Designing Your Portfolio- Part 5 (Putting together the asset allocation)

In part 3 of this series, we discussed how to choose asset classes to include in your portfolio.  In part 4, we listed dozens of possible asset classes you could include.  At this point you have hopefully decided which asset classes you’d like to include in your portfolio.  But how much of each one should you include?

This process can be very personal because there really is no single right answer.  There probably isn’t even a single right answer for you.  There are literally hundreds of reasonable asset allocations that, combined with a reasonable savings rate, will allow you to reach your financial goals.  So don’t worry too much about getting this step perfectly right.  Besides, portfolios that are only slightly different only perform slightly differently.  Perfect can be the enemy of good here.

The All-Important Stock to Bond Ratio

A portfolio is traditionally composed of risky stocks and relatively riskless bonds.  The ratio between these two is the most important factor determining both the risk and the return of your portfolio and is the first thing to decide when putting your asset allocation together.  John Bogle’s rule is that your stock allocation percentage should be approximately 100% minus your age.  So if you’re 25, you should have 75% stocks.  If you’re 75, you should have 25% stocks.  While no rule of thumb should ever be hard and fast, and there are plenty of good reasons to not follow this rule, if you’re not sure where to start, this is a great place.  Some have argued for as much as a “120 minus your age” rule, but I’ll be honest, when I start seeing people advocating this it usually is after a long run-up in stocks, and shortly before the beginning of a bear market.  That would put a 50 year old at 70% stocks, which is probably a little on the aggressive side.  I have two pieces of advice for you when deciding on your stock to bond ratio.

First, Benjamin Graham suggested you should never have more than 75% of your portfolio in stocks, nor less than 25% of the portfolio in stocks.  Warren Buffett claims that everything he knows about investing he learned from Benjamin Graham.  I suggest you listen to those two.  Your portfolio is not the place to be an extremist.

Second, when you are first developing your portfolio, I suggest you be more conservative than you think you should until you pass through the fire of a bear market the first time to see how you react.  The worst possible outcome for a portfolio is for you to sell low during a bear market just before your retirement.  I have two colleagues who did just this.  Guess what?  They’re still working shifts.

The time to learn your true risk tolerance is not during the last bear market before your retirement.  It’s during the bear market you go through in your 20s or 30s.  During the bear market of 2008-2009, the US stock market declined over 56%.  Other asset classes, such as emerging market stocks and REITs lost even more.  The US stock market declined approximately 90% during the Great Depression.  You should expect to lose at least half of the money you have invested in stocks 2-3 times during your investing career.  That means at least a 25% loss on a 50/50 portfolio.  If you’ve never watched several years worth of savings evaporate before your eyes, you don’t know what it feels like in your gut to go through that.  DO NOT overestimate your risk tolerance.  It is far better to underestimate it.  You can always ramp up the risk after your first bear market managing your own portfolio if you find you can tolerate it.  In my experience, it is far more common for people to take on more risk than they can handle, and most end up buying high and selling low.

International Stocks

Another difficult question a portfolio manager (you if you’re managing your own) is how much of the portfolio you should expose to the unique risks faced by international stocks, including currency risk.  There are lots of good reasons to invest internationally, including significant diversification benefits and the possibility of outstanding returns in many countries.  I personally recommend you invest at least 20% of the money designated for stocks in your portfolio in stocks of countries outside your home country.  In my opinion, the maximum you should invest in international stocks is the market weight, which is currently about 55% of your stocks.  Any number between those is reasonable.

Total Market Approach Versus Tilting

One very reasonable way to invest is to just buy all the stocks and all the bonds.  For example, you could design a portfolio that is 1/3 Total Stock Market Index (US Stocks), 1/3 Total Bond Market Index (US Bonds), and 1/3 Total International Stock Index (Non-US Stocks.)  This has many benefits, including ultimate diversification, very low costs, and simplicity.

