Business is Personal (Finance)

I've been saving a nice chunk of my salary since I started working fulltime 15 years ago. Over time, it has grown mostly due to contributions but there have been periods of euphoric market gains. I can split out my investing activities into several distinct periods.

Period 1: Random Fund Picks

Like most people, I knew little about asset allocation and portfolio construction. Instead, I looked at Morningstar ratings and past returns. This meant I had a slew of random funds in my T.Rowe Price 401K and a slew of random funds (Janus, Strong, Columbia, Franklin Mutual, Pioneer) in my taxable accounts. This lasted for a good decade before I finally decided to enter all my statements into a database and analyze how I was doing. The answer -- I was underperforming the market by a good 1% per year -- or roughly the average extra expense ratio I was paying in these funds.

Period 2: Index Fund Conversion

After realizing I could not pick funds worth squat, I closed all my accounts and moved everything to Vanguard. I still did not know anything on how to construct portfolios and I picked equal dollar amounts in Large Growth, Large Value, Small Growth, Small Value, Total International and REIT. To be honest, there's nothing that bad about this portfolio other than some of the asset classes would be better off in tax-advantaged accounts.

Period 3: Alternative ETF Experimentation

The next stage in my evolution came when I transfered my Rollover IRA to Wells Fargo to take advantage of the PMA free trade offer. I read up on all sorts of "neat" ETFs and ETNs and had visions of holding every single possible asset class mentioned at Index Universe. During this brief period, I held China ETFs, India CEPs, Timber REITs, Mortgage REITS, Commodity ETFs, Commodity ETNs, Gold ETFs, Dividend ETFs, International RE ETFs, International TIPS ETFs, Leveraged Muni Bond CEPs, Leveraged International Bond CEPs, Currency Carry ETFs. As you can imagine, all these holdings became quite complicated to track, maintain and rebalance. I actually ran out of my annual free trades and had to pay $5.95 commissions.

Period 4: Portfolio Planning

March 2008 was the turning point. With Bear Stearns going bust all the exotic/alternative classes I held went down at the same time. Except for SPDR International TIPS, none of the ETFs/ETNs/CEPs I had picked had provided any downside protection. When the core stock market dropped, they all dropped in lockstep. In reality, I might as well have stuck with regular equities and saved myself the hassle and extra expenses.

So I started paying much more attention to the portfolio construction threads at Bogleheads. The 2 ideas that really piqued my interest were Harry Browne's Permanent Portfolio and Larry Swedroe's Concentrated Risk Portfolio. The main points I picked up that drove my allocation decision:

• Slicing Equities into smaller pieces (for example, Japan Small Cap Value) cannot provide downside protection. When bad stuff hits, all equities go down. Hence, the #1 asset class to make bear markets less severe is Bonds. Commodities come in a distant second for the case when unexpected inflation hits.
  
• Hold only the safest bonds (U.S. Treasuries and TIPS)
• Hold more Gold, Commodities, Bonds to provide a counterweight to take more risk on the equity side.
• Hold Real Estate, Gold, Commodities, TIPS to provide inflation protection with all the government bailout money being thrown around.
• Value and Mid/Small Cap tilt to take more risk on the equity side.
  
• On the International side, developed markets (EAFE) are closely correlated with domestic markets. The major difference is you get currency diversification. Hence, concentrate risk and only hold Emerging Markets for currency diversification.
  

Ultimately, I want my target portfolio to look like the following:

• 15% Intermediate Treasuries
• 15% TIPS
• 5% Commodity Futures
• 5% Gold
  
• 10% REIT
• 10% Domestic Large Value
• 10% Domestic Mid Value
• 10% Domestic Small Value
  
• 20% Emerging Markets

The end result is 60% Equities, 30% Bonds, 10% Commodities. However because I'm taking more equity risk (hopefully compensated risk) by overweight on Small, Value and EM, the theory is I will get the same long-term returns as a 80% Equities, 20% Bonds portfolio but with less volatility. Entering my target AA into Morningstar X-Ray (I calculated the REIT allocations myself) produces the following report:

Country Breakdown

  U.S.        55%
  EAFE         0%
  EM          33%
  REIT        16%

Style Box

  | 19 | 16 |  9 |
  | 20 | 14 |  3 |
  | 12 |  6 |  2 |

At the moment, I'm about 75% of the way there. My overall mix is 76% Equities, 15% Bonds (4% TIPS), 9% Commodities (4% Gold). A X-Ray of my current portfolio shows:

Country Breakdown

  U.S.        37%
  EAFE        20%
  EM          17%
  REIT        20%
  Intl RE      6%

Style Box

  | 18 | 16 | 12 |
  | 18 | 12 |  6 |
  | 10 |  5 |  2 |

My value and size tilt is almost right on target. I have a touch more REIT than desired and a whole lot of EAFE. If I liquidate EAFE to move into equally into Bonds (TIPS) and Emerging Markets, that would bring my portfolio to 70% Equities, 21% Bonds, 9% Commodities. Then over time, I would target new contributions to get to the endgame allocation.

(Filed in investing)