Importance of Asset Allocation

What is an Asset Class? What is Asset Allocation? How should you determine your Target Asset Allocation?

If you read my blog often enough, and have started to think I qualify everything I write about as ‘most important’ – then you are mistaken (and partly it is my fault). I might be saying those things in a different context.

For example, when I say compounding is your biggest friend, I mean it, but keep in mind that compounding happens over a period of time. When I say Asset Allocation is the most important factor in determining long term returns, I do not mean to say asset allocation is more important than compounding.

Things apart from Asset Allocation are important too, specially how much you save and how soon you start to save, how much expenses do you have etc; but once you have started to save/ invest, Asset Allocation is what will be a primary driver of your long-term returns.

What is Asset Allocation?

Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes.

If you do not understand big jargon like Asset Allocation and Asset Class (and some others) we are talking about today, please do not be discouraged, read till the end. I am introducing these terms so that you can interpret and understand host of information that is available on the internet on this topic.

I could have explained the basics even without using any jargon but I want you to be able to read that Wall Street Journal article with confidence the next time you see it, so getting familiar with the jargon is essential.

What is an Asset Class?

An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term.

By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.

While bonds on the other hand might return 10% in a given year or lose 10% in a given year. But over a long period of time, their returns are most likely to be lower than those of stocks.

Just to put things in perspective, stocks returned 10% over the last 28 years while bonds returned about 7% in the same period of time.

Simply stated - asset allocation is just the % of your portfolio you put in each asset class - a 50%/ 50% asset allocation means 50% in stocks and 50% in bonds.

A more aggressive asset allocation (higher in stocks as compared to bonds) is better suited for risk prone investors – say a 25 year old young chap who just started to work – no dependent, no large expenses, and a long working career ahead of him (generic ‘him’ that can refer to him or her).

While someone who is 55 year old and is contemplating retirement in 2-3 years might not be (and should not be) as comfortable with the riskiness (volatility) of stocks.

Various thumb rules exist – two most common are 100/110. So 110 minus your age should be in stocks. So if you are 30 years old, then 110 – 30 = 80% of the portfolio should be in stocks. For a 60 year old, only 50% should be.

Now let us briefly talk about expense ratio – expense ratio is the expense that you are paying annually to the fund/ ETF – this covers their management fee, admin fee, operating costs etc.

To put things in perspective – the lowest expense ratio I have in my portfolio is 0.02%, highest 0.48%, and overall average is 0.26% (overall average has ranged from 0.24% – 0.26% over the course of last 12 months).

Think of Asset Allocation as putting your hands into everything that is out there and expense ratio the cost that you incur in doing so.

A fundamental proposition that I believe in is – like you cannot time the market, similarly you can only expect to earn minimal (if at all) by trying to target specific asset classes when they are trading cheap. A good example – Oil fell a lot the last year or two, and many people are recommending buying oil on the pretext of ‘Buy low and sell high’.

Buy low and sell high is a great concept but almost impossible to implement unless you have a crystal ball that shows the future.

Assuming half of the Americans are invested in the stock market, we are talking about 150 Million Americans buying and selling stock. Is there something that all of them do not know/ understand but you do? If yes, then you should try to outperform the market, otherwise you should be happy if you track the market returns.

This recent published study shows that over the last 10 years, S&P 500 index has outperformed 82% of actively managed funds.

High Risk -> High Return

A picture says a thousand words. Here is a graphic that I created by collecting data for the last 25 years.

The overall theme: Risk and return are directly related. More the risk, more the probability of higher return. Converse is also exactly true – lower expectation of returns implies safer investments (lower risk).

The asset classes I considered in the above analysis include cash, alternatives, international bonds, US bonds, international stock, and US stock.

Here is the underlying data that went into creating the above graphic.

As you can see, average returns over long periods of time show a clear trend – they increase from top to bottom in this table.

At the same time, the ‘variance’ in returns (volatility/ risk) also increases from top to bottom. So stocks are more risk than bonds (that in turn are more risky than cash).

Asset Allocation

So far we covered – what is an asset class, some thumb rules to get started, and then risk/ return equation of each asset class.

Now it is time for us to revisit Asset Allocation. I earlier stated “Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes”.

To understand it conceptually, let us just take the two extreme Asset Classes – Cash and US stock. We know from our discussion above that Cash returns are the least BUT the cash returns are the least volatile. Cash does not have negative returns (leaving apart inflation).

