Diversification to Five Classes Brings Further Benefits to Strained Retirement Portfolios
03/05/2011 0 comments
We have previously highlighted the plight of boomers coming up on retirement with insufficient funds. There is a great deal of advice to get your portfolios in order. In this article we seek to quantify what moving to a portfolio with five different asset classes can do for you.
401K plans have moved from being an adjunct to a pension plan to being the mainstay of retirement income. In a study of over 800 mainly retirement plans, we noted that the majority of plans supported only three asset classes which is going to have a significant impact on the potential returns for the participant.
| Asset Classes | %age of plans |
| Three | 59 |
| Four | 23 |
| Five | 14 |
| Six | 4 |
In the last article we found that applying a tactical asset allocation strategy to a four asset class, historical simulations showed returns more than double over the longer time horizon. This is a significant jump and over a decade puts 60% more money in your pocket. Sadly only 23% of the plans have four asset classes and only 14% have five. Nonetheless, it is important to see what the difference is because it is always possible to create a more balanced portfolios with an IRA
We are going to use a simple benchmark vehicle -- SIB -- simpler is better to show the potential difference in returns between the portfolios with different numbers of asset classes.
Each of the SIBs are built from one ETF per asset class. The ETFs we selected for these portfolios are as follows:
| Asset Class | Ticker | Name |
|---|---|---|
| LARGE BLEND | VTI | Vanguard Total Stock Market ETF |
| Foreign Large Blend | VEU | Vanguard FTSE All-World ex-US ETF |
| DIVERSIFIED EMERGING MKTS | VWO | Vanguard Emerging Markets Stock ETF |
| REAL ESTATE | VNQ | Vanguard REIT Index ETF |
| COMMODITIES BROAD BASKET | DBC | PowerShares DB Commodity Idx Trking Fund |
| Intermediate-Term Bond | BND | Vanguard Total Bond Market ETF |
So the three asset SIB has US, (VTI), International (VEU) and fixed income (BND). The four asset SIB adds emerging markets (VWO). The five asset SIB adds Real Estate (VNQ). The six asset SIB adds commodities (DBC)..
The three asset portfolio is really old school. The four asset SIB adds emerging markets which provides diversification and assistance when the developed world equities are under pressure. As we struggle back from the recent financial melt down, emerging markets have played a significant part in leading the way.
Now we add real estate which may have a bad name as one of the major causes of the great recession but this highlights the importance of having diversification. While consumer housing was hammered based on overstretched valuations and risky loans, real estate trusts managed to weather their way through the storm and remain an important alternative. They have been performing well lately.
Performance table (as of Mar 4, 2011)
| Portfolio Name | 1Yr AR | 1Yr Sharpe | 3Yr AR | 3Yr Sharpe | 5Yr AR | 5Yr Sharpe |
|---|---|---|---|---|---|---|
| Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate | 2% | 17% | 3% | 29% | 4% | 37% |
| Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate | 16% | 115% | 4% | 18% | 4% | 19% |
| Five Core Asset ETF Benchmark Tactical Asset Allocation Moderate | 12% | 87% | 8% | 63% | 10% | 69% |
| Five Core Asset ETF Benchmark Strategic Asset Allocation Moderate | 17% | 127% | 5% | 19% | 6% | 23% |
We note that the five Asset Class SIB -- which only differs from the three Asset Class SIB by having one fund in each of Real Estate and Emerging Markets -- wins across the board. If we look over the five year horizon, buy and hold gives you an extra 2% and Tactical Asset Allocation gives you an extra 6%. Over a decade, that extra 6% puts 75% more money in your pocket than if you have three asset classes. This compares with an extra 60% with four asset classes.
How can you do this if your plan only supports three asset classes? If you have an IRA, overweight the missing asset class (or two) in the IRA to compensate and create a more balanced portfolio that can deliver higher returns and lower risk.
Disclosure:
MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.
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