How I Developed My Diversified Index ETF Investment Portfolio Part 2: Asset Allocation

In a recent post I discussed some of the reasons for diversifying your investment portfolio, and in this post I’m going to talk about how I put my ideas into practice with my investments.

The most basic decision to make is what to invest in, and aside from some cash savings I decided to invest 100% into the stock market, because I have a long time horizon and want to maximize my returns, something which I don’t think investing in things like bonds will allow me to do.  The best way to diversify your stock portfolio, in my opinion, is through index funds or index ETFs, because they provide low-cost exposure to many different securities at once.  But how much diversification is optimal and how should you go about doing it in order to maximize return while minimizing risk and volatility?  Nobody really knows, but in the following sections I’ll go through how I came up with my asset allocation, in a qualitative way.

The first decision I had to make was how to allocate my portfolio based on market capitalization.  When I came up with this strategy, I based my decision on a document by Morningstar which doesn’t appear to be available online anymore, but some screenshots are available here.  Basically, this Morningstar research piece analyzed the historic risk and return of portfolios with different allocations towards small and large cap stocks, and found that the highest return (between 1975 and 2005) was produced by a portfolio 100% tiled towards small caps.  This information is widely circulated and corroborated on the internet (The Motley Fool says that small caps have outperformed large caps by an average of 2.3% per year from 1926 to 2006), but the interesting thing about the Morningstar document is that they showed that a portfolio with a 40% large cap/60% small cap allocation carries the same risk as a portfolio 100% tilted towards large caps, while still producing an increased return.  This sounds pretty good to me and is where I came up with my allocation towards market capitalization, which is 60% small cap, 40% large cap.

It has been a few years since I have started using this strategy, and in that time my small cap fund has outperformed my large cap fund all the time except for in the last few months currently in 2017.  However, even though on average small-cap stocks have outperformed large-cap stocks since 1926, there are periods of underperformance (The Motley Fool gives 1984-1999 as an example) as well, so one of the keys to this strategy seems to be to have a long investment horizon, which I do.  There are also various arguments against this strategy, one of which being that small-cap stocks may not outperform large-caps if dividends are taken into account.  I haven’t found this to be true myself, though-my main large-cap fund, SCHX, yields 1.81%/year while my small-cap fund, SCHA, yields 1.46%/year.  That’s a difference of $35 for a $10,000 investment, which can easily be made up with just a 0.35% difference in performance.

The next decision I had to make was how to allocate between domestic (US) and foreign funds.  Vanguard has published a document entitled ‘Considerations for investing in non-US equities’, in which they argue that the logical approach would be to allocate based on market capitalization, an approach which would result in 54% exposure to international stocks.  Later on in the document, they make the case that real exposure should be less than this due to home country bias, an argument which seems to be backwards-to me, home country bias is the reason why most people have lower international exposure, not an argument for favoring domestic stocks.

However, Vanguard does also provide some logical arguments for an international exposure of between 20-40%.  First of all, they conclude that overall portfolio volatility (a measure of how prone an investment is to changing value dramatically) is reduced by allocating up to 40% of ones portfolio to international investments.  They also give a reason for why international exposure should lead to increased returns, which is that it allows the investor to participate whichever markets are outperforming around the world, leading to a higher average return overall.  Conversely, by diversifying across regions, losses will be limited when certain regions are under performing.

Investopedia analyzes the problem as well, concluding that the benefits of international investing include increased diversification and the potential to increase total return.  However, they also conclude that in recent times, international investments have outperformed during bear markets without reducing volatility, while during bull markets they have performed similarly to domestic investments.  High volatility investments are prone to changing value more dramatically, and therefore more risky, but as a long-term investor this is basically a non-consideration for me.  Therefore the Investopedia article seems to suggest that international exposure would generally increase my returns over time.

One good reason why not to invest in international funds is that they are generally more expensive, but these days we are living in an era of ultra-low-cost funds.  SCHX, a Schwab commission-free domestic large-cap fund has an expense ratio of 0.03%, while SCHF, the equivalent international fund, has an expense ratio of 0.06%.  This is twice as much, but still peanuts and easily made up by even a slight outperformance in the international fund.

Finally, a search around the forums seems to corroborate the fact that nobody seems to know how much to invest in international funds.  Therefore I decided to go along with the general consensus and start with 20% in international stocks.

The last factor I considered in developing my allocation is emerging markets.  A commonly cited reason for why to invest in them is that they tend to be weakly correlated to US markets.   This leads to increased diversification and decreased volatility in the overall portfolio.  However, emerging markets tend to be fairly volatile in and of themselves due to political and currency risk, but I am interested in capturing some of this volatility and risk in order to capture potential swings to the upside.

Even though I am interested in capturing some of this upside potential, there is also of course the potential for a swing to the downside.  Once again, with a long investment horizon, this is less of a concern, but given the much greater risk/volatility, it’s probably best not to get too crazy.  Emerging market companies make up about 8% of the total world stock market, and a figure I have seen thrown about often on the internet is to invest about 5% in emerging markets.  Again, I decided to go with the majority and invest 5% in emerging markets.

So now all that’s really left to do is to work out the final percentages.  If I invest 5% in emerging markets, 95% is left for developed markets.  This is then divided based on region and market capitalization as follows:

0.8*0.4*0.95 = 30.4% domestic large-cap
0.8*0.6*.95 = 45.6% domestic small-cap
0.2*0.4*.95 = 7.6% international large-cap
0.2*0.6*.95 = 11.4% international small-cap
5% emerging markets

When I decided how to allocate my investment portfolio, I tried to go about it as rationally as possible, but for every argument I found to diversify in one way, I found 5 counter-arguments, making it difficult to come up with a logical, scientific portfolio allocation.  At the end of the day, almost as important as deciding on how to allocate your portfolio is sticking with your strategy, no matter the market conditions, which I have been doing over the past few years by re-balancing my portfolio around every 6 months or so.

I have been using this asset allocation for at least a few years, so what do I think about it currently?  I am satisfied with my decision, but I think that I could probably increase my international exposure and also possibly reduce my exposure to large-cap stocks.  Since non-US stocks make up something like 54% of equities, it just seems rational to allocate more to international funds, especially given the fact that the European economy seems to be improving and the value of the dollar is falling.  And as far as large-caps go, Schwab recently did an analysis where they advocate a bias towards large-caps.  It’s a rather technical analysis, but one of the main takeaways is that small-caps tend to outperform early in the economic cycle, while we are currently already several years into a bull market.

Perhaps this was a bit of a rambling post, but what do you think of my analysis?  How do you allocate your stock portfolio?

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