US stock on the other hand has highest average returns over long periods BUT the volatility is also high – the returns are most variable.

Should someone who is two years away from retirement invest in stocks or cash? Keep Cash because the stocks might fall 50% in the next 2 years (they will recover at some point in time later but once you are in retirement you necessarily will need to sell your investments to finance your living expenses).

At the same time, someone who is 35 year old, single, stable job, no credit card debt, and a 6-month emergency fund invest in cash or stocks? Of course stocks, cash returns very little in nomimal terms (practically nothing if you take into account 2-4% inflation).

Should someone closer to retirement invest all of his money in cash and nothing in stock? Perhaps not… most of the money should be in cash (since cash and stock are the only two possibilities in our example) but some should be in stock. Why?

Because we want to be a part of the upside too – what if the stocks go up 50% in the coming 2 years?

Similarly, a younger person should choose to have something in cash but mostly in stocks.

This is all that there is to Asset Allocation. Things get computationally a little more interesting for 2 reasons:

  1. There are more asset classes, we just took an example of 2 asset classes to understand easily
  2. The risk tolerance of a person changes multiple times – for example with marital status, with job situation, with kids, and with age. So the Target Asset Allocation changes over a period of time – For me, today it is not what it was 10 years back and might not be the current one 10 years into the future!

Risk Tolerance

The basic principles of Asset Allocation are applicable to any situation – the fundamental principle is balancing risk vs reward. Over long term, higher risk assets potentially provide higher returns but do you have a long term horizon?

It is important to note – just because you are young it does not mean that you have a long time horizon. People panic, in fact most people panic when stock market crashes – look at the stocks data I summarized for the last 25 years:

There were years when the stocks fell 40% – imagine you have been investing in the stock market and your portfolio has reached $500,000: You are excited when you start the year…. but as the year progresses, your portfolio starts to lose value….

Let us say – this is what your portfolio value through the first nine months looks like (Jan – Dec).

You started with $500,000 on 1/1 (Happy, you hit a milestone, kinda big deal).

By 1/20, the portfolio has lost $65,000, you are at $435,000; you lost 13% of the original value – possible over a period of 20 days.

You keep your clam and in fact buy more from the paycheck of 1/15 – after all, you want to buy low and sell high.

By 2/5, your portfolio has lost $34,000 further, in total you have lose $99,000 – close to a six figure loss. All the news channels say ‘This is the right time to buy on dips’ so you buy more from the paycheck of 2/1.

My mid of march, the original portfolio that was worth $500,000 has reduced to $388,000; you are worried, you ask Bobby and he asks you

  1. Do you have credit card debt?
  2. Do you have an emergency fund?
  3. Are you still at least 7 years more from retirement?

If you answered No to question 1, and Yes to questions 2 and 3; then he suggests that you invest your ‘every pay check dollar amount without worrying about ups and downs‘. Since you have faith in Bobby you listen to him and buy more.

By 4/25, your portfolio value is $370,000; now you are starting to get worried. Your spouse realizes that they will not be able to retire in the same city where you live now. Your children realize that you are not as likely to be able to help them with college tuition.

You have some cash at hand, that you saved from the pay check of 4/15 but you do not know what to do with it, you just keep it in your checking account.

Come 6/3, your portfolio value is $360,000; you have lost $140,000 in the last 6 months. The entire media (TV, newspaper, blogs, articles, magazines, barber shop, dentist, and restaurant waiting queues) is talking about how America is in recession and this might be worse than before.

You are dumb stuck, you never expected this to happen. After all, you expect your money to grow over a period of time. Savings from pay check of 6/1 stays in checking account. You are not buying but you are not selling.

Come 7/1, your portfolio is at $333,000 – this sounds like 2/3rd of what you started the year with. Everyone told you not to invest in stocks but you had the wisdom – you looked at data and took a calculated bet.

Here you are with $167,000 loss – this is 3 times your monthly salary. This is a third of what you have saved in your entire life.

Come 9/15, and your portfolio is worth $298,000. It is not even worth 2/3rd of what it was just 9 months back. America is going into recession. You are more worried about preserving your capital than chasing higher returns.

No end to this plight seems in sight and you SELL OFF!

