Time for Boomers to Understand What Diversification Brings them

05/10/2011 Share 0 comments

At the end of 2010, we undertook a study to look at 800 plans that include retirement plans (401K, 403B, IRA), annuities and taxable plans. At that point, we reported that 59% of the plans had only three asset classes and only 4% had six asset classes.

 

Since then we have been catapulted through the first nearly half year following political and natural disasters, royal weddings and the demise of the world's most wanted man. How well are your new year's resolutions doing?

 

Today we repeat the exercise but with over double the number of plans as we have been adding more plans to our database to provide an ever broader support.

Asset Classes	10-Dec-10	15-May-11
Three	59%	60%
Four	23%	22%
Five	14%	13%
Six	4%	5%
Total	783	1590

The situation has not changed much with nearly the same percentage in each class. Both three and six have increased slightly.

This is a worrying situation as we have previously reported the benefits in terms of risk adjusted returns to having more asset classes.

To make this clear, we 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 VTI, VEU and BND. The four asset SIB adds emerging markets. The five asset SIB adds Real Estate. The six asset SIB adds commodities.

The three asset portfolio is really old school. The world comprises the US and the rest. US equities are enough of a microcosm that I can find enough diversification to give me protection against certain segments of the markets declining. Even if that does happen, I have fixed income and international equities to bail me out. We know that this is no longer the case. We can see on our browsers how the DOW, FTSE and NIKKEI act as if they are the same index, just on a different timezone. With a three asset portfolio, you really have very limited diversification.

Emerging markets are going to play a larger and larger part in our lives as countries such as China and India are increasingly powerful. We have already seen how these nations have sprung back from the great recession and are leading the recovery. This is an important part of any portfolio and if you want to know how to better your chances of a better retirement, now you know.

Real Estate trusts are now a domestic and international staple providing dividend income and an asset class that behaves differently than equities.

Commodities are volatile as recent movements demonstrate but they are a great hedge against inflation and will be an important part of a portfolio over the next few years.

We use two asset allocation strategies.

• Tactical Asset Allocation Moderate -- Above funds using TAA (40% fixed income, 30% for each of the top two asset classes)
• Retirement Income ETFs Strategic Asset Allocation Moderate -- Above funds using SAA (40% fixed income, 60% spread evenly over the risk based asset classes -- funds selected based on price momentum)

TAA is a more active strategy and assumes that when things are bad, all assets behave the same way and go down so it will move you out of equities into fixed income or even cash. SAA reflects all asset classes at all times.

Portfolio/Fund Name	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Six Core Asset ETF Benchmark Tactical Asset Allocation Moderate	10%	107%	8%	66%	12%	81%
Five Core Asset ETF Benchmark Tactical Asset Allocation Moderate	8%	91%	8%	66%	10%	64%
Four Core Asset ETF (EM) Benchmark Tactical Asset Allocation Moderate	1%	39%	6%	51%	7%	42%
Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate	2%	44%	3%	29%	4%	34%

Five Year Chart

The more detailed analysis and graphs give a better idea of the returns over time and you can see the drawdown and other key parameters of the portfolio.

Strategic Asset Allocation Performance Comparison

Portfolio/Fund Name	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Six Core Asset ETF Benchmark Strategic Asset Allocation Moderate	16%	157%	3%	14%	6%	30%
Five Core Asset ETF Benchmark Strategic Asset Allocation Moderate	16%	148%	4%	14%	6%	22%
Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate	16%	150%	3%	13%	4%	18%
Four Core Asset ETF (EM) Benchmark Strategic Asset Allocation Moderate	17%	148%	3%	10%	5%	17%

Five Year Chart

The more detailed analysis and graphs give a better idea of the returns over time and you can see the drawdown and other key parameters of the portfolio.


We can see that while equity markets are doing well, SAA gives the highest returns but when  you look over a longer period, TAA minimizes losses and so provides better returns considering the melt down over the past few years.

We should also note that the more asset classes you have, the higher the returns. This is less obvious with SAA but clear with TAA.

Having 60% of the plans offering only three asset classes means that you are potentially leaving 8% of additional returns on the table -- over a decade, that more than doubles your money.

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.

Exchange Tickers: (NYSE: VTI), (NYSE: VEU), (NYSE: BND), (NYSE: VNQ), (NYSE: VWO), (NYSE: DBC)

Symbols: VTI, VEU, BND, VNQ, VWO, DBC

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