When it comes to investing, the biggest and most important decision revolving your portfolio is asset allocation. Jack Bogle, the founder and former CEO of The Vanguard Group, once said, “The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve?”
Creating a successful asset allocation for your investment portfolio is partially based on carefully choosing good investments, but even more importantly it’s based on you personally, and your personal preferences. Your asset allocation should be built and designed to meet your personal needs and preferences, like your risk tolerance, time frame, personal financial situation, and your goals. In this article and the articles that follow, I’ll explain how to determine and build a successful asset allocation based on your personal needs and traits.
Dividing Investments Among Different Types Of Asset Classes
What is asset allocation? Simply put, it can be achieved by not putting all your eggs in one basket. More technically, asset allocation is when you minimize your risk by dividing your investments among different types of asset classes while maximizing returns.
In order to achieve this and create an efficient portfolio, you need to start by asking yourself a few questions. First ask yourself, “What investments should I choose to place in my portfolio?”
The Efficient Market Theory
To help you choose and decide what investments to place in your portfolio and how much of each investment to hold efficiently, while minimizing risk and maximizing returns, there’s an important theory that can help us, called the efficient market theory, which can be abbreviated as EMT.
EMT is an investment theory, which explains that beating the market isn’t possible since all relevant information is already reflected and shown in the current share prices. Through this theory, it can also be determined that predicting the market is impossible and cannot be accurately forecasted or predicted.
This theory also helps us understands why it’s important to ignore all the market news and media which is rambled of daily by so-called investing and stock market “experts.”
Giving into the all the hype the media rants off as “hot investments” can cause you to make poor investment decisions, such as buying into a bad investment, or worst, cause you to panic and sell an investment during the worst time possible when you should have stayed put.
The Stock Market Is Unpredictable
The efficient market theory became popular in the early 1900’s, when an investor and stock market researcher by the name of Alfred Cowles discovered that the stock market was unpredictable. This became clear to Cowles after watching the stock market peak in August of 1929, only to then tank horrifically in the summer of 1932, which eventually lead to The Great Depression.
Riding a bull market at the start of 1929, Cowles wondered why financial analyst and experts didn’t predict the stock market crash that happened just a few years later, in fact most of the market forecasts and predictions had positive outlooks for the market. After doing some research it became clear to Cowles that the so-called financial “experts” were unable to predict the outcome of the market, nobody could.
Trying to understand why, Cowles decided to dig deep and looked over 7,500 stock market forecasts and recommendations made by financial services between the years of 1903 and 1929. He then compared the recommendations and market forecasts with the actual stock market data and results, to see how many of the forecasts and predictions were actually accurate and true.
The research and evidence didn’t lie, he published his results in an article he wrote, titled “Can Stock Market Forecasters Forecast?” and gave an overview explaining precisely just how inaccurate so-called “expert” predictions can be when trying to forecast the market.
If you ever had any experience working with a financial advisor or personal wealth manager, then you probably know how confident they sound when they want you to invest in one of their “professionally managed funds” or try selling you a hot stock, because it’s a “sure winner” according to their analyst. Many of these so-called “professionals” believe they’re able to forecast the market and find winning stocks, even though there’s clear evidence showing that it’s impossible to predict the market.
Mutual fund managers like to establish themselves as professional investors and stock traders who are able to time the market perfectly, for when to buy and sell stocks. Professionally managed mutual funds tend to charge expensive fees at their investors expense and have been proven to underperform index funds 80 percent of the time.
Fast forward a couple years to the 1960’s, when a man named Eugene F. Fama, a professor at the University of Chicago began reviewing the prices of stocks and increase quantity of data associated to stocks prices. He too, was able to conclude that it is very difficult, if not impossible, to forecast the stock market and predict which stocks would be winners.
Not long after that, in 1973, Burton Malkiel a Princeton professor, also concluded the stock market was unpredictable after doing his own research and published the extremely popular book titled, Random Walk Down Wall Street. The book had become a best seller and an investment classic, which has been since updated and revised editions of the book are still bought and published today on a regular basis. Random Walk Down Wall Street is a must read, and deserves a spot on every good investors bookshelf!