If you can foresee yourself in this scenario, then do not fool yourself into believing that you have a high tolerance for risk.

Conclusion

Once you have started to save (hopefully early enough in life) and you have figured out the actual dollar amount you will save per pay check, your long term returns will primarily depend on Asset Allocation.

You need to spend time and think hard as to what is your risk tolerance and arrive at your Target Asset Allocation.

35 thoughts on “Importance of Asset Allocation

  1. I hope I am not bothering…but does any of this matter?

    You made great points, but I am old enough to have experienced a few market crashes and corrections. My theory is that nobody’s diversified account grows except because of new money they put in.

    I don’t think I can post a chart here, but I have seen a few that show that if you invest $1000 in the S&P 500 in they year 2000, it would be worth $1380 in 2014….but $1010 adjusted for inflation.

    I would love to see someone’s statement that showed they had XX amount in an account, and 10, 15, 20 years later it shows a higher number without new deposits!? When they announce the market is at an “all time high”, that only means it is $1 over what it was maybe nine years ago!

    It seems to be a timing game and we are told that timing doesn’t work (very nice post on that btw). If you don’t buy a ton while in the crash, your $1000 will only gradually come back and that can take years. Is the only way to pour more money in?

    I swore off expensive mutual funds years back, and now I have given up on tracking ETFs. I have a little over $100k “trapped” in a Wealthfront account for almost 2 years…just waiting for it to break even so I can pull it out!

    I will only buy individual stocks now…and when I get burned on those I suppose that is it for me. I bought quite a bit of stock during the correction in Feb. with good results so far…but I have played this game before. When is the next 40% drop??? What am I missing?

    • Many of us are old enough to have experienced a few market crashes and corrections, but we invariably remember the crashes more than the corrections. See graphic here. I created this graphic specifically for our discussion 🙂

      I know exactly the chart you are talking about – if you invested in 2000 in S&P, then you would have so many $$$ in 2015. I do not have an account statement that I can share with you – because none of my account statements had zero cash flow coming in later, they all had every pay check contributions, and they had tax loss harvesting done every year.

      But you rightly refer to my post Timing the market , you can download the Excel with 28 years of data, pick any 15 year period and I assure you that the returns are significantly more than inflation – I would be surprised if they are closer to inflation than they are to 10.3% (average for 28 years).

      • I also hear that the average investor returns close to 2% annually.

        “According to the latest 2014 release of Dalbar’s Quantitative Analysis of Investor Behavior (QAIB), the average investor in a blend of equities and fixed-income mutual funds has garnered only a 2.6% net annualized rate of return for the 10-year time period ending Dec. 31, 2013.

        The same average investor hasn’t fared any better over longer time frames. The 20-year annualized return comes in at 2.5%, while the 30-year annualized rate is just 1.9%. Wow!

        The average investor exclusively investing in just fixed-income funds has had an even worse experience. The annualized return is 0.6% over 10 years, 0.7% over 20 years, and 0.7% over 30 years.

        Just who is the “average investor?” The QAIB states the average investor refers to “the universe of all mutual fund investors whose actions and financial results are restated to represent a single investor.” This universe would include small and large investors as well as professionally advised and self-advised investors.”

        So when we pick dates off an S&P chart or similar, and it shows 8% or 10% or whatever, does it take into account fees? Which could effect your net return by 30% over time. And are people invested exactly like the S&P? Since we are told to be diversified…
        And do many guys actual do the calculations to determine what they actually returned in their accounts, taking out their annual additional deposits? Or do they generally just look at the gross returns of the funds they are in and assume they returned that much?
        Thank goodness after many years of mutual funds and crappy 401K plans, somebody finally did the math on the fees and shined some light on that scam. Now we have a few lower priced options, but I still wonder if anyone is making money. I know my IRAs are down.

        • You raise some great points.

          An average investor makes little money for the following reasons:
          1. They over-estimate their risk tolerance (the entire last section of my post describes a real life scenario of 2008)
          2. They feel dead scared and tend to sell out at the ‘low’ only to buy back again 3-4 years later when it is ‘high’

          You are right the S&P data does not take into account but the S&P 500 fund (V00) I have has an expense ratio of 0.05%. How does the account fee add to 30%?

          Fixed income funds follow the same rationale – ‘average’ investor tries to time the market, which I have proved in ‘Excel’ that it is not possible.

