years of data now and I wanted to take some time to revisit my asset allocation and to see if those results are holding up through the bull market of the past few years. The goal is to see if the asset allocation I have now is still something I’m comfortable with going forward.

The portfolio analysis below is a simple one using only index funds so it doesn’t mirror my portfolio exactly as I do have some individual holdings that will skew my results against a simple portfolio that only uses index funds. Still, I feel like it’s a very good approximation of whether or not my strategy is still successful on a historical basis or whether some changes are necessary.

I do know that historical returns do not guarantee future success but it’s still a fun exercise to see how my strategy has compared to simpler ones and whether all this “work” in balancing my asset classes is worth it. Do note the quotation marks around work because portfolio tracking is something I enjoy quite a bit but others may not find it as enjoyable and opt for a more simple approach.

Just like I did back in 2015, I ran the below data through portfolio visualizer using a $10000 starting point, $5000 in annual contributions and an annual rebalancing. This time, the tool runs from January 1995(the first year emerging market data is available) through September 2017.

There are a ton of different asset allocation strategies you can find out there but I wanted to keep the comparison simple.

I compared a three-fund portfolio(Portfolio 1) someone my age might use(50% US/30% International/20% Bonds), my own portfolio(Portfolio 2) and I added a Vanguard 500 Index fund as a benchmark.

The Asset Allocation Data

Guys, it’s clear that I’m an asset allocation genius and my Portfolio has KILLED THE S&P 500 in this time frame generating any investor that followed my asset allocation in this exact time frame an extra $769 dollars. I should start a newsletter!

In all seriousness, the results are still about what I expected from my portfolio. My portfolio had a bigger lead against an S&P index fund back in 2015 than it does now but that’s to be expected with a domestic bull market like this one.

The goal with this asset allocation isn’t just to beat the S&P 500 but to maintain similar(hopefully better) results while reducing volatility and potential loses during a downturn.

I have a high risk tolerance and am still a ways away from my retirement phase so the downturn protection doesn’t generate a huge difference. The S&P 500 lost 37% in the worst year and my portfolio lost 35.7% but I’ll take slightly better performance, lower volatility and that any day!

As a comparison, Portfolio 1 is the worst performing of the three portfolios but has the lowest volatility and portfolio reduction. That’s to be expected due to the inclusion of a bigger basket of bonds. Bonds are the biggest downside protection you can have in a portfolio and the larger your % in bonds, the lower your volatility and lower potential maximum loss.

Do note that I wouldn’t have my current portfolio if I was close to the retirement phase, had a poor tolerance for risk or if I needed the money right away due to the high max draw down which is right in line with the S&P 500(both draw downs occurred during the 2008 crisis).

I certainly wouldn’t want anyone reading this to think that 100% stocks or something close to it is the way to go because of the results above. We’re in the middle of a huge bull market and that will skew results towards more risky strategies. An investor needs to have a pretty high risk tolerance to stick with this for the long run. Making your portfolio 100% S&P probably isn’t a terrible idea if you can stick with it for 30 years but that means not selling anything when your 500k portfolio becomes 250k in a matter of months during a downturn.

It’s easy to forget the risk that comes with investing during a bull market such as this one. Many people in their early 30s haven’t been impacted by any market downturns yet and may overvalue their own risk tolerance. I think it’s important to evaluate your own positions and make sure you’re comfortable with where you’re sitting in case a downturn does happen because as the data above shows, the maximum reduction in size can be substantial even for those with some bond exposure.

My investment horizon is at least ten years out so I can stomach that sort of hit and keep going. The whole idea behind this portfolio is to allow me to maximize my returns by taking advantage of such hits due to my small allocation to Bonds and income producers like REITs which should allow me to rebalance and push income into investments when the market is low. I’m also OK with the additional risk because I have a separate emergency fund that should prevent any withdrawal needs in the event of a job loss which is more likely during an economic slowdown that would accompany a stock market decline.

The performance of my asset allocation strategy so far has been acceptable but there are certain things that piqued my interest as I looked at the data especially the asset specific data I show below.

Individual Asset Class Analysis

One of the main things is that international equities in both developed and emerging markets have had poor returns in this time period when compared to US stocks. They lagged US equities by 3-4% per year with much higher volatility and much bigger draw downs.

