Asset Allocation: A Primer

I mentioned in my last post my asset allocation plan. I've been aware of the concept of asset allocation for a while, but I didn't really know all the details until I started reading "All About Asset Allocation". So, I'm going to try to sum it up here.

Nobody can predict the way the stock market will go. Sometimes, you can make a prediction, and have it be correct, or get lucky, but you have the same information and chance that a fund manager does. A fund manager has education on their side, but they're human too, and they won't be right all the time. Overall, funds in the long run follow the market, but they have higher fees. This is an application of the random walk theory. So, if you want to follow the market and have low fees, index funds are the way to go.

But, there's a prediction problem here too. Which sector or index is going to do well? Every market has good years and bad years. Do you really want to put all of your money into a fund that only invests in 1 kind of stock? A smart investor would invest in more than one market so that his money is diversified. So, the portfolio I created has many different sectors, sizes, and markets that it invests in.

But, not every fund will act the same. Some will go up, some will go down, some will correlate well with others, while some will do their own thing. What if, in a year, my percentages are all different than when I began?

A good asset allocation strategy involves rebalancing. I would sell the excess fund that did well, and use the money to buy from the fund that lost money. The price of the respective funds don't matter, because I'm doing everything as a percentage of my own portfolio.

What does this achieve? There's an old saying: Buy low, sell high. Well, when I'm selling the fund that made extra money, I'm selling those shares for more than I purchased them for. This is the "sell high" half. Then, I take that money, and purchase the fund that costs less then I originally paid. That's the "buy low" half.

There are 2 main theories to rebalancing. One has better performance, but requires extra work and maintenance, and the other requires less work for slightly less effect.

• percentage based: When one of your assets deviates a preset percentage from your ideal, you rebalance. Works slightly better overall, but you have to be constantly keeping track.
  
• time based: Rebalance after a specific period of time, say, quarterly, or annually.

Which is better? Depends on your style. I'm a fiddler. I love to tweak this, adjust that, change things up a lot. I'm opting to rebalance on percentage, and I'm choosing a relatively low limit: 2%. So, the instant a fund hits 8% or 12%, I'm rebalancing. If I didn't want to think about it until the next year, I would use the other method.

So, in a nutshell, that's asset allocation. I like the concept. I love the fact that it's not depending on somebody else to have better knowledge than me. It's just pure statistics at work.

My asset allocation plan

I've been putting together an asset allocation plan for mine and Mrs. Dreamer's IRAs for a while now. We have a good amount socked away especially for investment, and it's best to make sure that your portfolio is balance all across the board.

First, my investment plan. I plan to take full advantage of any and all tax advantaged funds before opening a full brokerage account. Here's that plan: The idea is to start at the top, and contribute at the next level only if the previous level is maxed out.

1. 5% into 401(k) and TSP plans. The combination of tax savings and employee matching make these especially appealing. The 5% number keeps my tax bracket from accidentally crossing that borderline.
   
2. Roth IRAs. Both Mrs. Dreamer and I are very young (mid 20's), and the tax exempt growth is an unbeatable deal. Plus, putting after tax dollars in there is like putting an extra 15% on top of what I could have put from a traditional IRA. If our income ever breaks the income limit, we'd open a traditional IRA.
   
3. 529 plan. We don't have kids now, but we may in the future, and the earlier we start saving money for college, the better. We do have a niece whom we could give the money to if we decide not to have kids.
   
4. increase 401(k) and TSP up to 15%. If the day comes that I can max both Roth IRAs and have money left over, obviously I could be saving more in taxes from that money. 15% is the max for my 401(k)
   
5. increase TSP up to 100% (minus allotments). The max for TSP is 100%. I would need to determine how much would pay my SGLI (life insurance) and any other allotments, then contribute the rest to the tax deferred TSP.
   
6. Brokerage. If I've maxed all my retirement plans, tucked away money for college, and still have money to invest (wouldn't we all love that), THEN I'll look at a regular brokerage. Why pay capital gains and earnings taxes if you don't have to? If I ever reach this point, I'll gladly pay those taxes, but until then, I need every penny I can get.

Now, for the asset allocation plan. Much of the inspiration for my asset allocation comes from the investment advice provided at FundAdvice.com, combined with the advice of the investment advisors from USAA.

401(k): The 401(k) at my work just got a huge makeover, and it's much, much better. Before, there were no mid-cap or small-cap offerings, a majority of large-cap, some international, an S&P 500 index tracking fund, and some "balanced" (asset allocation) funds. They got rid of some of the large-cap in favor of a mid-cap value, mid-cap blend, and small cap value fund.

