William J. Bernstein, in his book, “The Investor’s Manifesto” writes, “Before diving into the most important issue faced by any investor–the asset allocation decision–you will need to understand four things: save as much as you can, make sure you have enough liquid taxable assets for emergencies, diversify widely, and do so with passive or index funds.”
If you are not a saver, it is questionable how much useful information you will derive from this blog, ITA Wealth Management. Perhaps I can persuade or scare you into saving more than you ever thought possible. This blog is also about diversification and using index funds or index ETFs as the primary investment vehicles. My preference is to use ETFs provided one is not seduced into day trading. If one can hold commissions to something below 50 basis points per transaction, then I favor ETFs. It is now possible, through TDAmeritrade (and other discount brokers), to populate a well-diversified portfolio with commission free ETFs. Drive costs lower as it works to the bottom line. And now to that important investment decision — one of asset allocation. For investors following or using one of the momentum models, asset allocation is less important and may not even enter into portfolio construction.
The first decision, and the most important according to available research, is to determine the stock/bond ratio. Will it be a 50/50 or a 90/10 ratio? This decision is unique for each investor, and to help with this determination, once more I direct investors over to http://www.ifa.com for the Risk Capacity Survey. I’ve long favored skewing the portfolio toward equities. With interest rates crawling along the bottom, they have one place to go and that is up. When that happens we do not want to be heavy in bonds.
If you have not already done so, take the Risk Capacity Survey to see where you fit on the stock/bond continuum. Be aware that the survey will end up on the conservative side, particularly if you are older. IFA uses this survey as a recruiting tool, so if you are shy about saying no over the phone, you may want to avoid the survey.
The next asset allocation step is even more difficult as we need to decide what asset classes will make up the equity portion of the portfolio and what bonds to use for the bond portion. Platinum members have a good idea what I use. A lot of attention is given to these decisions here on the Platinum level of ITA Wealth Management. Once the different asset classes are identified, investors are ready for the last decision and that is — what percentage should be allocated to each asset class? For example, if 40% is allocated to bonds do you place all 40% in BND or is it better to divide bonds into several different bond ETFs such as TIP, HYG, TLT, JNK, PCY, BIV, and BND, or some other combination of different ETFs? The Rutherford portfolio is set up to use only 10 ETFs plus SHY as the “circuit breaker” ETF. In most Dashboards, Commodities and Precious Metals (Gold) are included. Those are the first two I would scrap if you want to keep the asset allocations simple.
When I first wrote this blog many years ago, the title was – The Most Important Decision. Over the last few years I’ve concentrated more on reducing portfolio risk through the SHY cutoff and/or ITA Risk Reduction (ITARR) models. While the Schrodinger, Copernicus, and Pasteur portfolios are passively managed, the majority of the portfolios are now managed using some form of the Momentum Model. It is still too early to tell how effective this approach is in real time. We know back-testing looks great, but actually putting the model to use is more challenging. To see how well we are doing, check the Portfolio Performance Data each week to see IRR returns and trends.
Regardless whether you are a passive or active manager, follow Bernstein’s four points found in the first paragraph.