I believe that international equities are a decent deal when compared to their domestic brethren. YTD performance there is encouraging but we’d need a few years of international out performance for international to generate better returns than domestic for those of us who tilt that way. The issue is that there’s 20+ years of data showing lagging results and I’m not sure how long I want to wait to see that.

International investing also brings with it a bunch of other risk factors. There’s currency exposure, different levels of political and social risk, different levels of liquidity and higher potential costs.

The other part to consider is that domestic companies have a lot of international exposure these days so there’s potentially no need to tilt international anymore for diversification. The historical results certainly support ignoring international and anyone who did so in favor of a higher domestic allocation has been better off in the past few decades.

I’m not sure I want to change anything now but it’s certainly something I’ll monitor as this is a small time frame in the grand scheme of things and international could very well do great in the coming decade. There’s certainly a demographic shift there that can support that thesis but it’s possible that a lot of US based companies will also benefit from that.

The various asset classes beyond international performed as expected in this time frame. Mid cap, small cap and REITs outperformed large cap with higher volatility and bonds lagged everything while reducing overall volatility by quite a bit.

Another important thing I noticed is that my asset allocation has lagged the S&P 500 during the current bull market starting in 2009.

As the data above shows, the major cause of this is international again which has lagged large cap by more than 6% on an annual basis and that’s a huge difference when you compound it across a decade. My portfolio also had a higher volatility in that time frame again driven by international and REITs as the large cap domestic market has been pretty stable in this time frame.

That’s something I expected as well and is one of the reasons that the results I saw in 2015 were better than the results I see right now. Adding two more years of a stable growing US market will swing the results in favor of a 100% large cap portfolio.

REITs have also lagged US large cap in this time frame which is concerning given the fact that they introduce a lot more volatility to the portfolio.

This is all valuable information as I think about my asset allocation going forward. It’s clear that having a tilt towards international has provided no value in the past decade when compared against domestic securities. I would have been much better off ignoring international all together from both a return and volatility standpoint. I took a look further back to see how international has done since 1986(the first year portfolio visualizer had data) and there was a similar return profile of domestic versus international with international being a laggard.

REITs are another controversial asset class when it comes to asset allocation and I can see why based on the data sets above. In the 1995 data, tilting towards REITs has provided a small bonus in return over domestic but it hasn’t been huge and has increased volatility substantially. As mentioned above, REITs also lagged a tiny bit in the current bull run especially in the past few years as rates started to rise.

I also took a look at the last ten years to see where REITs have been and how impacted they were by the housing crisis.

As shown in the data above, the last ten years haven’t been as kind to REITs versus the historical long term data as they’ve lagged by over 2%. That’s about what I expected as a housing crisis is going to have a bigger impact on REITs but it makes the bull market performance even more disappointing since you’d think they’d have a bigger bounce back than stocks.

Based on all the data above, it’s clear that REITs had good results starting in 1995 until about 2007 after which they have lagged the market. I’m not sure if this is a long term trend but if it is, it potentially means I’m no longer getting a boost in return while increasing my overall volatility, not a good combination. The one benefit of REITs is there isn’t as much correlation between stocks and REITs mean that one can zig when the other one zags which can lead to some good opportunities on the rebalancing side.

Overall, these data points are something I’ll have to think about.

The data clearly shows that mid cap and small cap provide a boost to returns which is why they’re in my portfolio and I’m fully aware they’ll boost volatility. Bonds are there to reduce volatility and provide a rebalancing tool during bear markets and they’re doing that and if I had a lower risk profile, I’d have more bonds in my portfolio at the expense of returns.

REITs have lagged recently but have a better long term record and the high income and lower correlation to stocks means there could be some value during certain economic conditions. I still 100% expect REITs to tank right alongside the market during a bear turn but there may be years where one lags the other giving opportunities for rebalancing success. I’m not sure if I can quantify that success or if it actually exists but I’m not yet at a point where I want to cut ties with REITs although it’s less clear that there’s a huge benefit of over weighing them beyond the standard market weighting.

International is another story as it’s clear that the risk and reward profile isn’t good any way you slice it. The return has been terrible in any of the time frames studied and the asset class provides no added benefits like lower volatility.

There is a lower correlation to any domestic asset classes which can have benefits for investors when domestic markets take a pause. The market tends to work in cycles and it just so happens that we’re in a cycle that benefits the domestic markets right now but it’s possible that will shift sometime in the near future. We saw a similar thing after the 2000 tech bubble which was proceeded by years of domestic out performance and followed by years of international out performance. It’s quite possible that the recent lag will soon be followed by the opposite.

