Tuesday, October 30, 2012

Asset Allocation For Income Investors

When to buy a stock and at what price are very important decisions. However, serious investors will tell you the most important decision is how you allocate your assets. As I approach retirement, I routinely step back consider my asset allocation and how well it is working for me.

The first significant question you have to answer is how much do you allocate to equities and cash/fixed income. There are many approaches to answer this question, but the vast majority of investors use one of these two approaches:
I. Fixed Income % = Age
This approach by far is the most popular among conservative investors. One of its most prominent proponents is Vanguard Group's founder John Bogle. It is very simple to implement. Each year year you increase your allocation to cash/fixed income one percentage point to match your age and decrease your equity allocation one percentage point.

II. Equity % = 120 - Age

Many of the more "aggressive conservative" investors choose this approach. The theory here is that equities have out-performed fixed income historically and this formula keeps you in a higher percentage of equities over your life cycle. Using this formula, you would have no fixed income allocation until you are 21 years old. It too is easy to implement; simply subtract your age from 120 and the resulting amount is the percentage that is allocated to equities with the remainder going to cash/fixed income.
For my allocation, I chose to implement option II. However, given the low interest rates and the certainty of higher interest rates in the future I have reduced my bond allocation to a bare minimum. As a reminder, interest rates and bond prices have an inverse relationship - as rates rise bond prices decline.

After determining your equity/fixed income split. The next step is to decide what type of investments belong in the equity portion of your allocation. Traditional splits are based on capitalization (large/mid/small cap), origin (domestic vs. international) and sectors such as financials, healthcare, energy, etc. I chose a mixture of all the above. I look at 11 sectors as defined by Morningstar. In addition, I look at origin and capitalization. I review my allocation on a quarterly basis.

You will notice the targets are not clearly defined. After much modeling back in 2009, I finalized my allocation. As I am apt to do, I put together an Excel model (D4L-Calc-Asset-Allocation.xls) for illustrative purposes of modeling my asset allocation over time. You may want to use it as a starting point for developing your asset allocation. Here is a quick overview of how to use the model:

Input Section
  • Year of birth: What year were you born?
  • Fixed/Cash Status: Enter 1 (age) or 2 (120-age) here to select one of the two fixed income options described above.
  • Age Override: Let you see what your allocation looks like at any age.
  • Equities-Domestic: Percentage of the equity portion allocated to Domestic Equity
  • Equities-International: Percentage of the equity portion allocated to International Equity
  • Employer Equity: Percentage of the equity portion allocated to Employer Equity
  • Small/Mid-Cap: Percentage of the equity holdings allocated to Small/Mid-Cap Equity
The sum of Equities-Domestic, Equities-International and Employer Equity should equal 100%. The sections in the model below the Input section calculate the allocation percentages. For example, given that I am 50 years old, the Asset Allocation - Origin section calculates as follows: My allocation to equities is 70% (120-50), leaving 30% (100-70) to cash/fixed income. Equities-Domestic is 38% (70% x 53.3%), Equities-International is 23% (70% x 33.3%) and Employer Equity is 9% (70% x 13.3%).

Looking at the Asset Allocation - Capitalization section, Cash/Fixed Income at 30% and Employer Equity at 10% are as calculated above. Small/Mid-Cap at 15% is input, leaving Large-Cap as a plug to make the section total to 100%. Periodically, you will need to reevaluate the appropriateness of the Small/Mid-Cap allocation since it does not automatically adjust annually.

Let's consider some sample investments that would fall into each of these categories:

Cash/Fixed Income:
  • Money Market Accounts, CDs, Savings, etc.
  • Vanguard Long-Term Bond ETF (BLV) | Yield: 4.1%
  • Vanguard Intermediate-Term Bond ETF (BIV) | Yield: 3.5%
  • iShares Investment Grade Corp Bond ETF (LQD) | Yield: 3.9%
Equities-Domestic (U.S. for me):
  • S&P Index ETF (SPY) | Yield: 2.0%
  • Johnson & Johnson (JNJ) | Yield: 3.4%
  • The Coca-Cola Company (KO) | Yield: 2.8%
  • 3M Co. (MMM) | Yield: 2.7%
  • iShares MSCI EAFE Index (EFA) | Yield: 3.2%
  • Vanguard Emerging Markets Stock ETF (VWO) | Yield: 3.4%
  • Vanguard FTSE All-World ex-US ETF (VEU) | Yield: 5.1%
  • Vanguard Total World Stock Index ETF (VT) | Yield: 3.3%

The securities listed above under Equities-Domestic are all Large-Cap.

  • Vanguard Small Cap ETF (VB) | Yield: 1.2%
  • Vanguard Mid Cap ETF (VO) | Yield: 1.2%
  • Genuine Parts Co. (GPC) | Yield: 3.2%
  • Clorox Corporation (CLX) | Yield: 3.6%
  • Piedmont Natural Gas Co. Inc. (PNY) | Yield: 3.8%
Employer Equity:

Obviously, this would include stock in the company you work for. It would also include stock options, SOSARs (Stock Only Stock Appreciation Rights) restricted stock and company match stock in your 401(k).

As Charlie Munger, Warren Buffett ’s long-time friend and partner said, "Allocate assets wisely. Proper allocation of capital is an investor’s No. 1 job."

iShares MSCI EAFE Index (EFA)

Full Disclosure: Long JNJ, KO, MMM, GPC, PNY in my Dividend Growth Portfolio and VWO in my International Portfolio. See a list of all my dividend growth holdings here.
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