Monday, June 30, 2014

How nuts is our allocation

"My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors." - Warren Buffett

The asset allocation suggested by Warren Buffett in his 2013 letter to shareholders of Berkshire Hathaway is quite similar to "Aggressive Investor" profile in AAII Asset Allocation Models. The biggest difference is that in AAII models and many others, it is recommended to dial down risk with the remaining investment horizon.

Vanguard offers historical Risk/Return (1926–2013) for each of their portfolio allocation models.

100% bonds

Average annual return: 5.5%
Best year (1982): 32.6%
Worst year (1969): –8.1%
Years with a loss: 14 of 88

100% stocks

Average annual return: 10.2%
Best year (1933): 54.2%
Worst year (1931): –43.1%
Years with a loss: 25 of 88

That's historical perspective to risk vs. return.

One particular rule I have come across says that allocation to stocks should be 100 minus your age. I guess it depends on whether you are going to ultimately sell stocks to cover expenses or not. Because if you are not, then why move money from stocks to bonds - especially from the dividend paying kind?

I like Warren's advice for three reasons: For its stock vs. bond allocation, its simplicity and for the use of low cost index fund. In fact, I should probably benchmark myself to his advice in addition to my selected benchmark index.

Our own allocation is close to 100% stocks allocation so it is near the extreme end of asset allocation models discussed here. I feel good about it, but we also have very high risk tolerance with the money invested. I personally think people who take sure loss after inflation are nuts (i.e. people who park money to bank accounts or low yielding bonds).