          You rightly say that Life is not Excel but what’s the difference? Human over-confidence, greed, and fear, right? Once you remove emotions from investing; why will you not make the same returns as the Excel?

          You are right about diversification – S&P example is given because it is easy to understand and proves a point. 99% of the people will not ‘buy’ the point entirely. For those who do, adding some diversification into the equation is not difficult.

          You wonder if anyone is making money? I do not know one investor (who did not sell in 2008 – 09 CRASH) who is not making money. There were many who sold out in those periods of great declines – they did not want ‘their life savings going to 0’ – these people saw the markets recover in 2-4 years, and then re-entered around say 2012…. the markets were going up for 1 – 1.5 years, and then again have not returned great in the last 1-2 years (as a whole).

          To your question about ‘Do many guys actual do the calculations to determine what they actually returned in their accounts, taking out their annual additional deposits?’ – Surely I do!
          XIRR calculations - one of my accounts

          The 13% cell has the following formula: XIRR(J1:J39,I1:I39,0.15). The columns show the date and investment amount – the market value of the portfolio on 1/25 was $232,000.

          • So at 13% you are doubling your original investment every 5.5 years? I apologize for being naive, but I just find that hard to believe. I would wager most people didn’t double their money even with additional deposits the last 6 years.
            Or maybe I need to pay you to show me how to do this?
            And I am seriously not trying to be a pain, I just know I am missing something here and I can’t pin it down.

          • 13% is not important here. You asked if there are people would track their ROI (taking into account deposits and withdrawals) and I showed an example of where I exactly track it.

            Coming to 13% – as you will see that the 13% annualized returns are over a period of 6 months. It is not ‘over a long period of time’ – There have been times when I have made 13% overnight – that would be 2,600% annual assuming 200 trading sessions, but that never happens.

            I still am tracking say 8% or 10% over long term. In fact so much so that at 2-4% I am willing to borrow money from you and at 12 – 14% I am willing to lend money. In my mind, I am like a ‘market maker’ who has both the quotes – like a broker will give you 2 quotes – buy and sell. I also have 2 quotes in my mind ‘borrow or lend’.

            Many people get taken for a ride when ‘marketers show them numbers’ – for example, I could have had a hedge fund and I will show you that I make 13% annually even in 2015…. and many people will be ‘Wow’!

            You are not being a pain, these thought provoking discussions are the reason I share so many of my personal examples – I know my examples in and out, I also have implemented what I learned on Wall Street over years, and I also want to see you ‘reflect’.

          • I agree the 13% is not important. But even over time I am missing something. For instance, back to the S&P, I look at the chart over time and I see it was at 1527 in 2000. In 2007 it was 1534. In 2013 it was 1560. Now it is 2035. But can you understand my concern for all the “claimed growth”? In 13 years practically nothing?

            It seems people pick dates, like 2009 when it was 683 and say, “Look at the growth since then!” Well I say, look at loss you took to get to 683…and then you just went back to where you started.

            Now it seems to be up…great! But from 1500 to 2000 in 16 years?? And might we guess that if we give this a little more time that it will be back below that 1500? This just seems like a crummy investment.

            Again, I am guessing I am missing something?

          • You are thinking in the right direction.

            I had an old friend come over for dinner last night. He has about a million dollar annual revenue ‘data analytics’ business and pays about $2,500 to a CPA to prepare business taxes. In 3 years, the CPA has not been able to explain when will the business need to file business returns and when will it simply act as a pass through entity. It took me precisely 30 seconds to explain. Do you know why? Because Einstein said:

            Similarly, the question you are asking is very legitimate, the data you are quoting is equally legitimate BUT it takes a lot (asking too many people) before you find someone like me who will tell you in 30 seconds ‘What is missing?’.

            Dividends are missing: You have two options:
            1. Download my Excel at “Time the Market” and then look at the numbers (corresponding to 2000, 2007, and 2013)

            2. Take the 2% dividend yield into account along with the numbers you are quoting correctly

          • Pretty good answer!
            Do I still get the benefit of those reinvested dividends in that VOO fund? It seems that has gone from $100 in 2010 to $185 today…not horrible.
            And of course a lot of this argument depends upon what other investment options are available….not always a lot. I am moving into real estate…and I did read your blog on that.

            BTW, what do you see the market doing the rest of the year?

