Starting this as a separate thread for the portfolio construction exercise for tp2006 starting from his model portfolio that captures his circumstances and risk tolerance.
US Stocks Vanguard VTI ETF 21%
Foreign Stocks Vanguard VEA ETF 18%
Emerging Markets Vanguard VWO ETF 22%
Dividend Stocks Vanguard VIG ETF 13%
Real Estate Vanguard VNQ ETF 16%
Corporate Bonds iShares LQD ETF 5%
Emerging Market Bonds iShares EMB ETF 5%
Notes to
@tp20061. This corresponds to a 50% domestic, 40% international and 10% bonds selected for your age, income profile and risk tolerance, etc. You are just starting out with a small amount in a retirement account and hence the not so conservative portfolio.
2. It answers part of your questions on how to divide the allocation. This tool splits it between asset classes that have the lowest correlation possible for your profile on a risk adjusted performance basis. Hence the domestic stocks split between total market, real estate and dividend stocks. The total market divides it for size according to market weighting within the US total market.
3. Now create this portfolio on M* as if you invested your entire portfolio on Jan 1. Get the composite statistics provided by M* for the portfio in the Xray, volatility numbers and post them here.
4. The exercise will be to either just keep this portfolio or tweak it maintaining the risk/volatility profile. Some small deviations won't matter much. For example, you can try to solicit find suggestions to replace VTI. Or you can ask people to create an equivalent or better portfolio and compare its characteristics. You can also try to map your existing portfolio to this and create a transition plan.
5. If you are feeling adventurous you can go to hiddenlevers.com and create a dummy free account. The information you provide including email address can be fake. You can only add 5 funds for the dummy portfolio, so just use the equity etfs. It is a.very painful site to use but allows you to stress test your portfolio for various scenarios from commodity crash, end of QE, demographics change, etc. What you are looking for is how the portfolio behaves in those scenarios so you can withstand it. So, for example, it might say that your equity part may go down by 50% in the last financial meltdown scenario. Can you stand it without panicking? If not, go back to wealth front dashboard and turn down the risk tolerance to get new allocations and repeat.
6. At the end of this exercise, you will have a portfolio that you can buy and monitor perhaps once a year at most and go through the same exercise again or beter just rebalance it.
7. For the amount of money you have you should be aiming for 3-8 funds total. You can get to this in many ways including a single allocation fund for two or more of those model portfolio funds or splitting another. But every fund you add should be justified in the context of the whole portfolio.
8. With a larger portfolio, you can create another pot for funds with alternate strategies, other asset classes, etc. But this is not worth it for the capital you have available at the moment.
The above is what a competent investment advisor might do if you paid money. If you don't want to do the above, then find an advisor or try to stick as close to the model portfolio as possible without getting tempted by the blue and red marbles being suggested, however intriguing the fund might seem and just throwing it in to create a kitchen sink portfolio.
Good luck.
Comments
1) For M* X-ray, should I stick with just the Vanguard funds listed above? My accounts are with Schwab (75%) and Fidelity (25%) where these funds would get hit with their transaction fee. Initially it might not be an issue as I'll be doing a lump sum investment. But might matter when I start DCA as money comes into the account.
2) What should I do with my existing portfolio of funds? Most of them are actively managed funds and been with me for long time except for the bond funds (15%). Should I dump all (some folks have suggested dumping a few in the other thread anyways) and switch to the low cost ETF?
3) For #3, not sure I understand it fully, do you have to be a premium member at M*? Or should I just use the instant X-ray option and paste a screenshot here?
You dont need the M* premium xray for this exercise. Just the free portfolio analysis.
Don't be in a hurry to do any buys or sells yet. This is a paper exercise until you have finalized a target portfolio which might keep some of your funds and get rid of others. You can also do it over time. No hurry for a 40+ year time horizon. It is more important that you think through this and understand what you are doing before you make any changes.
I don't really know anything about the portfolio function you used, but remember there is no magic formula for building a portfolio. Only guides. This portfolio may very well build you greater returns, or not, but expect a lot of volatility with that high percentage of EM. If it were me, I'd go more the traditional path by looking at some Target Date fund allocations just to get an idea of how more traditional, possibly less volatile portfolios are constructed for your age.
By the way, I think Cman's ideas and guidance are excellent. Just not sure of the output.
