- Asset allocations: Equity allocation utilizing a domestic U.S. broad equity securities market index fund, such as VTSAX (ETF equivalent VTI) or VFIAX (ETF equivalent VOO). Fixed income allocation utilizing a domestic U.S. broad investment grade bond market index fund, such as VBTLX (ETF equivalent BND) or VBILX (ETF equivalent BIV). An approximate heuristic for retirement portfolio asset allocations between equity and fixed income allocations (note, the appropriate glide path may be highly variable depending on individual circumstances, including investment objectives, risk tolerance, risk capacity, liquidity needs, and investment time horizons): 135 minus age ≈ percentage allocation towards the equity portion of the retirement portfolio, with the remaining percentage allocated towards the fixed income portion of the retirement portfolio (asset allocations may be maintained once an approximate 50% / 50% split between equity and fixed income allocations is realized within the retirement portfolio). Asset allocations may be periodically adjusted to desired age targets at set infrequent intervals (e.g., at 5 or 10 year intervals). Alternatively, a balanced target date index fund can be purchased at minimal cost with automated rebalancing and adjustments to the underlying asset mix upon advancement towards a set target date (i.e., a single “set it and forget it” balanced fund with automated glide path), such as the range of Target Retirement Funds sold by The Vanguard Group, Inc.
- Asset location: If the objective of the asset location strategy is maximizing lifetime after-tax wealth, higher expected growth assets such as equity securities and equity funds should preferentially be located within tax advantaged accounts (e.g., traditional / non-designated Roth accounts or Roth / designated Roth accounts); regardless of their relative tax efficiencies, shielding higher expected growth assets preferentially in lieu of lower expected growth assets will generally result in greater lifetime after-tax wealth if the realized return spread between higher and lower expected growth assets is sufficiently wide. Accordingly, lower expected growth assets such as investment grade bonds and bond funds should fill any remaining space within tax advantaged accounts, with remaining assets then located within taxable investment accounts. If growth is expected to be similar across competing assets, the secondary priority is locating less tax efficient assets such as investment grade corporate bonds or bond funds within tax advantaged accounts. Tax-exempt or tax deferred assets such as municipal bonds and annuity contracts (please reference “Clearly detrimental strategies and products that we do not utilize, recommend, or offer” topic for discussion regarding annuity contracts) should never occupy space within tax advantaged accounts (e.g., qualified annuity contracts) because such asset location strategies will detract from available space within tax advantaged accounts for less tax efficient assets and compound the limitations of tax-exempt or tax deferred assets with the limitations of tax advantaged accounts without added benefit.
- Portfolio risk level: Portfolio risk level must be commensurate with individual investment objectives, risk tolerance, risk capacity, liquidity needs, and investment time horizons (please reference “6. Time horizons” below); risk tolerance, risk capacity, liquidity needs, and investment time horizons may differ for each investment objective. Appropriate asset allocations and diversification (please reference “5. Diversification” below) are essential to controlling portfolio risk level. Allocation towards assets with greater expected volatility and greater potential returns including equity securities or realty is appropriate for longer investment time horizons (a minimum of 5 to 10 years). Allocation towards assets with lower expected volatility including short or intermediate duration investment grade fixed income securities (reference portfolio durations or weighted average durations when utilizing bond mutual funds and bond ETFs) is appropriate for intermediate investment time horizons (2 to 5 years); to minimize interest rate risks and reinvestment rate risks, durations for fixed income securities (portfolio durations or weighted average durations for bond mutual funds, bond ETFs, and bond portfolios) should not exceed investment time horizons (duration matching). Allocation towards highly liquid, marketable, and stable assets (cash and money market securities) including bank deposit accounts, money market funds, bank certificates of deposit (CDs), or U.S. Treasury bills is appropriate for shorter investment time horizons (less than 2 years).
- Rebalancing: Please reference “Controversial strategies with limited benefit, no benefit, or possible detriment” topic for discussion regarding portfolio rebalancing. If periodic portfolio rebalancing to fixed asset allocations is desired, a rebalancing interval greater than 1 year should be selected to minimize transaction related expenses (e.g., broker-dealer commissions and bid-ask spreads) and recognition of short term capital gains.
- Diversification: Total risk (often approximated from historical asset or portfolio returns by calculating standard deviations) can be broadly divided into systematic risks and unsystematic risks (“Capital Asset Pricing Model” or “CAPM”). Systematic risks are nondiversifiable risks inherent to all securities within a particular market or asset class (often approximated from historical asset or portfolio returns by calculating beta coefficients in relation to benchmark returns, typically market returns). Whereas, unsystematic risks are diversifiable idiosyncratic risks inherent to securities issued within a particular business, industry, or sector. Systematic risks are nondiversifiable and must be compensated risks. Conversely, unsystematic risks are diversifiable and uncompensated. Stated another way, unsystematic risks are risks without rewards. Broad diversification effectively eliminates unsystematic risks, thus improving risk adjusted returns from investment portfolios. An investment portfolio comprising approximately 50 well diversified stocks of similar market capitalizations effectively eliminates unsystematic risks and significantly reduces total portfolio risk. Market portfolios (e.g., domestic U.S. equity securities market approximated by holding VTSAX) represent maximally diversified portfolios with optimal risk adjusted returns (“Efficient Market Hypothesis”).
- Time horizons: Portfolio risk level must be commensurate with investment time horizons. To illustrate this point, consider the approximate historical odds of experiencing losses while holding a market portfolio of domestic U.S. equity securities with 100% reinvestment of all dividend distributions and capital gain distributions:
- 1 year ≈ 32%
- 5 years ≈ 13%
- 10 years ≈ 2%
- 15 years ≈ 0%
Bentley Makkar
April 8, 2023
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