            Thanks again…I did not consider dividends.

          • The dictionary didn’t explain if the DRIP is part of an ETF. Do you still get that benefit in an ETF even though you don’t own the stock?

          • DRIP is not a part of ETF. DRIP is a program that is offered by brokerage firm – so as soon as the ETF pays dividends, brokerage systems will automatically buy additional units for you, makes sense?

        • You actually make it seem so stiaaghtforwrrd along with your presentation but I find this matter to be really something which I feel I would never understand. It seems too complex and quite broad for me. I’m seeking forward for your next post, I will try to get the hang of it!xrumer

          • I do understand that finance can be a complex subject, but like you said – I make it seem straight forward. I have studied and practiced it for many years, I try my best to translate the most complex subjects into every day common language.

            I hope you have subscribed to my blog using your email, I promise I will do everything within my power to make all of this less complex for you.

  2. Any view on including a well-diversified REITs index in one’s portfolio? Strong historical returns, added diversification.

    Also curious what you think of Fundrise’s eREIT. Thanks again for your advice.

    • I like the idea of including an REIT in the portfolio as long as it is a small portion. I myself own RWO.

      By small portion, I would mean 5% or 10%. It also depends on whether you have exposure to real estate outside the stock market – for example, if you own a primary residence, you already have some exposure. If you own rental properties, then you have even more exposure and hence REITs might not be required.

      I think of REITs as ‘alternates and rarely suggest alternates to be more than 10-12% of the portfolio.

      I like Fundrise eREIT – both of them – income and growth. I personally like income a little more (it is lower risk and lower potential return as compared to growth). I was trying to invest into income REIT but landed into some ‘documentation challenges’ – they needed more document about the corporate entity than I readily have, so at the moment I am not invested in the Fundrise REIT.

  3. Thanks! I just saw this now or I’d have considered RWO; I bought some VNQ this week (in large part because I like Wealthfront’s ideology / recommendations). Threw it into the Traditional IRA that will soon be converted to the Roth in large part due the advice I’ve received from this blog! Snuck it onto those 2015 tax returns.

    Looking to get involved in the income eREIT soon, looking forward to seeing how the first quarter performed (I know it’s only one data point and thus meaningless, but still, provides some sort of peace of mind to me). Some of my friends / colleagues are skeptical of the product, but I value your view as you’ve committed capital to the platform and have seen strong results (albeit via different vehicles).

    If you have any recommended reading material in the real estate area, I’d be keen to read up. This is a fairly new area for me, so it’s fun / exciting. I’m not sure how the subject matter got glossed over in my studies of finance – maybe it’s just a function of getting older.

    Thanks for all your help.

    • VNQ is better than RWO…. stick to VNQ.

      I am sorry to disappoint you but you cannot do a 2015 Roth conversion now… the deadline is 12/31 of the year. (Yes, I am aware that contributions can be made till 4/15 but not the conversions. Strange are the ways of IRS – same is true for account opening, the account has to be open by 12/31, only then can you make contributions till 4/15).

      Long story short, you cannot report the conversion on 2015 returns.

      Like you said, one quarter or even a few quarters data does not mean much for eREITs/ related stuff. There are 2-3 main points there:
      1. Income is taxed at regular income tax rates (no preferential capital gains tax rate)
      2. Platform risk – no one knows how ‘good’ the platform is – all of them claim to be good but I do not know one person in the history who started by saying ‘we cut corners’
      3. Now the times are good, everyone is making money… when bad times come (and they invariably do), then people will lose money… so not too much into eREITs

      Best wishes

  4. Oh, crap – haha OK, well I’m in the process of opening the Roth IRA with Vanguard (I figured you’d be able to just click a “convert” button, but it would seem that I need to again go through the cumbersome process of opening another account).

    So what’s the best move here? I filed the contribution for 2015, was planning on adding another 5.5k shortly for 2016. You’re telling me that the 2015 contribution shall exist in the Traditional IRA forever (no interest in paying penalty fees to unwind), whereas the new contribution can be converted to Roth? Or I get hit on some steep tax for converting the 2015 contribution outside the passed window of opportunity? I suppose there are probably some conditional factors here.

    You live and you learn – thanks.

    • Conversion is a kind of rollover, when you convert, you get a 1099-R. You can convert the 2015 contribution right now but the 1099-R that you will receive from the brokerage firm will not be for 2015, it will have to be for 2016.

