Author Topic: Asset allocation  (Read 7051 times)

Freestyler

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Asset allocation
« on: March 09, 2013, 03:24:19 AM »
I have been reading the blog and forum for a while now and this is my first post. I am a 34 yo Spaniard pursuing the virtues of Mustachianism and EREism.

Right now I hold a quite basic bogleheadsī style portfolio. We donīt have Vanguard funds over here and ETFs are not a great tool for really long term portfolios either (due to fiscal reasons). So I get by with "cheap" index funds (Amundi and Pictet, considerably more expensive than what I think Vanguard is in the US). Among the significant drawbacks of living in Spain (there are upsides also... just donīt know where they went) are the scarcity of good options to invest. The financial industry in Spain is not competitive at all and regulations for investment, saving and retirement just suck.

But letīs stop the "complainypanting" for now. Basically, I have a geographically diversified portfolio with 85% stocks (indexes) and 15% bonds. I chose this relatively risky distribution due to my also relative youth, my risk profile and to the fact that I thought bonds were overvalued at the moment. However, as time goes by and I am supposed to increase the allocation to bonds I find myself not being sure about the matter.

I guess my question is: if you have an allegedly eternal portfolio with a low enough withdrawal rate, why would you need more safety for? I mean, wouldnīt it be holding too much bonds just overpaying for that "false" sense of security that so much cost us in many other regards? With a big enough portfolio and a low enough withdrawal rate, why would we limit so much our expectations on return? Though I know the benefits of holding bonds in a diversified portfolio, itīs just hard to me to renounce to the extra return when I feel I otherwise have enough and reasonable security and stability.

I would love to read your opinions and also I would be very grateful if anyone could provide links or information that could help me make a more informed decision. Things like efficient curves and risk/return ratios with different allocations, etc. I already know firecalc.

Thanks for reading.
« Last Edit: March 09, 2013, 09:13:19 AM by Freestyler »

chucklesmcgee

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Re: Asset allocation
« Reply #1 on: March 09, 2013, 12:58:05 PM »
Quote
if you have an allegedly eternal portfolio with a low enough withdrawal rate, why would you need more safety for?

Good question. I assume by eternal portfolio you mean a portfolio which will maintain its purchasing power indefinitely even with routine withdrawals as interest will exceed withdrawal rate.

The issue is that there really aren't absolute eternal portfolios; the calculations which make a portfolio eternal depends on  assumptions of returns on the assets the portfolio is invested in. A portfolio isn't going to be eternal if the assets don't do as well as expected! The stock market may have returned an average of 7% or so in the past, but that's no guarantee of future results. Say we go into a major depression and the markets drop 50-80% for 10 years, your supposedly eternal portfolio might not be!

But that said, if you're young, you might as well keep it all in the markets. It's all a personal risk-reward calculation. Bonds are usually pretty safe, but you're right that you'd probably be giving up gains. On the other hand, if you wait until right before retirement to switch into bonds, it's possible we could hit a major recession and you'd have to either delay retirement or accept a lower standard of living. Some people suggest gradually transitioning to bonds as a person ages. That's all fine and good for a stable portfolio, but it also means that you'll need especially strong stock performance or larger annual contributions to be able to retire on time using this strategy.

Freestyler

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Re: Asset allocation
« Reply #2 on: March 10, 2013, 01:38:58 PM »
Thanks so much for the reply chucklesmcgee. I see your points. I am probably fooling myself or falling into a kind of "ambition" trap (what would I want more return for once I am assuming my portfolio will last forever and my lifestyle is going to be frugal anyhow?). I guess it all comes down to humanīs nature, in the sense that it is another form of seeking safety for me and my descendants. Also, since I donīt expect to totally discontinue money making activities any time soon I guess I feel less scared of short and mid-term portfolio performance.