However, there are also good arguments for “tilting” the stock portions of your portfolio to riskier assets.  That means holding MORE than the market weights of riskier assets such as value stocks, small stocks, junk bonds, and emerging market stocks.  The hope is that you’ll have higher long-term returns to compensate you for taking the additional risk.

An example of a tilted portfolio would be 25% Total Stock Market, 10% Small Value, 25% Total International Stock, 10% Emerging Markets, 25% Total Bond Market, and 5% Junk Bonds.

How much to tilt?

Once you’ve decided you WANT to tilt your portfolio to some riskier asset class, you’re left with the decision of how much to tilt it.  The more you tilt, the more theoretical return you will get, but you have to weigh that against the loss of diversification and the additional risk.  The reason small stocks have a higher expected return is that the risk is higher that they may not get that expected return, even in the long run.  It’s a bit of a Catch-22.  I suggest moderation in all things.  Although some authorities have advocated putting all of your stock allocation into risky asset classes such as small value stocks, I recommend you keep your tilts small enough that you still have a significant chunk of your portfolio invested in all the stocks in the world and all the investment grade bonds in your currency.

Splitting up fixed

Some investors also like to “slice-up” their fixed income allocation.  The smaller your stock to bond ratio, the more important this issue becomes.  I suggest you keep some portion of your fixed income in investment grade nominal bonds or their equivalents (CDs or perhaps the TSP G Fund) and some portion in bonds indexed to inflation, such as TIPS.  The percentages I leave up to you.  If your bond allocation is relatively small, and you want to keep it simple, there’s nothing wrong with putting your entire fixed allocation into a total bond market fund.


As I mentioned above, there are dozens, perhaps hundreds, of reasonable asset allocations.  I’ve outlined a number of popular ones here previously.  The most important thing really isn’t the specific portfolio you choose.  The important thing (once you choose a reasonable portfolio) is that you stick with it through thick and thin, modifying it rarely, only for very good reasons, and after giving it great thought over a period of months.  But for the novice asset allocator, I will provide 3 examples of portfolios I consider reasonable, as well as 5 portfolios I do not consider reasonable.

Reasonable portfolio # 1  Relatively aggressive, with a tilt to small and some alternative asset classes

  • US Stock Market  20%
  • Small US Stocks 10%
  • International Stocks 20%
  • Small International stocks 10%
  • Gold 5%
  • REITs 5%
  • TIPS 15%
  • Total US Bond Market 15%

Reasonable Portfolio # 2  Conservative and Simple

  • US Stock Market 30%
  • International Stocks 10%
  • TIPS 10%
  • Total Bond Market 40%
  • Cash 10%

Reasonable Portfolio # 3  The portfolio of an asset-class junkie

  • US Stock Market 20%
  • Small Value Stocks 10%
  • International Stocks 10%
  • Small International Stocks 5%
  • International Value Stocks 5%
  • Precious Metals Stock Fund 5%
  • REIT Fund 5%
  • TIPS 15%
  • Total Bond Market 15%
  • Junk Bonds 5%
  • Cash 5%

Unreasonable Portfolio # 1 Extreme, lacks diversification and/or lacks growth potential

  • Gold 60%
  • Cash 20%
  • Guns and Ammo 20%

Unreasonable Portfolio # 2  Lacks diversification due to no low-risk asset classes

  • Total Stock Market Index 100%

Unreasonable Portfolio # 3  Too much international tilt

  • Total International 50%
  • US Stocks 25%
  • Bonds 25%

Unreasonable Portfolio # 4  Bizarre, huge tracking error, lacks diversification.