      You can make 2016 contributions and then convert all of the account balance (including 2016, 2015, earnings) to Roth whenever you like. the 1099-R will be for the 2016 tax year.

  5. Ah, OK – so you’re telling me I can still get the full “never pay tax on this money again, and all its compounding, even when I withdraw as an old man” benefit for the full 11k by converting in 2016?

    I realize there may some marginal tax on gains – say the 5.5k grows to 6k in the near future, I pay Uncle Sam on for that $500 gain when I convert 11.5k.

    Sure, this is a little annoying I guess, but I still “snuck in” that 2015 contribution which now has 30 years to grow, right? I’m fairly indifferent to when the 1099-R is filed.

  6. Oh, awesome – my initial (wrong) interpretation of “sorry to disappoint, you cannot do a 2015 Roth conversion now” was “oh crap, now I get taxed upon withdraw: 5.5k * 1.08^31 = 60k… whatever tax bracket I’m in then – this could be an 18k mistake by not having deposited earlier!” All good – something like $150 today in an absolute worst-case-scenario is much more manageable. Crazy when you think about the compounding!

    Thanks, sorry for dragging this one out.

  7. Hi Bobby, thanks for this article and others, I discovered your website yesterday and learned so much from it already!

    I would like to ask your opinion on something that has been bothering me for many months and I am sure many people are in the same situation.

    Let me give you more details. I started investing in 2015, “bought and hold” QQQ for a year, and since the return was not much more than zero, I started learning (yeah, I should have done that earlier, I know) and looking for other options.

    At the moment I have about $25k in Betterment, Lending Club (debt notes and LC stock), VTI, and individual stock (proving myself by example that stock picking does not work :). At the same time, about $100k is sitting in cash! I know it introduces a cash drag, I know I should be invested but I can’t force myself to do that in the current weird environment, namely:

    1) Low interest rates created an overpriced/near peak stock market. Shiller PE (PE 10) is currently 26. While it was higher in 2000, it was about 27 in 2008 and 30 in 1929. Even “staples” are overbought (XLP P/E is about 24).
    2) Bond yields are extremely low; looks like we now have a bubble in bonds.
    3) Startup valuations are crazy. However, I should admit that in 2016 the situation improved a little;
    4) Real estate formed regional bubbles (especially in Bay Area). People overbid each over; houses sell at 300k more than the asking price; exposition time is days not even weeks! It is possible to buy a house with 3% (sometimes 0%) downpayment. CDOs are back on the market (now called “bespoke tranche opportunity”).
    5) Since interest rates are already near zero (and even negative in Japan and some European countries), they can’t be lowered further to stimulate the economy.

    I can’t find en example of the situation like this in the past. I missed two pullbacks (in August 2015, and Feb 2016) fearing they were downturns, and now I frankly have no idea what to do 🙂

    Would love to hear your thoughts.


    Thanks!
    Sergey

    • Hello Sergey, welcome to OneMoreDime and thank you for all the kind words, I would request you to like my page https://www.facebook.com/onemoredime.

      You learned from experience that stock picking does not work – in a way good, what you hear you forget, what you do you remember. Honestly, it’s not a big price to pay if you keep the lesson.

      All your points are valid – about Shiller, yields, and others. The main problem that you have landed into is because you allowed 100k to accumulate gradually.

      Anyways, that is past – the question like you rightly ask is: what now?

      You will need to get rid of QQQ (once you are at your target asset allocation). One of my other friends also has QQQ that he bought because the tech companies had a good performance but I prefer VOO as compared to QQQ (S&P 500 without any particular sector focus).

      Answer clearly (like you yourself know) is to invest the money but it is scary to invest at such high levels.

      Even then, take BIV for example, 12 months yield is about 2.6% and expense ratio is less than 0.1%. In the last 10 years, the worse year lost 4%, appears like a relatively low risk option:

      But remember this also makes you forego any potential gains from the stocks – no one knows what is going to happen tomorrow.

      The answer on how you invest between BIV and VOO will also depend on how much of additional investment money will you have every month/ paycheck?

      All of the above assumes that you have an emergency fund in place and no credit card debt etc.

