The asset allocation that we use, and explain below, certainly isn’t the only one out there. It’s a good one, though, and it’s also very simple. There aren’t a lot of decisions to make. We don’t have to worry about picking winning stocks or sectors, we’re not trying to time or predict anything. It takes very little thought, once you’ve started.
After you choose and invest in an asset allocation, it is VERY important to rebalance periodically. Personally, I check my allocation quarterly, but I think annual rebalancing is typically fine. I generally rebalance my exchanging assets in my tax-sheltered accounts, or by shifting where my future buys are going. I don’t worry overly much about getting things rebalanced exactly, but I try not to let things be more than a couple of percentage points out of balance.
One thing I want to make absolutely clear at the top: there is not one right way to do this, so don’t worry about getting it perfect. The big things are 1) find something you’re comfortable with (in terms of risk) 2) that makes sense to you (in terms of the types of investments) and 3) stick with it (by rebalancing as needed). This is a great place to practice satisficing, rather than constantly tweaking and changing things to try to optimize it.
Our asset allocation is pretty simple. We are invested in 90% stocks, 10% bonds, the the stock portion allocated to 52% US stocks and 38% rest of the world stocks. It looks like this:
This known as a three-fund portfolio. For a while, we had a four-fund portfolio with a 10% investment in REITs (basically an index fund for real estate). Once we bought a house, though, owning REITs felt less important, and we gradually reduced our holding to 5%. And as we got closer to FI, simplicity became more appealing, so we got out of REITs entirely. Note that this doesn’t mean we are literally in just three funds (although that would be great!). Because we have a few employer-offered accounts, we have accounts with several different brokerages, and thus have over 20 different funds in our three-fund portfolio.
Deciding on the Stock vs. Bond Ratio
Generally speaking, you’re going to have a higher percentage of stocks if you’re more comfortable with risk, and a higher percentage of bonds if you’re less comfortable with risk. At the same time, I would argue that having a high percentage of bonds is actually more risky, as you’re risking missing out on the additional gains you would typically capture with a higher percentage of stocks.
Another way to look at this is based on your time horizon. Personally, if I were 10 or more years away from withdrawal, I would never go below 80/20 stocks to bonds. And, honestly, I’d be perfectly comfortable with 100% stocks. Even today, when we are close to (or even at) our FI number, I’m totally comfortable being 90/10 stocks to bonds. My perspective is — I’d rather leave my investments in the place where they’re most likely to grow for as long as possible. In addition, my plan isn’t absolute retirement. I enjoy working on things, being productive, and thus I suspect that even when I quit working full-time, I’ll continue earning some sort of income for a couple of decades. We have modest expenses, so I expect that part-time work would cover most if not all of them.
Here are a couple of calculators that help you determine your stock vs. bond percentages. They ask questions to do with investing timeline, knowledge and behavior, along with risk tolerance.
Vanguard Canada Investor Questionnaire
Index Fund Advisers survey
I took both of the above recently, and got 80/20 stocks vs. bonds on one, and 96/4 stocks vs. bonds on the other.
Deciding on the Domestic vs. International Ratio
Often times people overweight their own home country when deciding how to divvy up the stock portion of their portfolio. Perhaps there is good reason to do this, as it may make sense to tie your financial fate more securing to the place that you live. Personally, though, I don’t subscribe to this. The ratio we have of US to non-US stocks is based on whatever the global market cap was at the time we established our asset allocation. Googling it now, it seems like we should shift a bit more to the non-US side — in mid-2021 I’m seeing 55% US to 45% non-US.
At the same time, we may end up with a slight home country bias to Canada when we start investing Canadian dollars in our taxable account, as we’ll be investing in individual Canadian stocks (in order to avoid PFICs). My expectation is that this would never be more than 5% or so of our total asset allocation.
Rebalancing
Once you decided on an asset allocation, rebalancing is the key to maintaining it. All that means is, on a regular basis (somewhere between once a year and quarterly) you check your asset percentages, and then you adjust accordingly, selling one and buying another to bring the portfolio back into alignment with your desired asset allocation as needed. The great thing about this is is means that you are always selling high and buying low.
And, over time, you may want to shift your asset allocation (for example, becoming more conservative as you approach retirement) but I would encourage you not to make lots of changes as your going through your accumulation phase. Sticking with an asset allocation and rebalancing is better than chasing past performance by constantly adjusting your asset allocation based on the flavor of the day.
More Ideas on Asset Allocation
Ultimately, though, it’s a personal decision. I found it helpful to browse through some ideas for sample portfolios when coming up with our asset allocation.
Bogleheads – A great website for investing advice, with an American focus. They’re very much into low-cost index funds, which is great, but they are a bit conservative for my taste in terms of asset allocation. They have a page on asset allocation, and also one offering several sample portfolio ideas.
Finiki – Similar to Bogleheads in philosophy, with a Canadian focus. They also have a page on asset allocation and one of sample portfolio ideas.
As you look at those sample portfolios, you can see that we are significantly more aggressive than most of them (in terms of our stock percentage). That tends to be a pretty common orientation in the FIRE community — stocks gain more than bonds, so we’re willing to risk a short-term loss for the long-term gain, rather than being more conservative and guaranteeing a slower path to financial independence.
Small Value Tilt / Factor-based Investing – I don’t do this, but there is an argument to be made that tilting your portfolio a bit towards things like small cap value can boost returns over a long time horizon. Here is a good look at what those portfolios might look like. And here is a good post on why these may not be worth doing for most investors. At the 2021 Canadian Financial Summit, I listened to Ben Felix’s talk on this, and I was struck by his estimate of the value add — he said something between 30 and 40 basis points (aka .3 – .4%). Again, do your own research. I don’t personally do this (I’m more drawn to simplicity) but I think there’s a reasonable argument for it. 2023 Update: I have added a slight small value tilt to my Roth IRA, which amounts to a 3% portion of our overall investments.
Approaching Retirement
As we close in on financial independence, I’m starting to think about shifting things a bit. One idea that appeals to me is holding more cash (in CAD), rather than more bonds. This would have the double benefit of helping us to avoid having to sell stocks at a low, and also helping us to avoid having to change money from USD (which our investments are held in) to CAD (which is how we spend) at a bad time. The above asset allocation, though, has worked well for us during our accumulation phase.
Tax-efficient Fund Placement
One last thing to think about in terms of asset allocation is which type of account you want to hold the different types of investments in. You don’t need to over-think this, but there are a couple of general rules that I follow. Note that I came to these opinions while investing in the US, and I have more to learn about Canada, but I *think* they are generally true in both places.
Hold bonds in something tax sheltered as interest is taxed like regular income.
Hold foreign stocks in a taxable account, as you’ll get credit for foreign taxes paid.
In Canada, holding Canadian stocks that pay dividends in your taxable account is good (as they are taxed more favorably). However, if you are a US citizen in Canada, doing this in the form of an index fund would be considered a PFIC, which I avoid. Thus, as an American living in Canada, I would do this by buying individual dividend paying stocks.
For more thoughts, here is Bogleheads’ page on tax efficient investing, and here is the a simliar page at Finiki.
Again, though, don’t worry overly much about this. Per Finiki: “Relative to holding the same asset mix across all accounts, asset location strategies have been estimated to potentially add on the order of 0.07-0.3% per year in after-tax returns, depending on the methodology of the study.” In other words, this doesn’t make a huge difference. Plus, if you aren’t filling up your tax sheltered space, it’s all pretty much moot as you should just put everything in there.
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