Regards,
Ted
US Stocks Vanguard VTI ETF 51%
Foreign Stocks Vanguard VEA ETF 24%
Emerging Markets Vanguard VWO ETF Reduce To 5% Put 17% In VTI
Dividend Stocks Vanguard VIG ETF 13% Sell Put 13% Into VTI
Real Estate Vanguard VNQ ETF Reduce To 10% Put 6% In VEA
Corporate Bonds iShares LQD ETF 5%
Emerging Market Bonds iShares EMB ETF 5%
1) 15% to VNQ for diversification/inflation hedging is notable. Given that they are now incorporated in VTI/VOO, do you think REITs retain their diversification and anti-inflationary benefits? I noticed that in the non-taxable model there is a 5% allocation to natural resources through direct commodity exposure instead. Surely that's to avoid the tax ramifications for REITs, but should the non-taxable account have something of this sort? Either through DJP/DBC or through energy/precious metal stocks? Perhaps RING or something like MLPI could conceivably give more diversification than VNQ, while still delivering a dividend?
2) Using traditional market-cap weighted indices like VTI, VEA and VWO gets you a small amount of domestic small cap exposure and zero international small cap exposure (though the equivilent ishares core international funds will give you some). Traditional asset allocation models in the EMT/Fama-French mold for accumulators urge small cap exposure for greater returns. Ignoring current valuations since the horizon of this portfolio is longterm, is there room for VB/VBR and VSS (or an active product since the SPIVA data suggest outperformance from an active international small-cap manager) here?
3) Similarly, if tp2006 wanted to put in some work towards the portfolio, Prof Snowball illustrated in his October commentary how active EM managers can control for downside volatility (Similarly, Rekenthaller shows here that a good developed market manager might outperform an index). Would an active EM manager be worth it, given the relatively high allocation to them (and I do like that high allocation given the time horizon and passive nature of the portfolio)?
4) Should he seek more flexibility from his bond allocation? Particularly the EM? Corporates and not treasuries? Room for TIPS?
FWIW, the Ibbotson/M* lifetime allocation charts are here and their recent "investor starter kit" is here. I actually think they do these sorts of thing well.
Thanks for the thoughts.
"On aggregate, an investor can hold close to 10,000 underlying securities covering the global markets in a small account for very low cost.”
wealthfront-review
It is useful to keep in mind that @tp2006 is 40yo with just $85k in his portfolio that needs to grow it over some 30+ years. The tool has also taken into consideration how much he earns and how much he is able to save annually, how stable his job is, etc. The output may seem surprising but is it the unemotional tool (granted someone had to program it) or is it the emotional us that is causing the disconnect? There are ways to find out starting with M* analysis. Hence the exercise.
Ted's suggestions are colored by his perpetual bias towards domestic equities and penchant for high beta sectors even if they are all highly correlated. It might be fine for a fairly active investor who is willing to jump in or out if it should become necessary but is it appropriate for a passive investor if that highly correlated assumption should come to grief and the investor sits there like deer caught in headlights? Stress testing tools like hiddenlevers make those scenarios and drawdowns explicit.
Regarding reaction to EM, other than Ted, this would not be the reaction 5 years ago so how much of that aversion to EM is colored by recent year or two. More importantly, is the fears of just looking at one sector in isolation justified in the context of the whole portfolio? Analysis of the whole portfolio will tell you that in terms of volatility and drawdowns.
Would using great owl funds increase the risk of underperformance and shortfall in one's financial goals? If so, should the investor prioritize that over volatility or understand volatility better so they can withstand the volatility better? Are the great owl funds as appropriate to a 40 yo as they are to a 60 yo?
These are difficult questions and there are no abaolute right or wrong answers but just because fund pushing is easier doesn't mean it is the right thing to do. It just hides the risks.
So, I encourage the board members to suggest portfolios with their mix of funds or allocation changes as Ted did rather than single fund suggestions and keeping the profile of @tp2006 in mind not molding him in your mind. They could have any selection of funds from the great universe but at least such suggestions would make the underlying assumptions explicit and they can be compared and analyzed against the base portfolio. Some of them may even turn out to be better than the model portfolio.
For example, one might suggest replacing the international allocation with one or two allocation funds to let the manager make that allocation decision. Perfectly valid thesis. And the effect can be tested by analyzing the whole portfolio. Does it risk severe underperformance? Does it provide small returns without reducing the drawdowns? Or is it just equivalent to more allocation to DM over EM or vice versa at higher fees? Or does it provide as good a return but manages volatility better in which case it makes sense to use it instead.
So the challenge for the board, come up with a better portfolio FOR @tp2006 (not for your circumstance) than one created by an algorithm and tell us why and the compromises. It may lead to a better portfolio than kitchen sink of individual fund stars.
Regarding market efficiency, I think one can safely assume market efficiency over a long investment horizon. It is the small time scales where the assumption might break down.