  8. Hi Bobby,

    Thanks for the detailed response! Liked you Facebook page 🙂 Btw, please note that even though I subscribed to your posts on this site, I did not receive any email notifications, so subscription is likely not working. You may want to look into that.

    You are absolutely right, I allowed money to accumulate gradually, now I understand not investing was a big mistake.

    I have no credit card debt, actually no debt whatsoever. My current plan is to come up with an asset allocation and DCA into it over the next 12 months. I will also set up automatic contributions from paycheck so I don’t end up in this situation in the future.

    I am thinking about the following classes:

    1) S&P/ Total Stock Market (VOO/VTI)
    2) Dividend stock (VDIGX or REGL?)
    3) REITs (VNQ?)
    4) EM (VOO?)
    5) A little in bonds (BIV)
    6) Little of “play” money to satisfy my active investment crave and not touch items 1-5 🙂

    Can you please recommend good resources tools that would help to come up with asset allocation? I don’t want to manually gather data about historical returns and correlations and then calculate the efficient frontier. Hopefully, there is a tool out there that does it. What do you use?

    Thanks,
    Sergey

    • Hi Sergey – I will look into the email notifications part, thank you for letting me know.

      How will you set up automatic contributions from your paycheck (except for retirement accounts)?

      Item number 4 says ‘VOO’ – VOO is item 1 (S&P 500).

      I know there is a lot of buzz around dividend stocks but you will be double counting some stocks if you consider dividend stocks a different category. You know what I mean?

      Here is what I would have done if I was in your place – invest heavily in bonds right now and like you say ‘gradually dial it into stocks over 12 months’.

      When you graduate to stocks, do not forget to get into the small caps too (IJR).

      But remember bonds have a risk too – not only credit risk but interest rate risk too (bond ETF prices will fall when Fed raises interest rates). I will still take that risk rather than keeping cash.

      • Bobby,

        Vanguard (and I am sure others) support automatic deposit from bank account where my paycheck goes via direct deposit. It is not tax advantaged as 401k, but it is still automated and removes the human (me) from decision making 🙂

        Item 4 was supposed to be VWO, thanks for the catch.

        As to bonds, can you please elaborate why you recommended BIV? VCLT looks more attractive as it has higher yield.

        I am also looking at preferred stock (PFF, which has 5.8% yield and .34 beta) in addition to bonds.

        You should open a firm. Seriously, I am sure there are people who will be willing to pay for no BS fee-based advice 🙂

        Thanks,
        Sergey

        • Hi Sergey,

          Oh you meant automatic transfer from your bank account. I misunderstood ‘automatic contributions from paycheck’ to mean deductions from paycheck.

          VCLT is also a good ETF but BIV is more suited for the purposes we discussed, specially the ‘interest rate risk’ part.

          VCLT is LONG-TERM while BIV is intermediate term. I can get more technical but suffices to say that long-term bonds suffer more when interest rates rise (lower coupon payments for a longer time as compared to the new bonds in the market make it less attractive).

          VCLT has much higher historical yields (because the maturity is 10 – 25 years) as compared to BIV …. and interest rates have dropped in the recent years. As the interest rates rise, BIV yields will not decline as much as VCLT. Makes sense?

          I have several times thought about opening a firm. I love the finance part and I love the people part. What I am not entirely sure about is the ‘sales and marketing’ part – I do not appreciate many things that many ‘successful’ businesses do. Let us see what happens in the future 🙂

          Cheers!

  9. Hi Bobby,

    Just wanted to thank you for this blog. You’re doing a fantastic job and I’m learning a lot from each and every post you write. Also the discussions in comments are very informative. I’ve liked your Facebook page and looking forward to new posts 🙂

    Keep up the great work and thank you!

    – Ivan

  10. Hi Bobby,

    Thanks for explaining the difference between VCLT and BIV in raising rates environment.

    I believe, since I live in California, VCAIX (Vanguard California Intermediate Term Tax Exempt FundClass Inv) makes more sense for me.

    Thanks again,
    Sergey

  11. Hello Bobby

    Thanks for posts and trying to learn dime from you. I have old 401k account and would like to transfer the funds out to some other brokerage firm. So, that I can invest in Stocks, ETFs etc. What is best firm to transfer the funds and in the same way lowest fees. I know merrill edge gives free stock trades per month if balance is more than 50K. My friend is suggesting Vaguard (it has lower fees). Please let me know. thanks.

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