On Asset Allocation - The average investors most important decision

In Chapter 3 of Common Sense on Mutual Funds, John Bogle emphasizes the importance of getting your personal asset allocation correct.

Asset allocation means your stock to bond mix. Bogle emphasizes that bonds should be used as a moderator to your risky stocks. Not as another risky investment alternative. He says this because there are bonds that are very risky such as low grade and junk bonds. So by mix he means stable investments (short term high grade bonds) relative to risky, volatile investments (stocks).

He sites the famous 1986 study in the Financial Analysis Journal by Brinson, Hood, and Beebower that over 90% of the variation in pension plan returns studied were due to the stock bond mix. Not the particular stocks or bonds chosen.

Bogle clarifies the meaning behind the study's outcome: "Long-term fund investors might profit by concentrating more on the allocation of investments between stock and bond funds, and less on the question of what particular stock or bond fund to hold"

He goes on to emphasize that an investor needs to understand their time horizon, ability to stomach volatility, and whether the savings is for accumulating wealth or the distribution of wealth. Longer time horizons and investors in the savings stage can invest in a greater percentage of stocks. Versus an investor who is in the distribution phase of their investment cycle who should have a lower percentage of stocks. All investors should work with a trusted, competent advisor in order to develop the allocation mix that is best for them.

Bogle goes on to demonstrate that once the allocation mix is defined. The second most important thing an investor should do is fill the portfolio with low cost, preferably index, funds. Study after study show that when comparing similar funds, low cost is the best determinant of long term performance (see blog post 8/27/10).

The advice is straight forward: Determine the percentage of stocks you should own, then fund your portfolio with low cost index funds.

In future posts we will discuss what makes up the stock and bond portions. But you cant get to this question until you have determined the allocation.