0

This question does a good job covering the basics of asset allocation. My question concerns the asset allocation of stocks, so we leave the bonds out of the question.

All the recommended portfolios seem to have the stocks divided into 4 or 5 markets: EEUU, Europe, Pacific and emerging markets.

Now, typical distributions for stock funds I have found are 41% EEUU, 25% Europe, 17% Pacific and 17% emerging markets (this is one of the typical boggleheads recommended asset allocations for stocks).

The Gone Fishin' portfolio (to name another one) recommends a similar (but percentages vary substantially) allocation for stocks (this one includes REITs):

24% Vanguard Total Stock Market Index (VTI) 23% Vanguard Small-Cap (VB) – 15% Vanguard European (VGK) – 15% Vanguard Pacific (VPL) – 15% Vanguard Emerging Markets (VWO) – 8% Vanguard REIT (VNQ)

FTSE All-World has 57% of its market allocation in EEUU, 8% in Japan, 4.4% in China, 4.4% in the UK...

What are the reasons (if any) for the different percentages? It would seem like 57% for EEUU is a lot, compared to the 24% allocated in the Gone Fishin' portfolio

1

First off, the answer you reference is comprehensive but not unambiguously correct. I don't feel comfortable answering this one without correcting that one first.

Whether human capital is similar to a bond indexed to inflation or to a stock is very much a matter of debate. The great finance theorists have not settled the question but inasmuch as there is a consensus, it is that for a large fraction of people, human capital actually has a very high beta. This suggests that a risk-equalizing investment pattern would involve starting with a large bond allocation when young and increasing the allocation to stocks as you age. Of course, risk-equalizing isn't an obvious investment choice as our risk-aversion changes over time. Some people become more risk averse as they age but others become much less as they realize the probability of being poor in their old age has diminished. Moreover, as people age, many of them have fixed income, which means they have strong background inflation risk and relatively little background market risk (via human capital). By increasing bond exposure with age, they double up on the risk they are already exposed to. In short, the rule of thumb that investors should move money into bonds as they age, or into safer assets in general, is not based on sound finance theory and is essentially an old wives tale. The theoretical "justification" for it was thought up to back up a rule that had been floating around for a long time, rather than guiding the advisors in what a reasonable rule should be. There are many good reasons to think the opposite rule would actually be a better rule of thumb.

Now, how much money to put in various geographical sectors: the initial theoretical guidance we have for asset allocation comes from the Capital Asset Pricing Model, which suggests that our asset weights should mimic the market capitalization of the associated stock markets. However, many assumptions of the global CAPM are not met. For one thing, transactions costs and fund fees for international investments are higher. And in a taxable account, there is a significant difference between the way domestic and international investments are taxed. These lead most people to have something of a domestic investment bias. How large this bias should be depends on your particular costs and is, in general, an extremely difficult problem to solve. There may also be reasons to increase your international exposure if your human capital is more highly correlated with the domestic stock market than it is with the international market. Without knowing all these things (some of which can't be known) we can't come up with a final optimal allocation. For this reason people rely on rules of thumb to give them confidence in their decisions, even when that confidence is not justified.

The rules of thumb you mention here and read about in your other answer are to be taken with a great deal of salt. In my opinion, it is important to have a strong understanding of what is known and what is not known. The fact is that neither this question nor your last have known solutions that are really good. The CAPM advice of buying according to market capitalization is a good starting point but going much beyond that involves trusting people who don't actually know better than you do. Doing so involves self-deception and I cannot condone that.

| improve this answer | |

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.