1. I have noticed that the tool selects commodities or real estate or a mix based on the profile. Don't know what the calculation is. It may very well have to do with the size of the portfolio as well. Larger the portfolio, more sense it makes to further diversify. It is impossible to avoid some overlap between funds. Too much diversification amongst correlated classes might not produce anything over the long term and too much over uncorrelated classes might reduce performance and volatility but risk shortfall in portfolio growth. Only way to check this is to create a portfolio with that allocation and compare with base.
2. Yes. One possibility is to split the domestic allocation into two using the conventional large/small split to exploit small premium. You can even split it further to exploit value premium. And then you can either pick pure exposure or managed exposure via active funds. But is it worth it for a small portfolio? The portfolio is a balancing act. Will this change affect the returns or volatility of the entire portfolio. Plugging it in and analyzing it us the only way to find out.
3. I personally think actively managed funds can play a role in a passive investor portfolio. But I do think they do better to decrease volatility at the cost of performance than increase performance with less volatility. If that is the case, the investor's age becomes important. Think of it this way. When you are young and able to heal quickly, you need less protection in using a bike to travel fast than if you were older and a tumble would be more catastrophic. So, perhaps the need for risk managed active funds grows as you grow older as an alternative to just reducing beta exposure.
4. Not sure further diversification in the small allocation to bonds is warranted. The difference in volatility will be negligible and those classes would just drag down the performance in this growth phase.
I actually really like the wealthfront profile. One thought experiment I forced myself to go through was to think of my retirement date, 30+ years off, as I would gifting a fund to a newborn through a UGMA in order that they have something substantial at 21. Bonds serve very little purpose there, so I like that allocation. That, of course, assumes tp2006 is dispassionate and doesn't look often. I think his purpose should be buying lots of equity shares now he will hold for 30+ years. That being said, I'd prefer to see a less volatile bond index for ballast, more small caps, and a greater exposure to natural resources. I've also slightly increased U.S. Dividend stocks as a sort of ballast as well. This is a little more complex, but I think a little more diverse and able to grow.
US Equity = 35-40%
US Stocks: VTI/ITOT 15%
Dividend Stocks: VIG/SCHD 15-20%
US Small Stocks: VB/VXF/IJR 5%
Foreign Equity = 40%
Foreign Stocks: VEA/IEFA 15
Emerging Markets: VWO/IEMG 15
Foreign Small Stocks: VSS 10%
Inflation Hedge =10-15%
US Real Estate: VNQ/IYR 5-10%
Natural Resources/Energy: MLPI/VDE/DBC 5-10%
Bonds = 10%
US Bonds: BND/AGG 5%
Emerging Market Bonds EMB 5%
Notes:
-Using the iShares cores funds would give you greater small cap exposure in the foreign funds. You could then decrease the two small cap funds.
-Regarding natural resources funds, my preference is for funds that deliver future cash flow. If you choose a commodity fund, go 5% at most.
-This is a highly volatile portfolio. If that's going to bother you, increase BND/AGG while decreasing domestic and foreign exposure equally.
-I've replaced LQD with a broad bond market index for diversification purposes. Short term, treasuries are probably a bad bet, but this is for long term, and corporates behave more like equities.
-If you did want to explore some more active funds, start with Small Cap Int, EM equities, EM Bonds, US Bonds then Foreign/DM equities. Since this is mainly an AA discussion, I've not included any suggestions here. I will say, I'm not a fan of indexing any EM product as state run firms can play games here.
Debate away, and good luck!
Here's Vangaurd's
https://investor.vanguard.com/mutual-funds/target-retirement/#/
Here's TR Price's 2050 fund composition:
www3.troweprice.com/fb2/fbkweb/composition.do?ticker=TRRMX
At any time, you can find a target date fund that seems to be doing well. But what can you say about what a particular target fund will do with its glide path, will it remain too risky or become too conservative?
You can see online services like wealthfront and betterment as lower cost versions of some of these high ER target date funds.
My suggestion for @tp2006 is to take these alternative portfolios and create them on M* and compare the analysis. Will be extremely illuminating and expose assumptions and compromises made.
Competition between the target funds should also have some positive attributes...this is not always a negative.
My understanding is that an investor with wealthfront has no control either. In fact, Weathfront seems to have restrictions on withdrawals (limiting increments of $2500 / transaction).
Wealthfront does seem to spend quite a bit of time explaing the similarities and diffrences in the FAQ section of their site:
https://wealthfront.com/faq
Thanks for mentioning this site...I would like to chart its historical portfolio performance against other Asset allocation strategies...is this possible?
There is no wealthfront asset allocation strategy, it is just a convenient EF allocation tool. EF has been in existence for lot longer than weatherfront. It uses the tool with a fairly standard risk evaluation of the investor as most advisors do. It is as good as anything for a starting point and better than using a single allocation model for all investor profiles.
