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Friday, June 24, 2011

Step One - Pick an Asset Allocation Model

The very first step in DIY investing is to come up with an asset allocation plan. Today this is pretty straight forward because suggested models are easily accessible online with all of the relevant parameters.

Today we'll look at the American Association of Individual Investors (AAII) models and tomorrow we'll consider Schwab's. These are just two of the many available.

Keep it Simple

The first thing to know is that there is considerable value to keeping the whole asset allocation business simple. It isn't as scientific as is sometimes presented by financial advisors.

The objective is to arrive at a targeted percentage to invest in various asset classes.

The simplicity of the process is illustrated by the three models proposed by AAII:

(Source: American Association of Individual Investors).

As you can see, the AAII models suggest 3 categories: aggressive, moderate, or conservative. The aggressive model has 90% stocks, 10% bonds. The conservative model is split 50/50. Note that there are 7 asset classes.

Here are the historical returns of the 3 models:

(Source: American Association of Individual Investors).

As shown, the longer term performance of the Aggressive model exceeds that of the other two. This illustrates the reward for taking on more risk.

Which model should you choose? To help, AAII provides "Broad Allocation Scenarios." This tells you the relevant points to consider:

(Source: American Association of Individual Investors).

Notice that age, investment horizon, and volatility are listed. Notice that the worst year return is given. These are all important in choosing a model. Still, overall, I'm sure you'll agree that the process is fairly straight forward.

Additional Points

A couple of additional points should be kept in mind. First, the model isn't set in concrete. If the market gets you nervous and you are having trouble sleeping at night, by all means get more conservative. What you don't want to do is continually switch back and forth and, thereby, let your emotions dominate the investment process. Secondly, this is where you have some control. I know from experience that many people have a difficulty working with an advisor simply because they feel they are losing control of their money. In my view, this is where to keep control - make sure the allocation model is well specified and that you are able to track it. Then you can have the advisor do the nitty-gritty work of buying and selling of the securities. Finally, recognize that over time you'll likely get more conservative (i.e. increase the bond exposure)in your allocation.

Tomorrow we'll look at Schwab's models. After we're comfortable with model selection, we'll go to step 2 of choosing investments.


  1. Excellent introduction to asset allocation! Anyone who wishes to start investing in the stock market should start with this.

    I see no mention of longterm bonds - were they removed due to the current rates or were longterm bonds never a part of this allocation model? Or putting it another way, does AAII tweak this model depending upon the market or is it static? I've seen models tweak the percentages, not the asset class itself. Just curious.

  2. I'm not absolutely sure but I believe that AAII keeps these models static. Typically the fixed income allocation is for intermediate bonds so that they can index against the Barclay's Aggregate Bond Index. In managing the actual allocation of assets some tweaking is possible. For example, overweight corporate or mortgage backed securities. If successful you can do a bit better than the benchmark although it does introduce some basis risk

  3. I am tottally agree with the post.

    Few steps to financial independence are to keep it simple, save 20%+ of your earnings, diversify investments.

    There is no silver bullet just time and one step at the time.