As I see it, having more time, the change in lifestyle and the increased sense of freedom and empowerment are the good things of FI and early retirement. As an ophthalmologist MD and eye surgeon I mostly like what I do. However, I often would like to be able not to do it all the time, not to do it in someone elseīs terms or have more time and energy to pursue other interests. I donīt need so much to stop working very soon but to be able to decide more and feel less subordinated to others. Thus, I figured that over really long periods of time a higher proportion of stocks would benefit me more in the end than a higher one of bonds.
« Last Edit: January 26, 2014, 03:47:08 PM by Freestyler »

Nords

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Re: Asset allocation
« Reply #3 on: March 10, 2013, 03:31:28 PM »
But letīs stop the "complainypanting" for now. Basically, I have a geographically diversified portfolio with 85% stocks (indexes) and 15% bonds. I chose this relatively risky distribution due to my also relative youth, my risk profile and to the fact that I thought bonds were overvalued at the moment. However, as time goes by and I am supposed to increase the allocation to bonds I find myself not being sure about the matter.
I guess my question is: if you have an allegedly eternal portfolio with a low enough withdrawal rate, why would you need more safety for? I mean, wouldnīt it be holding too much bonds just overpaying for that "false" sense of security that so much cost us in many other regards? With a big enough portfolio and a low enough withdrawal rate, why would we limit so much our expectations on return? Though I know the benefits of holding bonds in a diversified portfolio, itīs just hard to me to renounce to the extra return when I feel I otherwise have enough and reasonable security and stability.
Most people use bonds to reduce the overall portfolio volatility.

However if you're living off interest/dividends, and if you can sleep at night through the volatility while holding a high equity allocation, then you have no reason to add bonds.  As long as the dividend is not cut then you probably don't care about the share price.

As you retire you may prefer to have a base income from a single-premium immediate annuity (or Spain's equivalent of Social Security).  You may also prefer to move from small-cap stocks and growth stocks into large-cap dividend-paying stocks which have a long history of conservatively being able to pay those dividends.  But you may also want to keep some small-cap and growth as well.

Much of my expenses are covered by my U.S. military pension (inflation-adjusted annuity).  Because of that reliable income we have over 90% of our investment portfolio in equities.  It's split among Berkshire Hathaway, a Dow dividend ETF (DVY), the iShares S&P600 Small-cap Value ETF (IJS), and an international value ETF (EFV).  You may be able to invest in those through a foreign exchange, or find your own European equivalent.

Kazimieras

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Re: Asset allocation
« Reply #4 on: March 11, 2013, 11:51:55 AM »
It is all dependent how much risk you're willing to take. Traditionally, bonds are considered safer than equities, especially when you look at in what order people are paid out in times of bankruptcy. The current situation with Europe and the global interest rates have killed this thinking for the time being. Think of bonds like a hedge on your risk. Bonds react inversely to interest rates, so they are your protection from interest rate changes. 5 years ago, for the previous 10 years in many cases bonds outperformed stocks since interest rates were falling, and bonds increase as interest rates decrease. With rates near zero in many cases (or where they are higher in cases such as Spain and Greece the countries may default) putting a lot of money into bonds right now doesn't make a ton of sense. Equities are doing well since contrary to what you hear in the news, most companies that survived the recent recession are doing very well now.

Freestyler

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Re: Asset allocation
« Reply #5 on: March 11, 2013, 05:59:56 PM »

However if you're living off interest/dividends, and if you can sleep at night through the volatility while holding a high equity allocation, then you have no reason to add bonds.  As long as the dividend is not cut then you probably don't care about the share price.

As you retire you may prefer to have a base income from a single-premium immediate annuity (or Spain's equivalent of Social Security).  You may also prefer to move from small-cap stocks and growth stocks into large-cap dividend-paying stocks which have a long history of conservatively being able to pay those dividends.  But you may also want to keep some small-cap and growth as well.

Much of my expenses are covered by my U.S. military pension (inflation-adjusted annuity).  Because of that reliable income we have over 90% of our investment portfolio in equities.  It's split among Berkshire Hathaway, a Dow dividend ETF (DVY), the iShares S&P600 Small-cap Value ETF (IJS), and an international value ETF (EFV).  You may be able to invest in those through a foreign exchange, or find your own European equivalent.
Those are all good ideas more or less in line with my thinking. Yes, we have "Social Insecurity" here in Spain, heading to social unrest and so on. Though I may qualify for that kind of a pension at some point Iīd rather take an alternative route since that implies paying so much more than you can eventually get, provided you are able to get anything. In fact, Iīd rather be able to manage my contributions to the system. However, thatīs not the case.

