Recent Transactions
In the last quarter of the year, we ended up putting in the maximum $15,500 salary deferral in both of our 401k/403b’s. I had already put in $12,500 already in my Solo 401k, so I sent in a last-minute check for $3,000. For my wife’s 401k, it was done in big salary deferrals in October, November, and December. We were lucky that the company allows almost 100% salary deferrals.

Summary and Performance
My last portfolio update was back in September, but I figured with the end of 2007 it was definitely time for an update. It was a late decision to go ahead and contribute a lot to our tax-deferred accounts and taking away a bit from our cash hoard, so I was more concerned with getting them in on time than what I was actually investing in. Lots of changes to come soon, so I’m just posting a snapshot of what we have for now.

I did go back and track the cash inflows, and calculated our time-weighted rate of return, which ended up being 2.49% annualized for 2007. For a very rough comparison, the S&P 500 via Vanguard 500 (VFINX) returned 6.13% YTD. Part of this low performance was just due to timing, as the latter half of 2007 was a lot worse than the 1st half, and that was when we invested a lot more money. (Remember, this is the exact performance of our money, not just the averaged returns of all the funds we hold.) In 2006, our portfolio return was calculated at 24.9%. How did you do in 2007?

I’m still planning on reshaping my investments and continuing my choosing an asset allocation series, but Thanksgiving and work has thrown me off a bit.

To skip ahead a bit, here are several sample asset allocations from various sources for the equity (stock) side of your portfolio. I thought it would be helpful to see them all side by side and compare how different authorities might split things differently between domestic and international stocks, how they deviate from the “total” market indexes, and whether they choose to incorporate additional asset classes like real estate or commodities.

For more information about any specific portfolio and the source, just click on the pie chart.

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So far we’ve looked into the stock/bond ratio and the domestic/international ratio. Instead of taking these total stock markets as whole, you can further subdivide them into “styles” or additional asset classes. Although these vary in specific definition, in the general layout is shown by the Morningstar style box shown to the top right.

Value vs. Growth Stocks
Value stocks are those that tend to trade at a lower price relative to objective measures like dividend yield, earnings, sales, or book value. For example, you could screen by low P/E ratio. To generalize, value stocks tend to have low growth prospects or are in unglamorous industries. On the other side are growth stocks, which have high relative valuations. Again to generalize, these companies tend to have big growth expectations like Google or Apple.

If you look across long periods of history, it actually turns out that value stocks outperform growth stocks as a whole. People use different ways to explain this phenomenon. One camp says that value stocks are riskier because they are more likely to fail due to poor prospects, so obviously they should have higher return. Others use a behavioral view, saying that since they are “boring” or “ugly” stocks then they tend to be undervalued by investors in general.

Either way, including value stocks as part of a portfolio has also historically provided a diversification benefit, as can be shown by this graph from the excellent book All About Asset Allocation:
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I don’t know if this is the proper next step, but after deciding on a stock/bond ratio for myself, I want to think about the specific breakdown of stocks (equity). As mentioned when talking about investing in total markets, you could simply “own the world” using just two funds or ETFs and weighting them according to market capitalization – using one Total US fund and one All-World Except-US fund:

If you use the ETFs, the total weighted expense ratio would be a mere 0.17% annually!

Concerns About Investing Abroad
However, according to various surveys the average US investor has much less than 55% of their equity portfolio in international stocks. Here are a few reasons that have been cited:

• Country/political risk – This includes the possibility that the economy of certain countries could collapse due to war or other internal strife. Also many governments have less oversight and transparency than the US and other developed countries.
• Currency risk – These days it seems like people want to hedge against a falling dollar, but only recently people were worried about a strengthening dollar affecting international investments. Either way, it does add an element of risk.
• Added cost – Investing in international mutual funds usually cost more in management fees.
• Existing exposure – Some statistics show that a very large chunk of revenue from US-based companies now come from outside our borders, so even without adding international companies we are already being exposed to many of the same effects. This also explains the recently increasing correlation between domestic and international stocks.
• Performance-chasing – Recently international funds have been on a very good run. Some believe this is the main factor in increasing foreign exposures, as opposed to fundamental factors.

Historical Risk/Reward Relationship – Benefits of Diversification
On a very general level, the reason to invest in international stocks as it pertains to Modern Portfolio Theory is that you get a diversification benefit. Historically, international stocks in general have had higher average returns, but also higher risk (volatility). But due to low-ish correlation, mixing domestic and international stocks has resulted in less risk and greater return.
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Last time I did a really simplified overview of Modern Portfolio Theory. Much of the credit for this is due to a fellow name Harry Markowitz, who figured out that if you combine two assets with the same return that aren’t perfectly correlated, this diversification can result in reduced risk without reducing return. Even if you don’t combine two assets with the same return, combining two assets that have low correlations (don’t move together) will get you a better reward/risk ratio. Markowitz later won a Nobel Prize for his work in this area.

Stocks vs. Bonds
Studies have shown that somewhere between 77% and 94% of the variability in portfolio returns are determined by asset allocation. So our goal is to use asset classes with low correlation to get the best reward/risk ratio. One of the most popular examples of assets that have low correlation is stocks and bonds. Accordingly, adjusting your ratio between stocks and bonds is one of the most basic ways to adjust the amount of risk you wish to take in a portfolio.

The chart below shows the risk/return trade-off between bonds and stocks for 1980-2004. The stock portfolio is represented by the S&P 500 index, while the bond portfolio contains 60% five-year Treasury notes and 40% long-term Treasury bonds. The portfolios range from 100% bonds, to 95% bonds/5% stocks, 90% bonds/10% stocks, all the way to 100% stocks. (via this AAII article)

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Building upon the idea of investing in broad markets, next up is Modern Portfolio Theory. This is another advanced topic that entire careers can be built around, but here is my attempt to explain it in one quick digestible chunk.

