Asset allocation (AA) is an important part of portfolio design, and I like pinning down a target asset allocation for personal reference. This helps keep me focused as my portfolio shifts over time and makes it easy to re-balance back. For some educational posts on this topic, please refer to my asset allocation starter guide.

Below is my updated target asset allocation. Here is my target asset allocation from 2008. It’s not dramatically different, but I’ll try to explain the slight changes below. This is just my own AA, and I think everyone should develop their own based on their own beliefs and learning. If you just copy someone else’s without thinking, when things go awry you won’t have the foundation to stick to your guns. I have been strongly influenced by the writings of Jack Bogle, William Bernstein, David Swensen, Rick Ferri, and Larry Swedroe.

Stocks

I separate things out first into stocks and bonds, and then later it’s easy to go 60% stocks/40% bonds and so on. Here’s my stocks-only breakdown:

• I now do a 50/50 split between US and International stocks. In general, I would like to mimic the overall world investment landscape. On a market cap basis, the US stock market is now about 45% of the world, while everyone else takes up 55%. 50/50 is just simpler, with a slight tilt towards domestic stocks.
• I consider REITs a separate real estate asset class. I used to put Real Estate under US stocks since I only held US Real Estate Investment Trusts (REITs), but in the future I would be open to investing in foreign real estate as property laws improve and investing costs drop.
• On the US side, I add some extra small-cap value companies. Historically, adding stocks of smaller companies with value characteristics (as opposed to growth) has improved the returns of portfolios while lowering volatility. There is debate amongst portfolio theories as to why this happened and if it will continue.

  If you buy a “total market” mutual fund or ETF, you’ll already own many of these types of companies (although many will not be held due to their small size relative to the big mega-corporations). I feel this adds a bit of diversification.

• On the international side, I add a little extra exposure to emerging markets. You may be surprised to know that “emerging” countries like China, Brazil, Korea, India, Russia, and Taiwan already make up 26% of the world’s markets when you remove the US. These are countries that have a greater potential for growth, but also lots of ups and downs. I add a little bit more than market weight for these as well.

Bonds

I try to keep things simple for bonds, partially due to the fact that they are currently a smaller portion of my portfolio.

• I like a 50/50 split between inflation-linked bonds and nominal bonds. Inflation-protected bonds provide a yield that is guaranteed to be a certain level above inflation. Nominal bonds pay a stated rate that is not adjusted for inflation. I like to balance the benefits of both.
• Instead of only short-term US Treasuries for nominal bonds, I added some flexibility. I used to invest only in short-term US treasuries, as they provided the best buffer in my portfolio as they were of the highest quality and had a low sensitivity to interest rate fluctuations. Both TIPS and nominal Treasuries did great during the 2009 crash and the subsequent flight-to-quality, but now the yield on Treasuries is just too low in my opinion. There are trillions of dollars from countries and huge institutions around the world that are tucking their money away under the safe Treasury mattress. By venturing into other places they won’t with my tiny portfolio, I feel I can stay relatively safe yet increase my yield significantly. Possibilities include bank CDs, stable value funds, and high-quality municipal bonds.

Want more examples? Here are 8 model portfolios from respected sources, an updated Swensen portfolio, one from PIMCO’s El-Erian, and Ferri’s personal portfolio. Have fun!

In a recent post on the NY Times Bucks blog, portfolio manager and author Richard Ferri shared his own personal portfolio. As a proponent of low-cost, passive investing, it was not surprising to see mostly index funds in his portfolio, but it was interesting to see that his overall asset allocation is 80% stocks and 20% bonds. He is quick to note that he does have a pension and defined-benefit plans which balance out his overall financial picture. Wouldn’t you like to know what all those financial advisors out there actually own?

Asset Allocation

Here is his asset allocation broken down into stocks and bonds separately using pretty pie charts:

Here’s the overall 80/20 breakdown with ticker symbols (based on this Bogleheads post):

34% Vanguard Total Stock Market ETF (VTI)
10% S&P SmallCap 600 Value Index Fund (IJS)
5% Ultra-Small Company Market (BRSIX)
8% Vanguard REIT ETF (VNQ)

6.5% Vanguard Pacific ETF (VPL)
6.5% Vanguard European ETF (VGK)
5% DFA International Small Cap Value
5% DFA Emerging Markets Core
—- [alternative: Vanguard Emerging Markets ETF (VWO)]

12% Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
4% Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX)
4% Vanguard High-Yield Corporate Fund Investor Shares (VWEHX)

Reading his book All About Asset Allocation was very helpful in creating my own portfolio. (Also see Model Portfolio #3 taken from that book.) I haven’t been updating my own own portfolio asset allocation as diligently as I should, although I have been keeping track of it. Here’s the last snapshot I took:

I’ve had some asset allocation drift for sure, although I have been countering this by rebalancing with new funds. I really need an update…

Emergency Funds

It’s also interesting to note that he keeps an emergency fund of two years’ living expenses, and that he uses the Vanguard Short-Term Bond (BSV) with a current SEC yield of 1.08%. Very simple and almost no-maintenance.

I prefer using a mix of high interest savings accounts and longer-term CDs/rewards-type checking accounts. I figure that index fund investors get so excited by saving 10 basis points (0.10%) on mutual fund, but with a bit of work you could beat a short-term bond fund by 100 basis points (1%) with what I would call less risk.

Bond funds still have risk to principal, meaning you may have to sell for less than you bought in for, while FDIC-insured bank accounts do not. Money market funds are currently averaging less than 0.10% yield.

The last time I wrote about stable value funds was in late 2008, both before the 2009 crash and a time when most of my 401k was in stocks. This time around, as I was trying to figure out how to rebalance my larger portfolio in a tax-efficient manner, I took another look at this asset class found almost exclusively in defined-contribution plans like 401ks. According to the Stable Value Investment Association (SVIA), approximately 15 to 20 percent of 401(k) assets are in stable value funds.

