My 1st Million At 33 – yes, you can do it too

Now that we’ve got the MPT out of the way, let’s get to the meat of any asset allocation plan: the asset mix. It’s the primary determinant of the portfolio risk and return and the one factor that you can control (the other one being luck).

For illustration purposes, I’m going to take a top-down approach where I will simply pick a number of asset classes and describe their risk/return characteristics. There is a complementary, bottoms-up approach where you answer questions like “What’s the maximum decline in a year you can tolerate?” and a computer model spews out a plan according to your target return, investment time horeizon, and risk toloerance. For a good example, see this questionair from Index Fund Advisors: http://www.ifa.com/SurveyNET/index.aspx.

Starting Point
The two major asset classes that everyone knows about are stocks and bonds which I’ll address here. REITs, other income trust, and commodities will be discussed in the next part of this series. Stocks (used here interchangably with equities) are more risky but has a long term return around 10% per year (basis S&P), or about 3% higher than that of bonds. The old rule of thumb would have you keep “100 – your age” in percentages in equities. That is, 70% stocks for someone 30 years old. Nowadays, this rule is wildly considered to be too consertive (i.e. the equity portion too low), perhaps a consequence of the bull market of the 90’s and the need for return for older Americans. Since everyone’s situation is different, there cannot possibly be a one-size-fit-all solution. So I’ll use what I do personally as an example. At any rate, I hope this series enable you to make your own decision.

As I mentioned before, my wife and I are in our early thirties. My appetite for risk tolerance is rather high, but more than adequately satisfied by the actively managed portion of my portfolio; therefore, I settled on a standard 30% bond 70% equities weighting. When constructing my own asset allocation portfolio, I was heavily influenced by Paul Merriman’s website FundAdvice.com. This is his recommendation for allocating the equities portion:

Shown above are two Morning Star style boxes for mutual funds/ETFs. Each style box contains 9 variations depending on the market capitalization of the targeted stocks and growth/value orientation of the fund. The check marks represent Merriman’s asset mix which is a modified “four corners” approach. As the name suggests, the “four corners” approach calls for allocations in large growth, large value, small growth and small value to take advantage of the lack of correlation between large and small cap, growth and value (Recall from the previouspost that lack of correlation of assets in the portfolio enhances the risk adjusted return.). Merriman’s plan contains a value bias as the large and small blend replaces the large and small growth components. This bias was justified by another seminal work called the “Fama-French three factor model” that quantified additional contributions to portfolio return from value stocks and small cap stocks. Merriman assigns equal weighting to each of the four selected boxes in his model portfolios and I saw no reason to deviate.

The same style box is applied to international equities, although note that Merriman is referring only to the developed foreign markets above. There is actually a fifth element: emerging markets, so that in his model portfolio 1/5 of the weighting in international equities is assigned to each of the four checked boxes plus emerging markets.

In the fixed income arena, Merriman’s advice can be summed up as, “keep it short”. Here “it” here refers to bond maturity. He used the following figure to show that “the longest maturity you needed in order to achieve high bond returns was five years. And it shows you that in this 40-year period, one-year Treasury bills gave investors nearly 95 percent of the return of five-year Treasury notes, with much less volatility.”

In Merriman’s model portfolios, there’s an equal split between short term (1-3 yrs) treasures and corporate bonds.

Asset allocation plans found around the web
Here’s a short description of things I found around the web. If you have something to add to this list, please leave a note in the comment section.

http://www.fundadvice.com/portfolio.html

Paul Merriman’s model portfolios using Schwab, Vanguard, Fidelity, T. Rowe Price funds or ETFs. No REITs or commodities.

http://www.ifa.com/portfolios/

Index Fund Advisor’s portfolios using DFA funds. Has REITs, no commodities.

http://www.radicalguides.com/2005/06/radical_guide_t_41.html

An ETF based asset allocation plan, part of a very well written guide to investing. Has REITs, doesn’t have commodities and otherwise not (quite) enamored with sector ETFs. Tries to cover the entire domestic stock and bond markets.

http://www.thepeaches.com/investing/ira.htm

What do you know? A fellow fan of both Paul Merriman and Jim Rogers! An AA plan using mutual funds.

http://www.thepeaches.com/investing/ira2006.htm

A similar plan to the one above, using mostly ETFs.

http://randomroger.blogspot.com/2006/01/model-etf-portfolio.html

Random Roger (Roger Nusbaum, a money manager with a great blog) discusses a model portfolio from Agile Investors that includes commodities and energy MLPs. Heavily tilted towards Japan.

http://moneycentral.msn.com/content/P128314.asp

Tim Middleton from MSN Money regularly writes about his model ETF portfolio. No REITs, includes IGE.

http://moneycentral.msn.com/content/P128311.asp

A portfolio using Vanguard funds that’s very similar to the ones from Index Fund Advisors.

http://theassetadvisor.com/portfolio.html

A portfolio that tries to cover all bases using mutual funds.

In the next section we will fine tune the allocation plan by looking at income trusts and commodities.