The “Three Fund” Portfolio Part 4 – Asset Allocation

The final questions to answer in building an aggressive portfolio are: 1) how much to allocate to stocks vs. bonds, and 2) how to weight domestic stocks vs. international stocks. In other words, asset allocation.

Domestic vs. Foreign Stocks

I ran the domestic vs. international stock asset classes on PortfolioVisualizer’s optimization tool going back to 1993. The minimum variance portfolio is approximately 80% US and 20% foreign or 4 to 1.

When I ran DGRO vs DNL since 2014, I got 63% domestic and 37% foreign. Similarly, DGRO vs VEU results in 62% domestic. About 2 to 1. However, VTI vs VEU since 2007 results in 100% domestic.

Note, minimum variance seeks the combination with the lowest standard deviation. Allocating 100% to domestic stocks provides the best risk-adjusted returns (Sharpe ratio) due to foreign underperformance. Indeed, Warren Buffett suggests omitting foreign stocks altogether in asset allocations and “buying US.”

Risk-parity combinations, where positions are weighted in terms of how much risk they pose, are another popular method. Here, it would be 55% domestic and 45% foreign (implying foreign stocks are riskier).

Vanguard’s VT All-World ETF weights the world stock market by market cap, and allocates 58% to the US.

Looking at Blackrock’s Aggressive model, they allocate 72% to US stocks. First Trust weights domestic at 76.5%. The iShares AOA aggresssive ETF allocates 70% of its stock exposure to US companies. Blogger Mad Fientest ran the efficient frontier of US vs. foreign issues from 1970 to 2008 and chose a 72% allocation to domestic stocks.

After weighing the evidence, I personally chose to invest 75% of my stock exposure to the US, and 25% in foreign companies. YMMV, as I don’t think it makes a huge difference in the long run if you weight domestic at 65% or 85%.

Stocks vs. Bonds

First Trust uses 15% bonds in their Aggressive model.

In his 2013 letter to Berkshire Hathaway shareholders (page 20), Warren Buffett wrote about the asset allocation in his will. Buffett’s trust will invest 90% of his assets in a S&P 500 index fund, and 10% in short-term government bonds.

Blogger Mad Fientist ran the efficient frontier of stocks vs bonds from 1960 to 2004, and also concluded that a 10% bond allocation works well.

I have chosen to allocate 8% to bonds in my Aggressive model.

Conclusion

The final Aggressive Portfolio breakdrown:

  • 69% Domestic Stocks
  • 23% Foreign Stocks
  • 8% Bonds

If I wanted to build a more moderate or conservative model, I would increase the bond allocation and keep the 3:1 domestic to foreign stock ratio. For example, here is a moderate portfolio:

  • 57% Domestic Stocks
  • 19% Foreign Stocks
  • 24% Bonds

A balanced portfolio:

  • 39% Domestic Stocks
  • 13% Foreign Stocks
  • 48% Bonds

Finally, a conservative portfolio:

  • 15% Domestic Stocks
  • 5% Foreign Stocks
  • 80% Bonds

In Part 5, I will examine the tax consequences of the Aggressive model.

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