  • REITs 25%
  • Gold 20%
  • Silver 20%
  • Transportation Stocks 15%
  • China Stocks 10%
  • Israeli Stocks 5%
  • Mid-Cap Growth Stocks 5%

Unreasonable Portfolio # 5  Too complicated and slices are too small

  • US Large Growth Stocks 3%
  • US Mid-cap Growth Stocks 1%
  • US Small-cap Growth Stocks 3%
  • US Large Blend Stocks 3%
  • US Mid-cap Blend Stocks 3%
  • US Small Blend Stocks 3%
  • US Large Value Stocks 2%
  • US Mid-cap Value Stocks 3%
  • US Small-cap Value Stocks 2%
  • Microcaps 3%
  • REITs 3%
  • International REITS 3%
  • Large International Stocks 3%
  • International Growth Stocks 4%
  • Emerging Market Value Stocks  5%
  • China Fund 3%
  • Small International Stocks 3%
  • Gold 2.5%
  • Silver 2.5%
  • Copper 1%
  • Platinum 1%
  • Employer’s Stock 5%
  • TIPS 4%
  • Short-term Treasuries 6%
  • Short-term corporates 7%
  • Long-term treasuries 8%
  • Junk Bonds 3%
  • Peer to Peer Lending 2%
  • Energy Stocks 4%
  • Commodities Fund 4%

Next time we’ll discuss how to implement the asset allocation, by choosing actual investments in order to arrive at your desired allocation. The series continues with Part 6 here.


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Designing Your Portfolio- Part 5 (Putting together the asset allocation) — 22 Comments

  1. My portfolio would be controversial among Bogleheads. I have fixed income, but it’s negative fixed income. I have more than 100% of my portfolio in stocks; I’m using margin lending. IMO, if one has at least a 20 year time horizon, it’s a portfolio to be considered. Anyone considering it as a strategy should spend considerable time thinking about it.

  2. I appreciate the concept and it has a lot to offer to you. My question is how should the concept be modified to reflect the current artificial low yeild enviroment that we find ourselves in. Especially for those of us who need income in retirement.

    This also plays into the previous comment where younger people feel that they must take additional risks or never reach their goals.

    Any additional input would be appreciated.

  3. Park-

    Most young investors, whether they realize it or not, are investing with significant margin already. Consider a doctor with $100,000 in student loans, a $300,000 mortgage, and a $100,000 portfolio. You’re basically already highly leveraged, investing at 400% margin or so.

    However, that’s significantly different from purposely investing on margin. The main problem with margin is margin calls. The market falls and you have to come up with some serious cash to meet the margin call. If you have the cash to meet a margin call, why not invest it instead of holding it and investing on margin? Especially at today’s low cash rates.

    A mortgage loan has several advantages when compared to a margin loan. It is usually at a fixed rate, for a long-time period, at a favorable rate, and cannot be called so long as the payments are made. Big difference.

    In general I recommend against investing on margin (the real margin, where you’re subject to margin calls.) But if you decide you want to, I suggest you read the tale of “Market-Timer” first.

  4. Barry-

    I’m not sure if your comment is directed at me or Park. I’ll assume at me and the “concept” you’re referring to is the concept of a diversified, static asset allocation portfolio.

    A strategic (or static) asset allocation doesn’t change in regards to market conditions or valuations. You ride the market up, rebalance, ride the market down, rebalance, ride the market back up etc. It’s buy and hold investing. So the answer is you DON’T change your plan based on our current low-yield environment.

    Income investing for retirees is folly, IMHO. Even an investor in retirement should be a “total return” investor. A total return investor can create income any time he pleases by selling shares and isn’t handicapped by a low-yield environment. Granted, if his total return is 5%, he can’t blow 10% of his portfolio every year without soon going broke, but the idea that he can only spend his 1.5% yield when he has a 5% return is overly conservative.

  5. I agree with everything you’ve said, except that following.

    Assume one has a leverage ratio of 130% stocks. Assume a maintenance margin requirement of 25%. You’ll need a market decline of slightly greater than 69% to get a margin call.

    Although in a highly diversified portfolio, such a decline is unlikely, let us assume it happens. If one is going to engage in leveraged investing, I would advise against a cash reserve to meet a margin call. It’s very unlikely that the return on the cash reserve will be greater than the interest rate on the margin loan. However, one could have a line of credit or other loan to deal with margin calls.