Your question of comparing the "wealthfront strategy" against other strategies misses the whole premise entirely that the strategy creates a portfolio customized to a risk profile. How do you suggest you will find something tracking this in general? Either you will agree with the assumptions behind EF allocation or you dont.
Regards,
Ted
Also, not sure about your comments about the great owls fund and volatility/risk. If I understand it correctly this list also shows the risk in a scale of 1 through 5 (based on some of the volatility measures) as well as shows the volatility measures in the table. So couldn't you pick a fund that is more riskier that has a history of giving better risk adjusted returns?
I'm not all that experienced as an investor either, and certainly not compared to some of the people here. Much of the talk about momentum strategies, for instance, goes right over my head because I was taught as a kid to be a buy-and-hold value investor. But one thing I did do when I started investing on my own is read voraciously. It strikes me we've gone through this whole exercise without actually asking a really simple question: How much basic knowledge of investing theory do you have? If the answer is very little, or if most of what you've gleaned comes from here or M*, might I suggest something like Bill Bernstein's Four Pillars of Investing or Intelligent Asset Allocator? A little of the stuff in those might be a little dated, but you can move on from there to other sorts of classic investment lit with at least a floor under your feet. Any other suggestions, MFOers?
If you have those basics down, apologies. It just seemed like a fair question to ask.
http://stockcharts.com/school/doku.php?id=chart_school
but I'm prepared to be shot down.
You noted: " In accumulation phase, asset allocation is 90% of the battle. MFO is great for phase two -- picking funds, particularly risk aware funds -- but @cman is correct, people don't really discuss AA much here."
My memory sure isn't what it was in the past; but AA has been discussed here if it was part of a question/answer thread so related. I, of course; don't have clue as to whether cman was a member (a different name) of MFO since the move from FundAlarm in April, 2011; but the current tenure is from Dec. 2013. If this is the case, he/she and other new members here would not be aware of the intermixed discussions regarding AA, previous.
A common circumstance for some queries here is thoughts regarding a particular sector of funds. Responses may be directed as needed based upon other's experience with a particular fund, be it active, passive, etf or index.
Such a question will not likely evolve into an AA discussion with/to the poster. I may only assume the poster is satisfied with their AA otherwise; but wants to allocate to another sector, too; and is requesting thoughts from others.
If I pose a question about the pros and cons of "x" number of funds that invest in the EM sector; I don't expect a question as to whether our house's AA is in proper order. The answer would be that it is, at this time; based upon our risk/reward and all other financial circumstances for a total picture.
My inflation adjusted 2 cents worth.
Take care of you and yours,
Catch
Sometimes however, it is useful to review some of the basics. With tp2006 and some of the other recent questions, it seemed like a good opportunity. And at least part of it is, as I said, self-serving as well. I'm younger and still figuring out that part of things myself.
Take care and have a great Sunday!
P.S. Tony, that site looks great. Still flipping around it.
A decent site, as there is always something to learn about investing.
Regards,
Catch
When I have said passive, I usually mean passive on your part in managing the portfolio, not necessarily a passive fund as in an index fund. You can use an active fund if it fits the asset allocation. So, in theory, nothing wrong with using active funds as a substitute for the index fund placeholders. But the active funds suffer from two things. Higher fees and underperformance if the manager is trying to reduce volatility. But that has to be determined on a fund by fund basis. My view is that in the early stages where you have a long time horizon and a relatively small portfolio, you are better off with just index funds in the core portfolio and active funds in the satellite part if you have one. As you grow older and the portfolio size increases, there is more scope for using active funds to diversify amongst fund strategies, reduce volatility, etc.
It might be a useful paper exercise if you have the time to take the model portfolio as just a sector/asset suggestion and select active funds to satisfy each such allocation instead of the index etfs. You can then create a portfolio of such funds in M* and see how the portfolio as a whole behaves relative to the model portfolio. You can ask for opinions and suggestions for funds in such an exercise. That is what this site is good for.
There are two parts to fund selection - fund discovery that is knowing a fund exists and fund fit which is whether it fits the portfolio. You are correct about the former and assuming that people do the latter on their own. But, I don't think this is the reality. It might work for seasoned investors but it certainly wouldn't be for newbies. It is easy and natural to get carried away with fund collection than reason the fit of a fund.
As to questions about AA arising naturally, I am reminded of the words of astrophysicist Neil deGrasse Tyson in a recent interview:
"You don't ask questions about how fast the galaxies are moving, if you don't know galaxies are moving. You don't ask about how many galaxies are there, if you don't know there are other galaxies"
Questions about AA don't arise much because that activity is not known or not well understood. It should be.