ITA Wealth Management

Asset Allocation refers to the diversification or the allocation of investments within a portfolio across asset classes or market sectors.  I favor diversification across a minimum of 10 asset classes vs. using market sectors as I think it provides for superior diversification.  For example, one could allocate various percentages of their assets to each of the following asset classes: Large-Cap Growth, Mid-Cap Growth, Small-Cap Growth, Large-Cap Value, Mid-Cap Value, Small-Cap Value, REITs, International (developed) Markets, Emerging Markets, Bonds, Commodities, etc.  Academic studies show that, on average, over 90 percent of the variability of a portfolio’s performance over time is solely attributable to the portfolio’s asset allocation.  This comes out of the Brinson et. al. papers.  That material has been moved over to the Premium Content side of this blog.  Further, on average about 100% of the level of a portfolio’s total return is due to asset allocation.  These results come from the Ibbotson & Kaplan research.  Different research papers answer different questions. Therefore, the asset allocation decision is by far the most important in the financial planning process and it should be the first plank in your portfolio construction plan.  Here at ITA Wealth Management, we consider asset allocation to be fundamental in the investing process.

Lowell Herr

Photograph:  Image is found just above the entrance to the Benedictine Abbey at Melk, Germany

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For long-term investors, now is a good time to check the asset allocation mix of your portfolio.  If you have five to ten years to go before you need any of your investments, stick with your plan.  Continue to save as much as you can as early as you can.  Save on a weekly or monthly basis rather than investing a chunk once a year.  In other words, save from every paycheck.

Check to see if your asset class percentages are within the target limits.  If not, begin to add to the asset classes that are below target by the greatest percentage.  This is an excellent practice for those adding to the portfolio on a regular basis.

There are situations when it is time to change the asset allocation plan.

• Has your aversion to risk changed?  Is your risk tolerance not as high as you imagined?  If so, you may want to move some assets into more conservative vehicles.  Here is a first approach.  Go back and retake the Risk Capacity survey on the IFA web site.  You may find your risk number is lower now that we are in a bear market.
• Will you need living money within the next five years?  If so, you may want to readjust the asset allocation of the portfolio.
• Using the Quantext Portfolio Planner, you find that you will not need all the money you have saved.  For those who have yet to use QPP, there is a section of the program that takes your assumptions and runs a projection of how long your money will last.  Given this information, you may wish to alter your asset allocation.  The QPP is a great aid in helping with this future planning.

This has definitely been a severe bear market so investors may not have as much stomach for risk as they thought they had when the market was rising. Don’t be too quick to change your asset allocations.  In other words, don’t “go conservative” unless you have good reasons for doing so.

Photograph:  Lighthouse on Kauai, Hawaii

I am investigating software that will aid in the development of portfolio asset allocation, reduction of risk, and give some insight into what asset classes to emphasize in the coming year.  Look for more information beginning sometime around the middle of November.  There is a high probability a new portfolio will be launched using these additional asset allocation tools. Specific details will be made available to Premium Content subscribers.

I just finished building a spreadsheet using the asset allocation targets of the Passive Portfolio.  The projected return is 11.8% with a standard deviation of 8.75%.  The S & P 500 is projected to return 8.3% with a standard deviation of 15%.  While I don’t expect to see anything close to an 11.8% return next year, I do like the fact that the SD is lower than the S & P 500 due to broad diversification.

Lowell Herr

Photograph: Venice, Italy

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Do you have the stomach to stay with equity investments or are you fleeing to CD’s, treasury bills, or cash?  For those who do not need the money over the next three to five years, I recommend sticking with your asset allocation plan. Take dividends and other available cash and begin to shore up asset classes that are under target.  I would not be in a hurry to do this as the broad market is likely to be in a “funk” for another year.  Examine the StockCharts for asset classes of interest and carefully pick your buy-in points.

The current “rescue” plan does not adequately do the job.  One economist I respect said the bill that was voted down in the House was superior to the bill passed in the Senate.  One can only hope that additional spending measures will be placed on the back burner until the financial conditions of the country are turned in another direction.

The various portfolios are being upgraded over on Premium Content.  The youngest portfolio, Scrappy, was the latest to be updated and it is outperforming the VTSMX benchmark by over 40%.  We do not pay much attention to these numbers other than to look for trends.  Keep in mind that the younger the portfolio the more the Internal Rate of Return numbers will change from day to day.

The AA-Mosaic and Mosaic2 are also current so take a look at those spreadsheets.  Thus far, only the Mosaic2 portfolio is lagging the VTSMX benchmark.

Lowell Herr

Photograph: Shanghai, China

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The oldest portfolio built around asset allocation continues to perform much better than the VTSMX benchmark.  As of 9/26/08, the Passive Portfolio (PP) has an IRR of 5.1% over the past seven plus years.  During that same period, the VTSMX benchmark has a positive IRR value of 1.9%.  Keep in mind that this period spans one of the worst bear markets in history and the recover has been modest at best.

All the details for the PP are available to Premium Content clients.  One can download the portfolio and view all the transactions since 12/01/2000.

Lowell Herr

Photograph:  What is better than a cup of coffee in the woods in Central Oregon?