    About market timer, he used a much higher leverage ratio, his portfolio (at least initially) lacked diversification with market timer engaging in stock picking and he used futures. With futures, if you have a loss after 3 months when the contract expires, that loss becomes irreversible.

    Barry, I would not recommend any retiree borrow to invest. Even if one is using leverage, with 10 years to go to retirement, I’ve never seen anyone recommend more than 106% stocks. During the last 10 years, there should be a shift from negative fixed income (leverage) to positive fixed income (bonds).

  6. “Unlikely” happened in at least 2 of my asset classes in 2008-2009. 130% doesn’t seem like much. I’m leveraged much more than that if you include my mortgage.


    To make an analogy to evidence based medicine, there is evidence based investing. The evidence in investing is that leverage can work. See the above links. It should be emphasized that the word can, not does, was used. There has to be a set of conditions met for leverage to work.

    If you look at the academic literature on leverage, it works despite several factors that work against leverage in those studies. The interest rate in those studies is higher than the rate one can get through Interactive Brokers relative to the prime rate. The studies tend to look at leverage of national stocks only, and ignore the benefits of international diversification. International diversification will decrease the volatility of returns, and volatility hurts leverage. Also, the studies tend to ignore the tax arbitrage of margin lending. Dependent on local tax laws, it is possible to lose money on a margin loan on a pretax basis, but come out ahead on a posttax basis. Finally, the studies tend to rebalance frequently to maintain a constant leverage ratio. Rebalancing between positive fixed income and stocks improves returns by tending to buy low and sell high. Rebalancing between negative fixed income (leverage) and stocks tends to do the opposite. When it comes to leveraged investing, rebalancing should be done cautiously (during bear markets?).

    You implied that 2 of your asset classes had more than a 69% decline in the 2007-2009 bear market. Please remember, that bear market was the worst in nominal terms since the Depression for American stocks. I did see some data, about which I’m not that certain, that the last bear market was the worst that the world stock market has ever seen; the real decline was about 57%. In the final analysis though, leverage is an increased risk increased return play. If there was no risk of a margin call, there would be no increased expected return.

    I agree that 130% doesn’t seem like much. However, the debt to equity ratio was a criterion that Peter Lynch used when investing. Supposedly, when the leverage ratio of a company was greater than 125-130%, he looked on that negatively. I wouldn’t get fixated on the 130% number. There are those like yourself, whose leverage ratio is appropriately much higher. However, I wouldn’t be surprised if levering a total stock market portfolio by 130% over a 20 year period resulted in a better return than investing the same amount of money in SCV in a taxable account :-).

  8. I wouldn’t be surprised either, but I wouldn’t bet my retirement on it! Especially when I know I can reach my goals without that additional risk. Different strokes for different folks I suppose. There are many roads to Dublin.

  9. white coat investor,
    Can you tell us your personal asset allocation currently and your plan/strategy for changing your asset allocation as you age/reach your goal
    My asset allocation
    Age: 35
    Total Stock Market Index :70%
    Total International Stock Index: 20%
    Total Bond Market Index: 10%

    Once I reach 25% of my financial goal/”number” , I plan to change 80% Stock, 20% Bonds
    50% of goal: 70% Stock, 30 % Bonds
    75% of goal: 60% Stock, 40% Bonds
    100% of goal: 50% Stock, 40% Bonds

  10. It’s coming up in a post soon. I felt like I needed to get this series done first. My plan hasn’t really had a change in 5 years or so. What would be an interesting post is all the changes I considered but didn’t do over the years!

    Your plan looks just fine, BTW. Simple, reasonable, diversified. Are there better portfolios? Almost surely. Are there worse….an infinite number. But combine that portfolio with an adequate savings rate and you’re almost sure to reach your goals.

