Reader J has set himself a goal of being financially secure in another 10-15 years. In Part 1 of his financial plan, he talked about his investment goals and today he shares his thoughts on his asset allocation strategy.
Ready, Set, Go
Now I am at the point of transition, where I actually craft an asset allocation and implement it. I find this step to be rather difficult, so I will share my thoughts and hopefully get some feedback.
Dimensional Fund Advisors
Several smart people I’ve bumped into lead me to the path of a slightly different indexing strategy by Dimensional Fund Advisors that isn’t cap-weighted. Their research and track record in the US looks very promising that they can build a better index with lower risk and higher returns. Being a [new] money nerd, I get turned off their requirement to only sell through advisors — I have a bad history with them; from now on I want to be more involved. DFA Canada also doesn’t seem to be performing as well as its US parent, but if I had the choice to use them to build my own portfolio held at a discount brokerage, I would have. In fact the first step to choose my risk tolerance comes from the quiz I took from the IFA website which only sells DFA funds. I fit into the “Indexfolio 70” which gives me a start to my asset allocation with 20% bonds, 80% stocks. In stocks I’ve tried to keep generally the same allocation as follows:
16% — Canadian stocks
27.5% — United States
24.25% — International (developed)
4.25% — Emerging Markets
8% — Real Estate
20% — Bonds & Cash
Fund Selection
Without DFA my fall back choices are using traditional low costs indexes from iShares, Vanguard and maybe also “Fundamental” indexes from Claymore which are sort-of like DFA. Vanguard is instantly appealing because of their great history and ultra-low fees. I just wish they operated in Canada. iShares seems pretty good and has fairly low fees. Claymore costs more, is less liquid, and seems like more of a risk because their implementation hasn’t performed as well as their back-testing, but hopefully over the long term they will outperform a normal index. I’m hoping that by mixing these different styles of fund I can lower the weighted MER and possibly a little get a better return and/or little less volatility.
Amateur Versus Sleepy
Compared to the sleepy portfolio this allocation has significantly less Canadian exposure. I understand that based on the cap weighting Canada only makes up about 3% of the global market, but we overweigh it because of home bias, currency risk and local dividend tax advantages. But where does a 24% or 16% allocation number come from? I generally agree that currency hedging is a performance drag, but is it possible that by using some indexes with a currency hedge to US/foreign markets that this would in a way help bridge the 16% to 24% currency risk discrepancy of Sleepy vs. Amateur?
Do any nerdy individual investors go so far as to do mean variance optimization as described in the Intelligent Asset Allocator? Is there some a practical way to build and test asset class correlation and other metrics like alpha, beta, standard deviation? Without knowing how to do this myself, I’ve decided to copy IFA which probably has measured these technical indicators to back test their risk based performance.
