DIY Investing Resource #4: All About Asset Allocation
Our fourth selected DIY investing resource is All About Asset Allocation by Richard Ferri, CFA. Ferri is the founder of the investment advisory firm, Portfolio Solutions. He is also a dedicated “Boglehead” which is where I first learned of him.
This book is divided into three parts:
- Asset Allocation Basics
- Asset-Class Selection
- Managing Your Portfolio.
Parts one and three had a few unique insights which we will discuss briefly. They were primarily a review and reinforcement of information from other resources we have already presented that gave us the conceptual and theoretical framework to manage our own investments. The Asset-Class Selection portion is what we found particularly unique, detailed and helpful and why we included this book in our selected resources. This section of the book provided specifics that allowed us to construct our portfolio with confidence. This will be where we focus our review.
Asset Allocation Basics
The first section of this book explains basic investment principles, understanding investment risk, understanding the concepts of asset allocation and the reasoning behind multi-asset class investing. The key point we took from this section is the framework that Ferri laid out to choose what investments should be included in a portfolio. Each selected asset class should:
- Have a real expected return that is greater than inflation.
- Have risks that are fundamentally different from each other.
- Be accessible with a liquid, low-cost product or fund.
This section of the book made it the most practical resource for those of us who choose a path of index investing with some increased diversification and complexity over simply owning a S&P 500 or Total Market index fund. Each chapter in this section provided some unique and useful information, and I’ll try to highlight some key points.
- This chapter reinforced the importance of holding a domestic total market index fund as a core fund. The other big take home point I took is the potential advantage to tilting a portion of US equities to small and value stocks. This is because historically, these subsets of the market are under-represented in traditional market capitalization weighted indices and they have produced higher returns than the overall market. This book also discusses holding the smallest (micro-cap) stocks. They historically have produced returns in excess of other segments of the market. However, they also present a challenge in finding a cost-effective way of holding them.
- This book clearly explained the currency risk (and potential benefit) of owning foreign stocks. When the US dollar is strong, investors profit more by simply owning US stocks. As the dollar weakens, there is more benefit to owning foreign stocks. Since this relationship is cyclical, there will be times when having international currency exposure will be very beneficial, representing another diversification opportunity.
- The author did a good job explaining that there is no such thing as a “multinational firm”. A common argument against owning foreign stocks is that large US corporations do a large portion of business internationally, giving you international exposure. This chapter explains that each company is based in only one country for accounting and tax purposes. Thus to obtain the diversification benefit, foreign equities must be owned separately as they present unique risks and opportunities to US equities.
- An interesting case was made for owning separate US and foreign funds, rather than owning one global fund. Likewise a case was made for adding some increased complexity to your portfolio by further dividing international equities among European, Pacific Rim and Emerging Markets instead of owning only a single international fund. At different times, certain countries or regions tend to be dominant economically. This will be reflected by their domination of a total international fund at any time. Slicing the portfolio into these segments gives opportunity for better returns over time by periodically rebalancing.
Fixed Income Investments (Bonds)
- The author went into great detail on the many different opportunities to diversify the bond portion of a portfolio. He explained how bonds can be used to complement other asset classes to increase long-term portfolio return.
- There is an excellent explanation of the different risks associated with different bonds including interest rate, maturity, default, and inflation/deflation risks.
- While the author reinforced the idea of a diversified core Total Bond Market Fund, he also demonstrated that these funds don’t include Treasure Inflation Protected Securities (TIPS), high-yield corporate bonds, or international bonds. He explained why you may want to hold these for further diversification of your portfolio.
- There is also a detailed explanation of when and for whom tax-exempt municipal bonds may be preferable to taxable bonds.
- Ferri did a nice job of explaining the difference between a primary residence and investment real estate. He argues that a primary residence is an asset that should appreciate with inflation. However, it should be considered as shelter and not a part of the investment portfolio because it is not liquid and has little real return above inflation.
- The features that make investment real estate attractive is that it tends to appreciate at, or slightly greater than, the rate of inflation while also providing income in the form of rents. Thus it has a growth and income component.
- Real estate investment trusts (REIT) were described as a convenient, widely diversified way to own real estate. They have variable correlation with stocks and bonds making them attractive to hold in a portfolio. Their total real return is expected to be similar to that of stocks.
- A REIT provides a convenient way to own real estate without worrying about someone calling at 3 A.M. to tell you they had a pipe burst or the furnace is out. However, with that convenience you have a more efficient market, meaning you lose much of the potential upside as well as the leverage potential of traditional real estate investing.
- The author covered several alternative investments. While he did not recommend any of them for most people’s portfolios, the information contained was very useful to avoid being sucked into the hype that often surrounds them.
- Commodities ranging from gold to crude oil to pork bellies were explained. All are the same in that they offer no consistent long-term growth potential and no way of providing income. Instead, money is made through speculation and market timing.
- Hedge Funds are often mysterious and alluring to investors. The author points out that they have different regulations than other securities and are not fully disclosed, have very high investment costs, lack diversification and have poor consistency of performance.
- Collectibles were described as potentially personally rewarding and enjoyable. However, they can have high costs to acquire, store and insure and require expertise. They also are illiquid and are dependent on supply and demand and finding a buyer.
Managing Your Portfolio
This section covers realistic market expectations, building your portfolio, how behavior affects asset allocation decisions, when to change asset allocation, and the effect of fees in asset allocation planning. This section provided sample portfolios with specific funds and allocations which served as guides in our own portfolio. We also found helpful his recommendation of writing out an investment plan with your asset allocation and pre-established reasoning of when and why you would make changes. This helped us to develop a plan to follow and will likely prevent mistakes in the future as we refer back to it before considering any changes.
Of particular interest to us given our experiences and criticisms of the financial advice industry was Rick’s input on hiring an investment adviser. His book is balanced and objective. He makes some valid points about why people should have an advisor and also is very candid in criticism of the industry. He offers his opinions of the difference between those who are selling products and those who sell advice. Of note, Ferri’s own firm requires a minimum of $500,000 to be accepted as a client. While he provides useful advice and insights for those that have built savings, his advice reinforces the point we often make that it is a very challenging for a person starting out to get quality service from the financial industry. This is why there is such a need for self-education.
Thankfully, there are resources out there to help us DIY investors to educate ourselves. If you are looking for one that is thorough and extremely practical to assist you in designing, building and managing your investment portfolio, then I would highly recommend Rick Ferri’s All About Asset Allocation.
Have you read “All About Asset Allocation” and found it as helpful and practical as we have? Have you read any other sources that you feel are better? Have you started reading the first 3 resources we have shared? If so, are you finding any of them particularly useful? If you haven’t started getting more in depth with your investing knowledge, what is stopping you? Share your thoughts below.
Sign up to receive our posts!