  11. WCI wrote: “. I personally recommend you invest at least 20% of the money designated for stocks in your portfolio in stocks of countries outside your home country. In my opinion, the maximum you should invest in international stocks is the market weight, which is currently about 55% of your stocks. Any number between those is reasonable.”
    I don’t understand, what is “the market weight”.

    • It’s a little different now (since it’s been years since I originally wrote this post.) But if you look at the total market capitalization of publicly traded stocks in the world, you’ll see that about 50% of it is in the US. So market weight = 50% US stocks and 50% international stocks. What I’m saying is that if you are a US-based investor, putting 95% of your portfolio into international stocks isn’t a good idea. You shouldn’t have more than 50% (i.e. market weight.)

      • Here’s that list in order from most efficient to least efficient:
        • Total International Stock Market
        • Total US Stock Market
        • Small Value Stocks
        • REITs
        • Total Bond Market
        • TIPS

        I believe you & plan to act accordingly, but why/how are the top 3 (all stocks) different with respect to taxation?
        And since I’m unfamiliar with the last 3, if it’s possible to state briefly a bit about their tax issues/differences that would be helpful.


        • Keep in mind that what you put in taxable is not only about tax-efficiency, but also about expected rate of return. But with regards to tax efficiency, here are some explanations:

          1) TISM- You get a foreign tax credit.
          2) TSM- No foreign tax credit, but very little turnover.
          3) More turnover, higher dividends, but still a stock index fund.
          4) REITS- Most of return is taxed at higher ordinary tax rates and most of it is distributed each year
          5) TBM- Even more of the return is taxed at higher ordinary tax rates and distributed each year
          6) TIPS- Same issues as TBM, plus the phantom tax issue (you’re taxed on income you don’t actually receive.) Keep in mind that any treasuries are state tax free, further complicating things.

  12. After giving your opinion that International stock holding be between 20%-55% of the portfolio, you offer this:

    Unreasonable Portfolio # 3 Too much international tilt

    Total International 50%
    US Stocks 25%
    Bonds 25%

    Not that I disagree but it is completely contradictory to how you explained International allocation. Right?

    Just trying to understand in the “not-to” section… With the next one:
    Unreasonable Portfolio # 4 Bizarre, huge tracking error What do you mean? What is bizarre and what is a tracking error?

    • If I said international stock should be between 20-55% of the portfolio, I misspoke and should have said 20-55% of EQUITY. That explains the contradiction.

      Tracking error is when your portfolio performs very differently from the main stock indices. For example, someone with a huge international tilt would have had severe tracking error against the S&P 500 this year. This really bothered a doc I was talking to about his portfolio performance this last year. He thought his advisor was terrible since he only made 5 or 6% and the S&P 500 is up in the double digits. But he owns lots of bonds and international.

  13. WCI:
    4) REITS- Most of return is taxed at higher ordinary tax rates and most of it is distributed each year
    5) TBM- Even more of the return is taxed at higher ordinary tax rates and distributed each year

    “distributed” means? You must take a profit if is earned? At all ages? If there is a net loss for the tax year the obviously nothing gets “distributed”?

    • A mutual fund makes distributions of dividends and capital gains each year. Almost the entire return of a bond fund is from the dividends. Most of the return of a REIT fund is from dividends. Disappointingly, it’s possible to get distributions even if the overall return of a fund is negative for the year! Same applies to individual securities. If a REIT pays an 8% dividend, but loses 20% of its value that year, you lost 12%, but still had to pay taxes on that dividend.

  14. WCI: “Same applies to individual securities.”

    But a non issue w Stock Funds?

    Sorry I don’t know this stuff. My background is only w individual stocks & all in retirement accounts & I’m not retired so no tax implications other than the deduction for funding the ret. plan (& now I’m interested in learning about Mut.Funds).

    • The majority of a return of a stock fund is capital gains, which are deferred until you sell. So they are inherently more tax efficient than a REIT fund or a bond fund that way. Plus, what distributions there are, are taxed at a lower rate.

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