After spending some time getting to know your risk profile (Asset Allocation Step 1), you should have a much better idea of an appropriate equity/bond split for your portfolio. Now we can move on to the second step of the asset allocation process: breaking down the equity and bond portions of your portfolio. During this step, once again, your priority should be to develop an asset allocation plan that you can stick with in good times and bad, not simply to maximize your expected returns. With that in mind, let’s dive in.
First, add international stocks to your investment mix. Companies outside of the US represent more than half of the value of global equity markets. Although international investing introduces additional risks (e.g., varying exchange rates, less predictable political and social climates), investors have historically been compensated for these risks in the form of higher returns. Modern Portfolio Theory tells us that by adding a volatile asset class that doesn’t move in lockstep with the rest of our investments, we can increase our portfolio’s risk-adjusted return. This diversification benefit is maximized with an international allocation of 20-40% of your equity portfolio.
Next, consider adding Real Estate Investment Trusts (REITs). The unique structure of REITs allows individual investors to own a small piece of income-generating commercial real estate properties like offices, malls and apartments. REITs also exhibit low statistical correlations with the other asset classes in your portfolio, so they offer a great diversification benefit. To learn more about this unique asset class, see my post entitled REITs Belong in Your Investment Portfolio. In my opinion, it’s reasonable to allocate 5-15% of your equity portfolio to REITs.
Finally, you should consider adding additional small company and value exposure to your US and international equity portfolios. Investors have historically been compensated for the risks inherent in small company investments, and value stocks, or stocks that trade at low levels when compared to fundamental metrics, have traditionally produced better results than their more glamorous “growth” counterparts. That being said, if you’re not familiar with the arguments for overweighting these equity segments, it would be wise to steer clear of them in favor of simplicity.
There are a couple of ways that you can expand your bond allocation beyond a typical sampling of the US Bond Market. First, you can add Treasury Inflation-Protected Securities, or TIPS. TIPS are unique because, unlike traditional bonds, their principal adjusts with the rate of inflation, so they offer a government-guaranteed rate of return above inflation when held to maturity. In addition to protecting your portfolio from unexpected inflation risk, TIPS are also exempt from state and local taxes, and they offer a great diversification benefit in a portfolio context.
For investors in higher tax brackets, municipal bonds should also be considered in taxable investment accounts. These bonds are typically issued by state or local governments, and are often tax-exempt at the federal level for all investors and at the state level for those in the issuing state. In order to determine whether municipal bonds make sense in your taxable account, compare their yields with the after-tax yields of traditional bonds (yield * (1-tax rate)).
Portfolios can be sliced and diced in any number of ways, but a more complex portfolio is not necessarily a better one. Wise investors understand that the single largest determinant of their investing success will likely be their ability to maintain a risk-appropriate asset allocation, and for that reason, they err on the side of simplicity. Next time, we’ll discuss the final step in the asset allocation process: implementing your plan.
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