Iīll take a look at your suggestions, though both dividends and ETFs are heavily penalized from a fiscal standpoint and when compared to funds in Spain. Thatīs specially true for the accumulation phase when you want interest to compound without thievestaxes getting in your way before you more or less need to live off your portfolio.

I guess, Kazimieras, that when the tough times arrive I may have far less nerve than I am thinking. I am assuming though that after cycles are complete and provided I survive them in the most ample of senses, more stocks should yield a better overall return.

Marc

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Re: Asset allocation
« Reply #6 on: December 24, 2013, 05:33:01 AM »
Hi Freestyler,

I am living in Spain, and am wondering why you are saying that both dividends and ETFs are heavily penalized. Is there something else I do not see ? I understand that they are "only" taxed at 21% (both dividends and capital gains) or more, depending on the time you held the shares/ETF and potentially on your taxable income. Or is there any additional tax I do not see (well, I see the witholding tax for US ETFs, but you can reclaim it back the next year through tax credit if you had your W8B form filled) ? I buy VTI (equivalent to Vanguard VTSAX) for example on Selfbank.

Thanks for your answer,

Freestyler

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Re: Asset allocation
« Reply #7 on: January 20, 2014, 01:39:04 PM »
Hi Marc. I am sorry that I just saw your message.

When I say "heavily penalized" I refer to the fact that they donīt have a favorable taxation as funds may. Of course, everything is relative. As you say itīs 21% for the first 6000 euros and something like 25% (and 27%) for greater quantities. I donīt have the exact numbers in front of me and I donīt recall right now whether the law that put investments's earnings realized in less than one year under revenue tax (i.e. as high as 56% in the upper brackets) still holds.

With funds you donīt pay taxes if you sell them to buy another ("traspaso") which you do with ETFs. That may be a problem when balancing your (bogleheads) portfolio. So you are more likely to have to pay taxes at intermediate points with ETFs than you are with funds, which diminishes the returns due to compound interest.

Finally, it all depends on your strategy and style and though I had it very clear that funds were the way to go for me in Spain (no deposit fees and no taxes til the very end, as I am not planning to live out of investment income in a long while) now I am not that 100% sure.
« Last Edit: January 26, 2014, 03:50:23 PM by Freestyler »

Marc

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Re: Asset allocation
« Reply #8 on: January 24, 2014, 05:51:11 AM »
Thanks for your answer Freestyler.

ok, we are on the same page. For the moment, as I am beginning my financial journey to FI, I am putting almost everything in VTI. Simple, risky, but safe bet on a LT basis. In 3-4 years, plan to switch part of investment to REIT (or mostly buy only REIT instead of VTI to rebalance naturally the portfolio), and 3-4 years later add bonds.
not thinking of making much rebalancing sale and buy.

Out of curiosity, what do you mean by "funds" in Spain ? planes de pensiones ? or something else I am not aware of ?
I am putting some stash in the plan de pension, but the horrible fees they allow are almost killing the tax advantage they offer.

Thanks and my best,

Freestyler

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Re: Asset allocation
« Reply #9 on: January 25, 2014, 04:05:52 PM »
If you donīt do much rebalancing (or sells with benefits whatsoever) you should be OK as far as taxes go with ETFs. Another story is your strategy, whether you should in fact rebalance and other brokerage fees.

Funds are "fondos de inversión" which, as previously stated, have some tax advantages over ETFs in Spain as long term investments. The cheapest index funds are however significantly more expensive than the cheapest index ETFs. You just need to run the calculations depending on what you'd like to do.

Pension funds are indeed expensive and not good at all in Spain. I've been pretty happy with my Bestinver Ahorro, though. There's also an ING pension fund that replicates the SP500, and still others which track the European markets.


Further to that, see this thread on Bogleheads:
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=116038


Though I didn't read it all it looks to me they are discussing (maybe without mentioning it) around the concept of efficient frontier. That's why I donīt go all stocks. I would like to know, however, what asset allocation would yield the best long-term return... difficult, I guess.
« Last Edit: January 26, 2014, 02:27:30 AM by Freestyler »

Freestyler

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Re: Asset allocation
« Reply #10 on: January 26, 2014, 04:01:53 PM »
...

