Asset Allocation

So let's talk asset allocation.  Asset allocation basically means attempting to balance risk and reward by apportioning your portfolio's assets among different investment categories in accordance with the individual's goals, risk tolerance and investment time horizon.

When you talk about asset allocation, you're generally talking about three different types of investments - equities, bonds, and cash.  From there, things get complicated.  Within equities, you can break it down between U.S. and international and also between large-cap, mid-cap and small-cap (which is another way of referring to the size of the companies that you're investing in) and also between growth and value (I'll talk about the difference between growth and value in a later post).

For bonds, you can generally further break things down by duration (or the time until the bonds are due) - long-term, medium-term, short-term - between government and corporate bonds and also by quality.  Are the bonds that you're investing in investment grade or more speculative "junk" or high-yield bonds.  Also within bonds, you can invest in bonds issued by international companies or other countries and also in municipal bonds - bonds issued by U.S. state and local governments - which have special tax characteristics.

It's generally easiest to talk generally in terms of the general allocation between stocks and bonds, and the general rule of thumb is that the more risk tolerant you are and the longer the time horizon until you will need the money that you'll be investing, the higher the allocation to common stocks that you should be using.  Over time, equities have outperformed bonds, but tend to be much more volatile in the short run (although not always).  While bond prices can move up and down, particularly with changes in interest rates, those movements don't tend to be as extreme as those for common stocks.

Now, to level set generally on my perspective, I'm generally a fairly risk tolerant person and have a fairly long investment time horizon.  I'm probably around 15-20 years until retirement, depending on PowerBall.  So in general, asset allocation theory would tell you I should have a fairly large allocation to equities / stocks.

So, with that general background, back to my initial project of comparing my investment adviser portfolio with my robo-adviser portfolio.  One of the first ways of understanding the differences between the two is to look at the differences in asset allocation.

So here is the breakout of my investment adviser account:

Cash - 4.9%
Equities - 58.7%
Bonds - 13.2%
Alternatives - 23.1%

Alternatives?  Wait a minute Joar!  What the hell is that?  That wasn't on your list above.  So some of what my investment adviser lists as "alternatives" are really what are called Master Limited Partnerships and is really just another form of equity, so a chunk of this should just be in the basket listed as equity.

However, about 15.6% of my portfolio is in hedge funds.  Yes, I'm one of those assholes.  These are typically designed to move differently than the market as a whole, so providing some downside protection and possibly additional upside.  I'm still honestly not sure that I like having that percentage of my portfolio in that kind of vehicle, but it's been working as intended so far.  Not something I'd recommend for the average investor (and honestly, not something that's actually generally available to the average investor).   But it is there, so as part of this little experiment, we'll see how it contributes to overall performance compared to my robo-adviser.

If you were to further break-down the equity side of things, I'm about 83% large cap, 7% mid-cap and 10% small cap.  It's also about 30% value, 44% growth and 26% of what Morningstar defines as core.   Also, about 13.3% are actually foreign stocks or foreign stock mutual funds.   Most of the bond holdings are short term in nature (mostly to avoid the impact of expected increases in interest rates).

Now, for my Robo-Adviser.  Here is what they came up with as the initial allocation.  In general, based on my goals, they recommended 90% in stocks, and 10% in bonds.  Makes sense so far.

The break-out on the stock side is about 76% large cap, 20% mid-cap and 4% small cap, so a smaller allocation to large cap and small cap and a larger allocation to mid-cap than my adviser.  It also breaks down as 41% value, 24% growth and 36% core, so a much larger slant towards value stocks.
Also, a whopping 53.4% of the allocation on this one is to international stocks, so a much larger portion than my investment adviser.

Finally, on the bond front, while it's a smaller allocation than my adviser overall, it has a bigger chunk in longer durations, with 55% of it being moderate duration, high credit quality.

So that's where they are different.

Next week, I'm going to talk a bit about the significant drops in the market in the first part of 2016 so far and how I'm thinking about that as a longer term investor and whether it's having any impact on my investment strategy.

A Comparison of Approaches

So I had floated the idea around the holidays of doing some kind of blog series comparing a couple of different investment approaches.  One of the things that created some interest for me in doing this is the appearance on the scene of a number of "Robo-Adviser" type services.  These seem to be trying to fill a niche between a complete do-it-yourself, low cost approach, and the high cost of using a fully managed portfolio with an investment adviser.

Now, as a little bit of background with respect to the experiment that I'd like to launch, I'm one of the folks currently using the Private Client group of a full service investment adviser to manage a significant portion of my portfolio.  It depends on the particular portions of my portfolio, but in general, I'm paying a fee of around 1% of my total assets.  I'm using an asset allocation approach that they recommend and that I'll explain here.  

When you look at one of these automated adviser type services, the fees that they charge can be significantly less than what I'm currently paying my adviser.  They also come up with recommended asset allocation strategies, will handle rebalancing for you, and are investing primarily in very low cost ETF index funds covering a variety of asset types.  For the handful that I looked at, the average annual cost seemed to range from 0.15% to 0.25% (note that this is on top of the fees charged by the underlying mutual funds, but with low cost Vanguard ETF's, this is only around an additional 0.1%.  So that's a significant savings over what I'm paying now.

So what I wanted to find out is, am I actually getting better returns and a better asset allocation for the extra 0.75% that I'm paying each year.

So I'll be running a live real-money experiment here for the next couple of years.  I've put money into one of the "robo-advisers".  I currently expect that I have between 15-20 years until retirement, so I've selected retirement and that time horizon as my savings goal, and the program came up with an asset allocation based on those plans (which I will talk about in a future post).

What I plan to do here is to record the returns each month for my full service investment adviser versus my low cost robo-adviser and see how they compare.  I'll be using the actual account values for these calculations so this will reflect the "after-fee" returns on both of these.  

One other factor that makes these robo-advisers pretty attractive is there are relatively low minimum investments to utilize these services.  One of the services that I looked at had a $500 minimum balance and charged no fees at all for accounts under $10,000.  After that, it was 0.25% of asset value.  Another service was a little less friendly from a fee standpoint depending on how you set it up.  There was no minimum account balance, but they charged $3 per month on accounts under $10,000 (which still only works out to 0.36%), but waived that if you set up a monthly auto-deposit of at least $100.  The attractive thing for this particular provider is that for accounts over $100,000, their fee dropped to 0.15%.

For many of the full service investment advisers, the minimum account sizes can be pretty steep.  Generally more than $100,000 and in many cases more than $1 million, so this is also a way to get high quality advice and allocation without having to have the big bankroll.

In my next post here, I'm going to talk a little bit about asset allocation and compare the asset allocation approaches used by my full service adviser to the one used by my new robo-adviser.