Risk vs. Reward
As far as investing goes, the most basic component we have is cash. If we invest it in a Treasury bill from the government (as riskless as possible), then we will end up with a return after inflation of zero. You just keep up with inflation. No risk, no reward. In order to increase our reward we, must take on more risk. But it’s not a linear relationship. We want to find the mix of investments that offer the best mix of risk and reward. So again we turn to history and whip up some math. (I’ll go easy on the numbers here.)

Reward = Return
The idea of reward is usually represented by the historical average annual return of the investment. Sounds good to me.

Risk = Standard Deviation
The idea of risk has many possible definitions. Stocks are seen as riskier as bonds, because their prices have historically fluctuated much more wildly. For example, for domestic stocks, your best year would be +39% while your worst year would be -28%. In contrast, for a broad bond portfolio, your best year would have been +31% while your worst year would be -8%. (Source: Vanguard) A mathematical way to measure this volatility is standard deviation. The larger the standard deviation, the higher the risk.

Mix ‘Em Up
An asset class is a group of investments that exhibit similar characteristics. If we plot their historical returns vs. historical standard deviations, we might get something like this:

One dot might be the S&P 500. Another dot might be 1-Year Treasury Bonds. Now, what if we starting mixing them up into in various ratios. Like taking 50% S&P 500, 25% US Small Cap, and 25% 5-Year Treasury Bonds. We’ll get a whole lot more dots, err… data points:
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I am starting a new series of posts that describes how I will reconstruct my current investment portfolio from scratch, from general theory to the actual purchasing of specific mutual funds. Here I want to reiterate the point of this blog – This is how I am thinking of investing my money, not necessarily how I think you should do it. In other words, I don’t claim to be an expert, I just think sharing is fun and hopefully there will be a good debate and overall knowledge will be increased. You don’t really often get to see someone juggling a real portfolio across a multiple Roth IRAs, 403bs, 401k, and taxable accounts. It will also keep me organized and motivated as I’m been putting this off 🙂

General Philosophy
Here are some quick insights into how I approach investing. You’ve all read this ominous phrase before:

Well, you know what? All we have is past performance. The important thing is to look back at all the data available, and try to extract useful information that has the greatest chance of persisting into the future. This won’t be easy, and there will be eternal debate as to how where we draw the line between “likely to persist” and “unlikely to persist”.

Based on this life expectancy chart, if I’m lucky I’ll have another 50 years of investing ahead of me. However, much of the data I read about in studies only dates back no further than 1975. Even the really far-reaching ones only date back to 1926. So I’m supposed to use at best 80 (and often only 25) years of data and extrapolate that out for another 50 years? That doesn’t seem like a huge mountain of evidence, especially considering events like World War II which had huge consequences and occurred only 50 years ago. Wouldn’t it be nice to have something like 800 years of investment data to make decisions upon?

As a result, I will try to keep my portfolio simple and stick to things that I believe are the most reliable, including supporting articles and data. Most of this will come from my readings of books and various studies.

Read more: Index of Posts On Building My Portfolio

Actually, a better question is what percentage of your income should you contribute to all types of retirement plans? But the 401(k) plan is one of those cases when you have to choose something to start out with, and many people just never get around to changing it again. Too much, and your cashflow will get tight and uncomfortable. Too little, and you’re not taking full advantage of the tax benefits.

Start With The Match
As everybody says, matching contributions from your employer will probably offer the best return-on-investment you’ll ever get. Most companies have a cap after which the match stops, and my guess is that most people contribute up to that cap and then forget about it. Certainly, this number provides a floor, but most of us will have to chip in some more to accumulate a happy nest egg. (I’ve never heard of a match above 6% of pay, although I’m sure some exist.)

Take Into Account Other Accounts Like Roth IRA
The reason people like Roth IRAs is that if you think your tax situation now will be about the same as in retirement, the Roth IRA has a lot of extra advantages like the ability to make early withdrawals for a variety of reasons, as well the ability to never make any withdrawals and leave it to your heirs still compounding away. However, if you have a Roth 401(k) the difference gets a lot slimmer, you may just go with which one offers you better investment choices. Either way, it’s good to consider the whole picture.

Mint.com allows you to compare different IRA accounts available online … if you want to see how your IRA stacks up against what’s available, you should check them out.

Taken all together, I would say 10% would be good place to start unless you have a pension or other sources of retirement income lined up. But that’s just me… what do you think?

Each 1% More Can Make A Big Difference
On top of that 10%, it’s interesting to see how much difference nudging it up another 1% can do. I used this Increase 401k Contribution Calculator from Wachovia and ran some numbers. Assuming you make $50,000 gross annually, you’re 35, you retire at 65, 8% annual return, and a 25% income tax bracket, here’s what happens if you increase your contribution percentage by 1% (unmatched):

Not too bad for giving up just $31 per month; if you’re younger the payoff is even better. (Almost good enough to bump up your contributions by 1% today?) Still, start taking enough $31s out and it’ll start to hurt.

Give Until It Hurts?
To find the nice balance, there are a couple of ways to do it:

1. Analyze your finances, estimate a percentage, and just adjust from there. (More work.)
2. Start at match %, and keep increasing the % until it starts to hurt.
3. Start at a high amount (20%? 25%?), and keep decreasing it until your take-home pay is a manageable amount.

Each person probably has a different preference. But again, we go back to the real-life aspect – Will you remember to change your percentages later? Life gets busy, and each month you just keep forgetting and forgetting… In that case perhaps the third option is best, assuming you have some cushion to pay with.