Though I didn't read it all it looks to me they are discussing (maybe without mentioning it) around the concept of efficient frontier. That's what I donīt go all stocks. I would like to know, however, what asset allocation would yield the best long-term return... difficult, I guess.

Give this thread over on FWF a look too: http://www.financialwisdomforum.org/forum/viewtopic.php?f=29&t=115906&start=25

FWIW, I'm at 60/40 equity/bonds and it is NOT because of risk aversion: I was entirely comfortable with 100% equity. I feel that high a bond allocation goes a long way to reducing volatility and increasing "end value" of a portfolio.

In the bogleheads forum they indeed post efficient frontiers at the end that I didnīt see at the beginning, hehe. Very interesting, though at the end and as couldnīt be otherwise itīs difficult to know whatīs going to happen in the future. We can only look into the past and try to have hints and calculate probabilities...

Thatīs alright: the theory says that an equity/bond allocation should outperform an all stocks portfolio even in return terms. The best mixture? We'll know in the years to come ;-).

Thanks for the links, cjottawa.
« Last Edit: January 28, 2014, 07:15:11 AM by Freestyler »

Freestyler

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Re: Asset allocation
« Reply #11 on: January 26, 2014, 04:47:49 PM »
Just run some simulations in cfiresim... Yes, bonds reduce volatility, however end return is on average (an on median) greater the greater the amount of stocks (to all stocks). I may need to revisit my notes on efficient frontiers and the like... In light of these simulations and considered my current plans I might as well go to an all stocks portfolio and not forfeit return anymore...

Freestyler

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Re: Asset allocation
« Reply #12 on: January 28, 2014, 03:29:50 PM »

http://www.norstad.org/finance/risk-and-time.html

While your gamble may pay off, I would strongly suggest you do not select an all-equity portfolio.

Thanks for the informative link.

However, the more I think about it (and the more I read and run the calculations) the more convinced I am to go for an all stocks portfolio. Even at the article you suggest:

"The only argument supporting the conventional wisdom that survives close examination is the one relying on human capital. Younger people with secure long-term employment prospects may in some circumstances have good reason to be somewhat more aggressive than older people or those with less secure employment prospects."

And itīs not only about age and traditional long-term employment prospects, but also about adaptability, as also predicated in both MMM and ERE. The simulations also imply that as long as you have a sound enough plan (big enough portfolio, low enough expenses ad so on so forth) the more stocks the better. Those scenarios are pretty much pegged to my personality, so like it or not I am likely to end up with a relatively high ratio of portfolio to expenses. Thatīs the true safety of my plan. Once thatīs provided it doesnīt probably make much sense to sacrifice return for more (and likely unnecessary) safety. I find thatīs the most rational approach that I can take given my personality traits and my utility (which is also mentioned in the article that you link).

While I agree that standard deviation increases with an all stocks portfolio risk (maybe may personal definition of it, more than the financial one) does not necessarily, provided you take under control some of the variables (those you can). In fact, with the conditions that I set Iīll be much better off with and all stocks portfolio. Under those conditions, while standard deviation increases... itīs at the expense of more return! That meaning that the worst results stay equal or better than with more bonds, while all the rest (average, median and best results) just skyrocket in comparison with blended portfolios.

Finally, I can die much younger and the world economy may meltdown. In those events I donīt think bonds are going to help me that much anyway and then... sometimes shit happens.

« Last Edit: January 28, 2014, 03:41:41 PM by Freestyler »

Kriegsspiel

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Re: Asset allocation
« Reply #13 on: January 28, 2014, 05:07:59 PM »
More food for your thought, Wade Pfau here lists out 50% drops in country's stock markets, and how long it took them to recover.

http://wpfau.blogspot.com/2014/01/greatest-hits.html

Freestyler

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Re: Asset allocation
« Reply #14 on: January 28, 2014, 06:04:13 PM »
More food for your thought, Wade Pfau here lists out 50% drops in country's stock markets, and how long it took them to recover.

http://wpfau.blogspot.com/2014/01/greatest-hits.html

Thanks. I specially like the 89 years' period in the Austrian market ;-).

However, my portfolio is fully (not 20 countries) geographically diversified, so I would say figures at least as "good" as the ones on the two last rows should apply. I am aiming at an at least 55 years portfolio (not planning to die anytime soon), so I should be OK.