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Later this morning I will be posting a new data table on the portfolio performances.  Since September 17th, when I last showed the performace data, nearly all of the seven portfolios improved in an absolute sense, and they also improved with respect to the VTSMX benchmark.  These are encouraging results in light of this bear market.

The data will be made available over on Premium Content in a few hours.

Lowell Herr

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With all the market volatility over the last few days, now is a good time to check the asset allocations of your portfolio.  If the asset classes were close to target a week ago, there likely will not be any changes.  However, value and REIT asset classes are holding up better than growth and international so some shifting in the portfolio is likely.  The +/- 35% band provides considerable cushion against rebalancing.  Nevertheless, make a quick check using the Thomas/Lalla/Herr spreadsheet.

If any rebalancing is required, make every attempt to do it with an infusion of new cash or dividends rather than selling off any ETFs, stocks, or index funds.

If you happen to have more than one asset class below the 35% lower limit, take a look at StockCharts to see if the technicals are of any help.  I’ve discussed this in more detail over on Premium Content over the last few weeks.  If you have access to PC, click on the Technical Analysis link.

The StockCharts graph is set to view the Mid-Cap Growth ETF, VOT.  Type in the ticker of each asset class you are holding to see if any are showing RSI values below the 30% level.  Then look to see if the MACD is negative or positive.  Last, check the Chaikin graph to see if it is positive or negative.

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Lowell Herr

Photograph:  Alpenrose Velodrome Time Trials

Even though our commodities ETF (GSG) is in a swoon, we want to maintain our target in those portfolios that include this asset class.  Check out this article which provides support for our position.  For those of you who have read Roger Gibson’s book, remember how commodities rarely led the four major asset classes, but when it did it made a major impact on the overall portfolio performance.

To review Gibson’s four-factor model, you will recall he use the S&P 500, EAFE, NAREIT, and GSCI for his four indexes over the 27-year study.  Commodities (GSCI) had 5 first-place finishes while International (EAFE) and REITs (NAREIT) had 7 and 10 first-place finishes respectively.  By comparison, the S&P 500 also came in first only five times.

What is interesting in the Gibson study is that a four-factor model ends up with a better return/volatility ratio than any one, two, or three-factor model.  Diversification works whether or not you want it to.  Do a search for Information Ratio to learn more about the return/volatility ratio.

In our seven portfolios, we take the multiple factor model to a new level as we hold a minimum of eight (and usually higher) different asset classes.

Going back over Gibson’s material, I see where he recommends one not hold less than 5% in any asset class.  We have 3% set for some of our asset classes so that may require another look.  The idea is that if one does not hold at least 5% in an asset class, whatever that asset class does, it will not have a significant impact on the overall portfolio.  When Gibson ran his four-factor model, he placed equal percentages in each of the four asset classes.

Coming back to the original argument, do not abandon commodities even though they are in a correction faze.  Stay the course and be consistent with your asset allocation strategy.

Lowell Herr

Photograph:  Villefranche, France

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The following information is normally published on Premium Content, but today I thought I would show the data for the seven portfolios under management.  In the last four portfolios, beginning with AA-Mosaic, the portfolios are young and still under construction.  Don’t pay much attention to the percentage figures as the IRR values are exaggerated due to the short time in existence.

The Passive Portfolio (PP) is coming up on its eighth birthday at the end of November.  This portfolio received an infusion of new cash and that has yet to be recorded.  Depending when that cash was inserted, the IRR value for the VTSMX benchmark will change.  I do have Risk data for this particular portfolio, and as you will recall, it is very low.  The Information Ratio for this portfolio is unusually high, a very good sign of a well managed portfolio.  The asset allocation percentages are available upon request over on Premium Content.

Colter is an older portfolio that went through the transition of moving to ETFs from an entirely stock portfolio.  Before this move, the portfolio was trailing the VTSMX benchmark.  Here is partial proof that index investments and asset allocation work to the advantage of the small investor.

The AEM portfolio, nearly two years old, is the one portfolio that is balanced between value and growth rather than tilting the assets toward the value side of the equity spectrum.  This portfolio also holds a small position in bonds.

The remaining four portfolios are all less than a year old.  Hence the exaggerated IRR values.  The one relative disappointment in the group is the Mosaic2 portfolio.  It is the only portfolio not outperforming its benchmark.  This portfolio has been hurt by the dip in international (developed) and emerging markets. It will take considerable care to get this portfolio performing at a level higher than its benchmark.

Looking at the infant portfolios, one can tell what a mess the market has been over the last ten months.

Portfolio Performance

Lowell Herr

Photograph: Celebrity Cruise Line logo

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Investors will find the Asset Allocation Performance Spreadsheet of interest.  Move to the right-hand edge of this page, scroll down to Links and click on the second option.  Download the Asset.xls spreadsheet.  If you have questions, post them in the Comments section of this entry.

The spreadsheet includes data on eight different asset classes beginning in 1989. Be sure to check out all three worksheets.  The first includes the RAW data.  Performance shows how the asset classes rank from year to year and the third worksheet shows the “Horizontal Performance” or how well each asset class performed over the period studied.

Lowell Herr

Photograph:  Mark Twain sculpture

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