Asset allocation is generally defined as the allocation of an investor's portfolio among a number of "major" asset classes.
There are many asset classes that are more or less specialized. For instance:
- Corporate Bonds
- Small-Cap Stocks
- Medium-Cap Stocks
- Large-Cap Growth Stocks
- Large-Cap Value Stocks
- Mortgage-like securities
- Real-Estate investments
- International Stocks
Here is my pre-retirement asset allocation strategy:
- Four classes: commodities, stocks, bonds and real estate. Currently, about 65k$ invested.
- Commodities: 8% of the portofolio, currently invested in two stocks, an oil stock and a company specialized in rare earth products
- Real Estate: 17% invested in an Index ETF composed of a wide range of REITs
- Bonds: 17% invested in an Index ETF covering a broad range of bonds in Canada (government and corporate)
- Stocks: 58% invested in a mix of Index ETFs (covering Canada market, US market and International Market) and individual stocks
- The previous target ratio will have to be balanced from time to time as some assets will grow faster than others.
I have mentionned the importance of investing frugally, that is, to limit the cost of investing, thus the ETFs. However, everytime you balance, you have to buy some securities and pay commissions. To minimize these, I will do the following:
- 18% of my pre-tax salary is retained and invested in a wide range of mutual funds
- About 33% of my after-tax salary is also saved and invested at first in a cash account (ING Direct, currently yields 2.4%).
- After six months, I will transfer the cumulated amount so far (about 12k$) in a way to reach my target asset allocation. I will buy more in the asset classes that will have decreased in value that those that will have grow.
- Inside a single asset class, I will diversify on a yearly basis, that is, I will put all the money in a single ETF the first year, the following year I may select another ETF in the same asset class. The idea is to diversify, but to minimize commissions at the same time.
- I keep about 20% of my total portfolio for individual stocks. Most of these stocks are invested short term (less than one year)
- Bonds and real estates, which generate income, are mainly invested in registered accounts, while stocks and commodities, which generate capital gains are unregistered, which decrease the tax burden, since 1) only 50% of capital gains are subject to taxes in Canada and 2) capital gains are taxed only when securities are sold, thus a possibility of much better compounding with long-term stocks (my long-term stocks are actually index ETFs)
- My asset allocation strategy will change as retirement time approaches and after retirement to decrease the overall risk and have securities that yield more regular income.
Remember that diversification means:
- Market diversification: reduce the market timing risk, that is, by investing at the wrong time. Instead of trying to time the market, it is known to be better for most people to invest blindly at predefined dates. Thus, investing every six months, whatever the market conditions, is a market diversification strategy. It is better to do that every month, but it is costlier when you invest in stocks. This is why the money is invested in mutual funds during the six months, before putting the money into individual stocks and ETFs.
- Asset class diversification: economy follow cycles that are difficult to predict. When the commodities go well, stocks might decline and real estate stay a safe haven at the same time. By doing asset allocation, you are automatically buying more of an asset class that has been doing badly recently when you do the asset balancing.
- Company-specific diversification. A single company can go very bad, even when market conditions are very good. Investing in mutual funds (particularly low fees index funds) and ETFs is a good way to protect yourself from such risks