What are Stable Value Funds?

Generally, stable value funds are a bunch of bonds which have a insurance “wrapper” around them which protects it from interest rate volatility. The intended result is a product that pays the higher interest rates of intermediate-term bonds, with the liquidity and stable day-to-day price of a money market fund. Think “cash but pays higher interest”. A chart from the SVIA [pdf] illustrates:

The Attraction

Here’s my current situation. The stable value fund in my 401k has a guaranteed net interest rate in 2010 of 3.50%. The low-cost Vanguard Intermediate-Term Bond Index Fund Investor Shares (VBIIX) currently yields 3.17%, but will have a moderate amount of price volatility, especially if interest rates rise. The Vanguard Prime Money Market Fund (VMMXX) currently yields 0.11% with its high-quality, ultra-short-term holdings and Vanguard backing.

I could get the stability of money market fund, with an interest rate more than 3% higher! (All yields are net of fees.)

The Risks

Higher interest rates with no price volatility? Free lunch? Not quite. First of all, any guarantee is only as good as the entity doing the guarantee. Check the safety ratings of the insurer of your fund. Mine is Transamerica Financial Life Insurance Co. (TFLIC):

Not the greatest, but not bad. In addition, there are actually several ways an insurer can get “out” of the contract. From the SVIA FAQ:

Are there instances when book value or contract value does not apply?
There are a few, limited instances when participants do not get book value from a stable value fund. These limited instances are typically contractually defined. One such instance typically not covered is security defaults or downgrades. In order to protect the integrity of the stable value fund, most contracts incorporate investment guidelines establishing minimum credit quality requirements for the underlying securities. These contracts have established mechanisms to address downgraded or defaulted securities that fall outside the contractual guidelines.

Corporate-initiated events, which are employer-driven events such as an early retirement program, layoff, or bankruptcy, are also typically not covered. Corporate-initiated events generally cause withdrawals in masse from a stable value fund. These withdrawals can negatively impact investors and plans that choose to remain in the fund.

First up, if the underlying securities turn out to be utter crap via a default or credit downgrade, then the insurance doesn’t apply? Wait, the insurer gets to choose the securities in the first place? Sometimes smells here. In fact, this happened in 2009 to the insurer State Street, although they decided to step in to make investors whole in order to preserve their reputation. Via this CBS Moneywatch article:

In December 2008 and January 2009, State Street elected to provide support – a total of $610 million – to the bond portfolio in stable value funds the company managed. State Street was not contractually obligated to do this. As the company’s 8-K filing (a report filed with the SEC to notify investors of any events that could be of importance to shareholders) stated, “liquidity and pricing issues in the fixed income markets” so affected the accounts that the wrappers “considered terminating their financial guarantees.” State Street’s action to bolster its portfolios kept the wrappers in place.

Finally, there is the “corporate-initiated event” of a huge layoff or bankruptcy. At the end of 2008, Lehman Brothers infamously went bankrupt, which left their stable value fund managed by Invesco with a negative return of 1.7 percent in December and an annual return for 2008 of 2 percent. In April 2009, a stable value fund for Chrysler employees only paid out 89 cents on the dollar, a drop of 11% due to the company’s troubles.

As you can see, there is a lot of things that can invalidate the guarantee. So, the next step is to understand the holdings, which in the event of a liquidation can help you imagine your worst-case scenario. You should be be able to see at least an overall breakdown of the assets, and a market-to-book-value ratio must be disclosed at least once a year. This will show any discrepancies between what the insurer says is worth $1 and what the market says. My TFLIC stable value fund’s market-to-book ratio was 101.30% as of March 31s, 2010 and here is their holdings summary:

Bottom Line

In good times, the stable value fund has a pretty easy job of maintaining an image of price stability and paying out the stated interest rate. However, when the poo hits the fan there are a lot of ways the insurance wrapper can be worth less than a bubble gum wrapper. The only real good news is that you are still left with some intermediate-term, investment-grade bonds. Even with the upheaval of 2009, the worst example I could find was a drop of 11%. Even Lehman Brothers investors ended up with a overall positive return for the year. These losses are not insignificant, but something the order of the drop in other similar bond funds during that time. The key is to understand the risks that you are taking, which oftentimes people don’t (including me).

As for my personal investments, after doing my bit of due diligence, I am going to put a small percentage (less than 5%) of my total assets in my stable value fund, given the limited alternatives in my 401k. I am willing to take the risk of a small loss in order to earn 3.50% for all of 2010 in this current interest rate environment.

Good financial advice is hard to come by. There are so many variables, such that you have to find the balance between providing enough information, and making things digestible enough that peoples’ eyes don’t glaze over.

Check out this advice column found in the newsletter that comes in my 401k statement each month. Can you spot what’s missing?

There is no mention of what investment vehicle you should be sticking your money in, or even how much they estimate your future returns to be. Is it 100% stocks? 50% stocks/50% bonds? Orange juice futures? 6% returns? 12% returns? Who knows. Is this pre-tax or post-tax? Is it all in tax-sheltered accounts? Is my annual income supposed to rise as sharply as the chart seems to imply? I selfishly hope so!

Yet, I feel like this is what a large percentage of workers want to read. One impossibly simple chart that defines your retirement needs. So someone gives it to them. Maybe it gives them a general idea of where to start. But is a vague, possibly wrong answer better than guessing? I feel another poll coming on…

Is Such "One-Size-Fits-All" Financial Advice Helpful?

• Yes, something is better than nothing.
• No, on the whole it does more harm than good.
• It doesn't matter, we're all doomed anyway.

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