• 50% Fidelity International Discovery (FIGRX), International blended
  
• 10% Fidelity Equity Income (FEQIX, Large cap value
  
• 10% Fidelity US EQ Index Pool (no ticker), S&P 500 tracking fund, large cap blend
  
• 10% Columbia Acorn Z (ACRNX, Mid cap growth
  
• 15% Keeley Small Cap Value (KSCVX, Small cap value
  
• 5% Fidelity US Bond Index(FBIDX Intermediate Bonds

TSP: The TSP plan has a weird setup, but luckily, Paul Merriman had an artice about it that helped. Both Mrs Dreamer and I have a TSP account.

• Dreamer
  
  • 30% C fund (S&P 500 index)
    
  • 30% S fund (Wilshire 4500 index. Combining the S and C funds invests in the top 5000 companies in the US as a whole)
    
  • 40% I fund (International fund)
  
  
• Mrs. Dreamer
  
  • 10% F fund (Fixed income fund, tracks Lehman Brothers U.S. Aggregate bond index)
    
  • 10% G fund (special treasury securities specifically made for the TSP)
    
  • 24% C fund
    
  • 24% S fund
    
  • 32% I fund

Roth IRAs: For the purposes of asset allocation, both mine and Mrs Dreamer IRAs are included in the plan. This is the plan for overall funds we will hold.

• 10% Vanguard 500 Index (VFINX), Large cap blend
  
• 10% Vanguard Value Index (VIVAX), Large cap value
  
• 10% Vanguard Small Cap Index (NAESX), Small cap blend
  
• 10% Vanguard Small Cap Value (VISVX), Small cap value
  
• 10% Vanguard REIT Index (VGSIX), Real Estate Investment Trust (REIT)
  
• 10% Vanguard Vanguard Developed Markets Index (VDMIX), International large cap blend
  
• 10% Vanguard International Value (VTRIX), International large cap value
  
• 10% Vanguard Emerging Market Index (VEIEX), Emerging markets
  
• 10% Tocqueville International Value (TIVFX), International small cap value
  
• 10% T. Rowe Price International Discovery (PRIDX)

, International small cap growth

I estimate it will take about 5-6 years to set up this asset allocation plan. Once it's up though, I will only need to rebalance occasionally, and let the diversification work for me. Plus, once all the funds have their initial investment ($3000), I can either use dollar cost averaging for my remaining contributions until retirement, or use the yearly contribution to rebalance, depending on if I have the cash available all at once, or over a period.

Saving money on groceries

Me and my wife try to take every (reasonable) method we have to minimize our grocery bill. We make a list, we try to stick to it, we go shopping at WinCo foods (a discount grocery chain kind of like a cross between Costco and WalMart, except it's employee owned and local, and no membership is required), and we buy generic and pay close attention to price per unit.

One thing that we never realized was costing us money was one simple thing: We had no idea how much we actually had! We would sometimes grab diced tomatos, or canned beans, just because we thought we might need more.

Well, we just did an inventory of our pantry (I was looking for something to munch on, and I was so struck by how much actual food we had, we just fell into it.) We have noodles galore, over 12 cans of diced tomatos, side dishes, starches, rice, beans, canned and frozen vegetables, snack bars, sandwich stuff, you name it.

After looking at everything, we determined that we probably have enough food for a couple of weeks. It was like a shopping trip for free, discovering things up at the top of the cupboards that we forgot we had. Now, our shopping trip will only consist of fruits and veggies, and a couple of missing items for specific recipes.

The same concept is probably true all over the house. We haven't bought DVDs in months, because of how many movies and such we already have (I'm looking at just selling them soon, we don't watch them enough to justify the storage space). We have books we've barely read, toys and gadgets that sit in boxes, clothes that we haven't worn in a long time.

If we continue to tackle things like we just did the cupboards, we could not only clear out a lot of clutter, we could save money by not buying things we didn't know we already had.

Speculative investing

Buying "hot stocks", or investing in a fund just because it was just featured in some magazine is stupid. I know it, you know it, and yet, that's what everybody thinks will make them rich someday. It rarely happens, and it's just not worth the risk.

There is one, and only one time when you can indulge in speculative investing: When you don't care about the money you're spending. If every single penny were to disappear tomorrow, would you kick yourself, or would you barely shrug?

With that in mind, I did a little speculation myself. I used the remaining $300 of my stimulus check and purchased 10 shares of a new ETF, Powershares global nuclear energy (PKN).

Why would I do something like that? I weighed the pros and the cons, and here's what I came up with:

• Cons:
  
  • This ETF is brand spanking new. Although it tracks the WNA index, which hasn't done too badly, there is no real precedent Similar ETFs have done marginally well, although there is a volatility to them that is troubling.
    
  • The fees on this ETF are very high for an index fund: 0.75%! That cuts into compounding returns for sure. Still, it primarily invests internationally, and that always affects costs. Many countries charge exorbitant taxes for out of country stock sales, and that can be reflected in the management fees.
    
