Tuesday, March 10, 2009

Money Tips - Asset Allocation Continued

Last Money Tips post we spoke about Asset Allocation. It was more of a crash course on what asset allocation is, and it gave very general ideas on what to consider when creating your strategy. This post I am including my current asset allocation strategy for my Roth IRA, some other concepts to be aware of, and some examples of what I do to ensure that I am carrying out my strategy. Above you see a pie chart detailing my ideal asset allocation for my Roth IRA. I currently have all my investment holdings in funds from USAA and Vanguard. Both are renowned for their low expense ratios, customer service, and ease of use and I can attest that their reputations are well earned. As I touched on a bit in my other asset allocation post, I have a few different asset classes represented in my portfolio. I have mutual funds made up of stocks, bonds, real estate, and precious metals and minerals. Typically, these different asset classes are not heavily correlated, but in times like these it seems that way! Within those classes I have large, mid, and small cap holdings, foreign and domestic holdings, and every sector from financials to technology. What am I trying to illustrate here? Diversification and lack of correlation as to limit variation and lock in gains.

Here is my basic justification for what I am trying to do. I have 5% in my income fund which is a bond fund. I did this because bonds typically aren't correlated heavily with stocks and they are less volatile with regard to their returns. With lower risk comes lower returns and the bond fund is no exception, although many are predicting that the near future could be a great time for bonds. Since I am young and far away from cashing out my retirement fund I have a small percentage of bonds in my portfolio opting instead to take stocks that, although are more variable in their returns, provide a higher historical rate of return. 70% of my holdings are funds that are made up primarily of stocks. As we become more intertwined in the global marketplace I think more and more growth opportunities are going to be available overseas. For this reason, I probably have more of my portfolio than most people invested in foreign securities. I figure with a long term time horizon this is a safe play as well. I am also probably exposed more than most people to small caps and technology assets. This also goes back to time horizon and my ability to tolerate risk and accept short term losses. The largest fund in my portfolio is the S&P 500 fund. This fund is represented by the largest 500 publicly traded companies, and it serves as a very good indicator of how the economy as a whole is performing. If you think investing is too hard or you don't know where to begin, invest in an index fund like the S&P 500 or a total market index fund and you will likely be ahead of many people who try to outperform the market through buying and selling. I make this a large portion of my portfolio because it represents the market as a whole and traditionally it is a good diversified fund of large cap stocks. The rest of my portfolio is made up of a REIT fund and a valuable metals and minerals fund. I chose a REIT a while back because it is not normally heavily correlated with stocks (except in our current crisis when real estate caused the crisis), REITS are required by law to pay 90% of their income back to shareholders, and REITs are a low cost option to diversify into the world of real estate. REITs are also great to put into a Roth IRA (taxed on the way in, not on the way out) because the income returned and reinvested by the shareholders into the fund dodges what would be taxable income. The metals and minerals fund serves as a diversification fund that is not heavily correlated with my other holdings, and also serves as an inflationary hedge.

My portfolio is far from perfect and I would love to hear some comments on your recommendations. However it is a strategy that I created on my own that I follow and enjoy working with. And as I have said before, my returns are currently beating all the major indexes in the current economy so I am doing better than I would have by putting it all in the S&P and probably better than I would have turning my money over to an actively managed account with a broker. Some concerns that I have about my portfolio are that my funds have overlap. Some of my Emerging Markets holdings may be represented in my International fund or one of the other funds. I am sure the same holds true in most of my funds. This skews my actual percentages and naturally diminishes some of the diversification I am attempting to achieve. I also replicate some of my Roth funds in my non retirement holdings which alters my overall exposure to a certain asset class, segment, fund, or holding. I could probably track down funds with higher historical performance as well. However, all things considered with the time I put in I am fairly content with the strategy I have.
The chart above shows where my actual holdings are. They are off my ideal asset allocation based on a few factors. First reason is the gains and losses (mostly losses) over time. It also stems from adding new funds, and not investing up to the ideal amount based on IRA limits or lack of money. And finally it can become unbalanced due to a change in strategy. So what do we do about it? We can re-balance! Re-balancing is key to buying more when prices are low and less when prices are high alongside with another concept know as dollar cost averaging. Re-balancing is just what it sounds like. You are adjusting the amounts you have in each fund to return them to their ideal percentages. You can do this by shifting money from fund to fund, or by adding more to the lacking funds. Obviously you don't want to remove money from your retirement investments. As you can see, my REIT and Metals funds are the ones that are drastically lower than their ideal percentage. I like to look for the ones that are lower instead of ones that are over their ideal percentage because it forces me to add more money instead of just shifting money around. It makes the math a little more difficult but I just play with it in excel based on how much money I have to invest until I get close. Some people recommend re-balancing every quarter. I must admit that I typically do it around the end of the year or tax time as I am either putting last minute funds in to max out my contribution for the year, or I am putting money that I got back from my taxes into my next year's contribution (not a good habit as I should figure out my W-4 withholding and make that money work for me all year). The re-balancing shows you which funds have performed well since your last re-balance and which funds have not. When you buy more of the ones that have not to bring them to their ideal percentage you are buying when the fund is cheap. By buying less or none of the funds that are over their ideal percentage you are avoiding funds that are priced higher.

The other way to effectively buy low is through dollar cost averaging. Dollar cost averaging refers to investing the same amount each selected time period no matter how the market is performing. So if you invest $50 per month in each fund you will be buying fewer shares the higher priced they are and you will be buying more shares of the lesser priced funds. This is an excellent way to avoid timing the market while mindlessly, intelligently investing. I must say that I have not been dollar cost averaging as of late as I have been striving to reach another financial goal which requires more liquid assets. In this market I am actually making more on my money market anyway, but as a contrarian I want to take advantage of the sale the bear market has created. I have almost reached my cash equivalents goal and plan to start my dollar cost averaging habit again for my other investments.
The chart above shows what I described above. As you can see I added money to my REIT and Metals fund in order to get my percentages closer to the ideal state. I am expecting some money back from Uncle Sugar in taxes (again a bad habit I plan on breaking) and I will likely max out my Roth contribution for the year which is set at $5,000. I am sure if you Google asset allocation you can find a wealth of information out there, some good some bad and some that probably doesn't fully match all that I have told you. My advice as always is find what works for you. Is my method the most efficient and highest earning strategy in the world? Highly unlikely. But I am maxing out my Roth and learning a bit along the way and that is what truly matters. Like I said before please leave comments on my portfolio or request feedback on your own portfolio and start investing!

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