One reader describes Professor Malkiel’s book a Random Walk Down Wall Street particularly well:
“First published in 1973, this seventh printing of a A Random Walk looks forward and does so broadly, examining a new range of investment choices facing the turn-of-the-century investor: money-market accounts, tax-exempt funds, Roth IRAs, and equity REITs, as well as the potential benefits and pitfalls of the emerging global economy. In his updated “life-cycle guide to investing,” Malkiel offers age-related investment strategies that consider one’s capacity for risk. (A 30-year-old who can depend on wages to offset investment losses has a different risk capacity from a 60-year-old.) In his assessment of rocketing Internet stocks, Malkiel defends his “random” position well, explaining how “the market eventually corrects any irrationality–albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But eventually, true value is recognized by the market, and this is the main lesson investors must heed.” Written for the financial layperson but bolstered by 30 years of research, A Random Walk will help individual investors take charge of their financial future. Recommended.”
Index Funds Outperform Professionally Managed Funds
Just about all academics and anyone who has ever study the stock market would agree that it is pretty efficient. It can also be agreed upon that because stocks and bonds alike have very efficient prices, that there are very few, if any, professionally managed funds or investors that can outperform an index fund which isn’t managed. Index funds also have extremely low expenses associated with them, and little or no transaction costs, which is why a community of investing enthusiasts called Bogleheads worship index funds for investment portfolios.
The name “Boglehead” is derived from the love of Jack Bogle and the low-cost index funds he created. They’re a community made up of more than fifty-thousands like-minded investors who help one-another and share advice with other members though their own online Bogleheads forum.
The Bogleheads’ community that interacts with one-another on their forum, also have their own wiki page and two very popular investment books titled The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning. Both are excellent books that every investor should read to become a more sophisticated and intelligent investor. Both books cover asset allocation for successful investing in detail, they teach you about the history of investing and proven investment strategies.
Reviews written by readers who’ve read The Bogleheads’ Guide to Investing, Second Edition:
“I’m often asked to recommend a good, basic book on investing, and The Bogleheads’ Guide to Investing has been my go-to pick since its original publication. It focuses on all the right things: the virtues of maintaining a frugal lifestyle, keeping investment costs down, and building a simple, low-maintenance portfolio. And importantly, it also tells investors what they can safely tune out—namely, day-to-day market action and the latest ‘hot’ investment products. Its advice will stand the test of time.”
“John Bogle set out to reform the mutual fund industry nearly 40 years ago. He saw a high fee, self-serving, good ol’ boy network and thought it was wrong. Bogle believed the purpose of an investment company was to be investor-focused. His idea turned into a revolution. The Bogleheads’ Guide to Investing is a testimony to the massive changes that have taken place as a result of Bogle’s vision. The ideas in this book have saved countless investors billions of dollars in unnecessary fees. Hats off to Taylor, Mel, and Mike for a job well done.”
“The Bogleheads’ Guide to Investing describes a sophisticated and proven approach to successful investing. Nevertheless, its message of saving, investing in a diversified, balanced, low cost portfolio, and keeping it simple is easily grasped by investors of all levels of experience. Regardless of your investment acumen, this book provides many clearly expounded investment insights and is a great roadmap to financial success.”
—GEORGE U. “GUS” SAUTER
Reviews written by readers after reading The Bogleheads’ Guide to Retirement Planning:
“Meet the wisest and most generous crowd on Wall Street: the Bogleheads. The Internet’s worst-kept secret is now well out in the open; for the best in online investment education and advice, you can’t beat www.bogleheads.org. Wisdom of crowds, indeed: a thread for almost every need, an expert contributor for every subject. Now, for the first time between these covers, the Bogleheads assemble their formidable collective expertise on retirement planning. Savor, enjoy, and learn.”
—William J. Bernstein, author of The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between
“The Bogleheads have done it again! The web’s savviest and most caring investment consortium has gathered all the information you’ll need to plot a safe and sane course toward retirement. Their camaraderie, kindness, and commonsense wisdom will steel you to ‘stay the course’ and realize your retirement dreams. With the Bogleheads, asking the audience is always the best solution.”
—Don Phillips, Managing Director, Morningstar
“This book pilots the reader around the shoals of retirement planning, including tricky issues such as social security, health insurance, divorce, and finding proper financial advice. This not-for-profit collaborative enterprise answers recurrent questions raised by members of the Bogleheads online forum with clarity, wisdom, and humor. It exposes fallacies, suggests alternatives, and reassures the thorough planner. It is a welcome contribution to a world where unrestrained greed and complex financial arrangements have capsized many. I keep referring back to it.”
—Ed Tower, Professor of Economics, Duke University