  • Buying an ETF costs money. Since this was less than $2500, and it went into my IRA, I had to pay a $10.99 commission for this trade. For such a low number of shares, that's a huge chunk of change, and it starts me out at a loss.
  
  
• Pros:
  
  • A major reason why America's economy isn't as strong as it could be is our dependence on fossil fuels. Hopefully, with more money going into nuclear research, we could wean ourselves off of depending on an unstable region that hates us to provide our energy. I'm basically placing a bet that America will turn to nuclear energy before long.
    
  • It feels moral. I don't like the stimulus check, I didn't want it, and I'd rather that money went to the federal budget, honestly. If this ETF goes bust, I won't care. I'll just pretend I never got it in the first place.

Irresponsible? Probably. Will it work? Only time will tell. This is a buy and hold ETF for me, so I won't be selling it anytime soon. With luck, the value will continue to rise.

Henry Rollins on credit and retirement

Henry Rollins is awesome. I love his music, his show, and his spoken word performances.

Podcasts

At work, I can listen to my mp3 player (that Archos 650 wifi I bought earlier) while I work. Although music is great, even 30GB of music can get old after a few weeks of listening to it on shuffle for 8 1/2 hours a day, so I've turned to podcasts for constantly updating entertainment at work.

Of the podcasts I've enjoyed are some NPR podcasts (Wait Wait Don't Tell Me and Intelligence Squared being some of my favorites), and podcasts about humanism and atheism, two topics that also interest me.

I saw that there were lots of personal finance podcasts, but I was hesitant to listen to any, because I know that for every person out there with good knowledge and advice, there are 20 that are trying to sell something. So, there were no real finance based podcasts in my lineup.

Enter Get Rich Slowly. This list of twelve personal finance podcasts was just what I needed. I didn't pick all twelve to listen to, but I did start listening to some.

My favorite so far? Sound Investing. This is a podcast of a weekly radio show in Seattle, which is close to me. The hosts are obviously knowledgeable, and seem to really care about people's investments, especially retirement. Not only that, but they're very upfront about who they represent, and what financial interest they have: The host, Paul Merriman owns a financial advising firm that advocates index fund investing and asset allocation as a long term investment strategy. They share all of their secrets, and their website, fundadvice.com, is a wealth of information. Their policy seems to be this: If you want to manage your own portfolio, we'll show you how we would do it so you can do it well, but if you decide that we do well enough and it's worth it for you to let us take care of the day to day stuff, we'll be happy to. It's refreshing to see advisors that don't just push annuities or their own products, but will actually care enough to give you advice on funds that they have no chance of ever getting control of, such as the TSP account, a 401(k) like retirement plan for government employees and military members.

I've never heard of Paul Merriman before, but I like him already, and I would love to pick his brain. I wonder if somebody at that company would agree to an informational interview about what they do. I'm a little interested in exploring that sort of thing as a possible career.

More updates, more often!

So far, I've just been using this myself to keep track of my finance goals. I think from this point on, I'd like to be more active with this. I'd like to bring up things that I like, and personal finance issues that interest me. Maybe someday, I'll actually think about trying to get people to read this.

April Update

The official monthly update.

Items:

• My wife's bonus finally showed, and things are moving smoothly.
  
• My work union is negotiating a new contract, which will include a raise.
  
• I'm working as hard as I can to get back into school.
  
• I've increased my 401(k) contribution to 5% (3% matched).

Goals Update

• Review
• Financial
• Credit card debt totaling $0 (No change) ("deadbeat" credit card balance isn't counted. That card is paid off every month) (goal $0)
• Loan debt totaling $0 *GOAL REACHED*
  
• Loan debt totaling $0 *GOAL REACHED*
  
• Car loan totaling $18,448.46 (No change)
  
• Emergency fund totaling $7263.76 (up $1,955.04) (goal $7,500)
• Roth IRA contributions to date: In savings, $3590.74 (up $1114.8), invested in DCA plans, $300 (up $100)(goal $5000)
• Charitable
• Total hours volunteered: 21 (goal: 100)
  

My wife's bonus has already been distributed, and all the remainder after savings, investment, and the car down payment are hers, as she so graciously agreed.

The stimulus payment will show up soon. We had a direct deposit refund, so we'll get ours in a short while. Me and my wife had a discussion about what to do with each of our shares ($600 each, but I'm not going to decide what to do with her money.)

My wife has been halfway getting into this frugality thing too. I'm very proud of her. We agreed that half of our money will go to our largest debt (the new car), and the other half can be spent as desired. I'll probably just put mine in my IRA.

Right now, we just need to maintain, and cut costs where we can. I think at some point soon, we might sit down and discuss a monthly budget. I've got enough information from my pay stubs to know about how much I get paid now (paid per hour, and it varies by a bit from paycheck to paycheck.)