Weakon 206 and 207 covered asset allocation and diversification. The problem with what I did is the terms aren’t quite right. The two terms have merged definitions, with people referring to diversification when they mean asset allocation and vice versa. Confusion ensues. But instead of adding to it I’m trying to offer clarification outside of the Weakon articles. If I need to elaborate more on this please leave a comment and I’ll update the post to answer your question.
The main purpose for the supplement is to illustrate the point of asset allocation and diversification. We’ll start with asset allocation as we did with the Weakon posts. Let’s get back to idea of having $1,000,000 to invest with $750,000 in stocks, $200,000 in bonds, and $50,000 in commodities.
Asset Allocation:
To keep things simple, I’m going to use three funds. For stocks we’ll use iShares S&P 500 Index Ticker: IVV, for bonds we’ll use iShares Lehman Aggregate Bond Ticker: AGG, and for commodities we’ll use iShares S&P GSCI Commodity-Indexed Ticker: GSG. These are all iShares (no relation to Apple) ETFs, which are very similar to mutual funds.
Let’s say you invested your $1 million at the beginning of the year in these funds. By September you would have about $843,000. If you just put the money in stocks it would be about $796,000. This allocation protected you from losing as much money. The stocks declined sharply, but the bond fund had only decreased a couple of percentage points and the commodity fund is actually up slightly. By keeping your money in different asset classes, you protect your downside.
Now that was a pretty generic allocation of funds, but even at $1 million you don’t have to get too complicated. Now let’s break down that $750,000 for stocks and look at the diversification within that asset class we could have used.
Stock Diversification:
If you’ll recall our example from diversification took that same $750,000 and put $500,000 in an index fund of large-cap stocks. We’ll again use iShares’ index: IVV. We’ll also need $50,000 for the mid-cap, $50,000 for small-cap, and $150,000 for international.
The mid-cap ETF is iShares S&P MidCap 400 Index Ticker: IJH.
The small-cap ETF is iShares S&P SmallCap 600 Index Ticker: IJR.
The international ETF is Vanguard FTSE All-World ex-US ETF: VEU (They own many of the international stocks discussed yesterday and employ a diversification strategy that exposes you to emerging markets as well as established ones).
Had we kept all $750,000 in the large-cap index fund from before it would now be worth about $597,000. Because we diversified in the manner described about, our $750,000 is instead worth $631,000. This is especially fascinating because I expected the all large-cap to be worth more. It is the least risky of all the stock investments. Because of the current market conditions though the big companies have been bitch-slapped more than smaller companies and international companies. If the credit markets continue to be tight, expect the other companies to catch up and lose more. This is all the more reason why diversification is so important.
Please note that in all examples you’ve lost money, this is because of the down market we’ve experienced. By investing in these asset classes you’ve already said you’re committed to keeping this money locked up for longer than a year. We’ll recover, and your million will become $1.5 million, and more.
I do not own any of these funds discussed above, however the ones I do own are very similar. You don’t always have to figure out the proper asset allocation for your investments because mutual fund companies are trending towards doing that for you. Vanguard has what they call “Target Retirement” funds. You pick your expected retirement date and they have a fund for it. They invest in other mutual funds, like their “Total Stock Market”, bond index, and international fund. As you get closer to retirement, more money is shifted into bonds, which offer the stability that is so important to someone nearing the time they will need the money. I plan to use these funds when saving for kid’s college. If I expect my kids to go to college in 2030, I’ll invest in the target retirement 2030 fund. This hearkens back to the idea of “set it and forget it” investing. I’m very fond of this philosophy.
Well I hope you’ve had your fill of investing this week. I sure have. Put your questions in the comments and we’ll build from there. Thanks.
 By The Weakonomist |
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