There’s some explanations for the recent lag like the recent strength of the U.S. dollar which negatively impacts foreign returns. The opposite was true in the early 2000s where foreign currencies strengthened against the dollar and improved foreign returns. The problem is that the data from 1986 shows a clear trend of weaker performance and I’m not sure that will change with just one cycle of superior results as we’ve had plenty of those cycles within that data set.

I believe that investors are often a lot more comfortable investing in domestic securities and the domestic market has had a bigger P/E expansion which has translated to lagging results for international. There’s various reasons for this but a lot of them have to deal with stability and the US being seen as a safer bet over many foreign countries.

Still, in theory, the expected returns on a go forward basis for international securities should exceed the domestic markets based on current P/E ratios for certain international markets. The questions is whether or not the market is willing to give the same valuation expansion to overseas companies that the US has seen in the past few years. We’re nearly 9 years into this bull market and that hasn’t really happened yet although this year’s results are very solid.

I do think that it’s unfair to write off international solely on the basis of recent performance as the currency impact is probably a good chunk of that 6% lag we’ve seen since 2009. The problem is that the data since 1986 is harder to explain away with factors such as currency issues.

The YTD performance is good but any blips on the radar will hit the international markets just as hard as the domestic markets so I don’t think a bear market will offer any opportunities for international to correct the lag in performance. It might actually make it worse and we’re likely closer to a bear market now that we’ve been in a while.

I don’t think I’m at a point right now where I want to make any changes but international is certainly on a watch list based on the data I’ve looked at today.

The companies in the S&P 500 derive around 40% of their revenues from international markets so I already have exposure to any trends that benefit overseas growth and tilting towards international hasn’t had many benefits.

The one positive of my personal international holdings is that most of my exposure there is via an actively managed fund that has outpaced the index by ~3% in the last ten years and is up nearly 30% this year. That certainly helps the performance of my portfolio versus what the index shows but even holding an outperforming international fund has been worse than putting all that money in the S&P 500.

The other thing that troubles me with a high international allocation is that it’s harder for me to purchase individual securities in that asset class as a lot of companies don’t trade on the US exchanges and those that do, trade through ADRs which have costs associated with them. I will say that international is rarely on my list of individual stocks to analyze and that should definitely change going forward.

The Decision

I’m split on what I want to do right now and I think that means I stick with what I have for at least another year. I don’t want asset allocation decisions to be a spur of the moment thing and I want to be absolutely sure of my decision before I make it and I’m just not there yet.

International has definitely been a drag on my overall performance but that doesn’t mean it has no value within a portfolio. I do think there’s some value to having a low correlation equity like international in the portfolio as it may allow me to look for value when it’s hard to find in the domestic market.

One of the things I’ve been thinking about when it comes to my international exposure is taking a closer look at some individual securities out there as there’s some attractively valued countries outside the U.S. and plenty of good companies there as well. I am lucky that the only international fund in my 401k is a low cost active fund that has done great when compared against the index. Perhaps part of my lack of worry about what this data shows is driven by that but it’s also driven by the innate lack of comfort I feel in putting all my money in one country even if it is the U.S.

If I were to make any changes right now, it wouldn’t be a full move away from international but a reduction in the 20% allocation I currently have.

I think that international is a better value proposition right now and while I can be and probably am wrong, I’d rather not make any changes until I see how that plays out in the next year or two.

The other side of the equation is the risk profile of my allocation and I’m still OK with where I sit there knowing I’m pretty close to a 100% stock portfolio with the potential for a 50% reduction. I say this as someone who thinks we’re not too far away from a correction. I don’t believe I can time the market so I have no plans to sell anything but I wouldn’t be shocked if the market lost some steam soon.

That means the plan right now is to keep things steady and keep an eye out for individual opportunities outside the U.S. beyond just index funds. I’ll be doing this type of analysis every year around this time and I’ll decide next year if I feel comfortable sticking with it or if I want to make some changes.

Until then, the asset allocation strategy stays put and I hope international picks up the slack a bit!

Thanks for reading and let me know if you have any suggestions for some international companies that you feel are a good value right now. I’m also interested in your asset allocation and how it’s working for you so please leave your comments below!