Asset Allocation

Ben Graham said the first decision one must make when it comes to investing, is about asset allocation. How much should you allocate to stocks, bonds, real estate, gold, etc.? This is a very important strategic choice that every individual must make depending on two factors. In-fact this is true for institutional investors also. A landmark 1986 study confirmed Graham’s view. The study found that asset allocation accounted for 94% of the differences in total returns achieved by institutionally managed funds.

In-fact Graham also talks about Asset Allocation in his 1949 classic, The Intelligent Investor:

“We have suggested as fundamental guiding rule that the investor should never have less than 25 per cent or more than 75 percent of his funds in common stocks, with a consequent inverse range of between 75 percent and 25 percent in bonds. There is an implication here that the standard division here should be an equal one, or 50-50, between the two major investment mediums.”

Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his venturesome friends. 

There are two fundamental factors which determine asset allocation.

  1. Ability to take risk
  2. Ability to tolerate risk

Ability to take risk depends on one’s financial position. Ability to tolerate risk is a matter of preference and emotional makeup. Bogle recommends the following mix as per the stage of life:

  • Younger investors in the accumulation phase of their lives can look at 80/20 stock/bond mix. Older investors can be slightly conservative with a 70/30 stock/bond mix.
  • Investors starting the post-retirement distribution phase can consider a 60/40 stock-bond mix and later move to a 50/50 stock/bond ratio

Bogle himself at the age of 88, had a 50/50 stock/bond portfolio and used to say that he would be equally happy AND sad, whenever the market went up or down. It is all about meeting your goals with minimum regret. In his 1993 book, “Bogle on Mutual funds“, after discussing a number of asset allocation strategies, Bogle raised the possibility that “less is more”. A simple (Index) balanced fund 60 per cent in broad-based equity Index Fund and 40 per cent in Index Bond Fund would offer extraordinary diversificationoperate at rock bottom cost and would offer the functional equivalent of having the investor’s portfolio overseen by an investment advisory firm.

In the next article we will look at returns from a simple 60/40 balanced fund and later how to rebalance, a balanced portfolio/fund.

(Excerpt from an article written by Anish Teli which appeared on IndexHeads – )