How to Choose the Right Asset Allocation

Show Trancript

Jimmy Turner MD: I want to hear your take on this. So when someone says, Hey, Justin, I want to help with my investments and you start to have this asset allocation conversation. I know there are a lot of factors that dive into this historically, you know, in terms of things you read in textbooks, but I wonder how does this planner’s perspective?

Justin Harvey CFP: Yeah, it depends on who I’m [00:04:00] talking to. And there’s a couple different types of clients and we have this analogy. Some folks want to be able to. Tell the time and just look at the watch and see what time it is. Other folks want you to pull the cover off and see all the gears and the springs and explain it to me in great detail.

So probably today’s conversation will be somewhere in between, and then we can perhaps in the future, zoom in on some of those springs and gears. there’s a lot of assumptions. Philosophical underpinnings baked into the way at APM wealth and any investment firm that has an internally consistent investment approach.

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That approach is going to be founded on some sort of bedrock principles. And like what we talked about last week, you get your philosophy in place and then a lot of decisions to make themselves. So liquidity is really important to me. Low turnover and tax efficiency is really important to me.

Broad diversification and equity orientation are really important to me. And as such. There’s a lot of investment decisions that like, we’re going to be exposed to. And we’re never going to be exposed. At least I’m [00:05:00] never going to recommend that we’d be exposed to these other things. And so in the context of helping our clients, this, these sort of philosophical components are something that I will review with them and say, Hey, here’s the, you know, the five pillars that we review in the investment blueprint conversation, where I’m talking about.

Why is it important that we, be broadly diversified? And what does diversification really mean? When I’m talking about diversification, I’m talking about across a number of different sort of facets. So there’s geographic diversification. If we’re buying stocks of, in companies, also known as equities, an equity, Or a share of equity is a share of ownership in a company in a, we’re going to talk about public markets today, meaning stuff that trades on the publicly available stock market indices.

So you can buy a, you know, a share of the S and P 500. When you do that, you own a fractional share of the 500 biggest companies in the U S but that’s not diversified. That’s a U S large [00:06:00] cap. There’s also a U. S. mid cap, which means smaller than the large cap in terms of the total company size. And then there’s small cap and there’s micro cap.

And then there’s not only U. S., but there’s international. There’s Europe and Asia and Africa and all the different regions. And then there’s diversification across, sectors and different industries. And so when I’m saying broad diversification, I’m talking about geographic, I’m talking about by sector, I’m talking about by size.

And by company profile and all these different things. So we’re going to have at least my clients, and this is a very Not totally novel way to invest. We partner with other institutional folks who do a lot of this heavy lifting for us, namely dimensional funds who I partner closely with and really love the intellectual capital that they’ve developed, but we’re doing a little bit of everything in terms of diversification, us and international, big and small tech and telecom and banking and consumer, stocks and, and everything, and so when my [00:07:00] clients have a portfolio that we build for them, Has between 12 and 14, 000 different companies that they own and their equity exposure, and then there’s going to be some fixed income to fixed income is.

The bond piece, a bond is, if we’re thinking about stocks and bonds as like a seesaw, bonds are the more boring, at least the way that we, and again, this is part of the investment philosophy. When I’m investing in fixed income for my clients, I want the fixed income to be a quality asset that is going to be an asset that we know is going to be there when the stock market corrections inevitably come and from which we’re going to rebalance at times.

Meaning if the stock market tanks. We’re going to sell some bonds and buy some stocks. And that allows us to, when the stock market recovers, benefit from that recovery. And this, all of this, what I’m describing is sort of the beginning of the conversation for asset allocation. It’s the stocks, it’s the bonds and the interaction between those two primary asset classes, that is going to be [00:08:00] a really important chassis for The vehicle of wealth building as the physician is rolling towards financial independence.

Jimmy Turner MD: So let’s look at some of those springs and gears and without turning this into an interview episode, international exposure. I’ve always thought this is interesting and I’ve asked a variety of people. We’re actually gonna start having, actually the top by this time. This comes out. We’ve already had episodes on Friday where we’re interviewing people,and bringing guests on.

And so I’ve had some opportunities to talk about international exposure with a variety of let’s just say thought leaders and authors in this space. I’ve always found it really interesting that vanguard if you look at the target date funds they have 30 to 40 percent in international stocks and There’s a variety of reasons for that But i’m curious about your take on international exposure because there are some people out there on both ends of the extreme where they say hey The U.

S. Markets crushed it for 20 years. And because of that, I think that it’s not gonna crush it for the next 20 years. So you need international exposure. And there’s some people say, Hey, the American markets have crushed it for the last 20 years. And because it’s such a globalized economy, you don’t even need international exposure.

And so I’ve met people on both [00:09:00] sides of that spectrum. And, you know, I’ve never I don’t think I’ve ever asked you that. So, Justin, I’m asking you live on the air what your thoughts are on international exposure.

Justin Harvey CFP: It’s funny Jimmy I’m a little abashed knowing that some of the names that you dropped of other people that you’re interviewing on this topic who are Well recognized broadly published experts. I am a an intellectual midget compared to those guys So please listen to some of jimmy’s friends other friends.

But in terms of international. Yeah, I mean The answer with a capital a is well retrospectively we will understand the right answer to that question If us if international diversification was accretive to us returns or not We can only know looking back and on a prospective basis All we can do is look at what the past has done use that to inform A future, you know, allocation and then control what we can control.

You rightly point out Vanguard is 60, 40 us to international in their global equity fund dimensional is 70, 30 us to international. So this is what we call a home bias as it’s known, meaning [00:10:00] it’s not global market cap weighted. Exactly, but it’s close to that. And we are evidencing in our asset allocation.

We like the U S we think the U S economy is good and strong and worth investing in. And we are, prominently is featured in our investment approach. You rightly point out that the interdependency of the global economy means that. There is some correlation that there are links. if Europe goes down in flames, the U S is not going to be totally immune and vice versa.

This is true across every geography that there is a, we need each other. And so, yeah, you know, Warren Buffett says you should just buy the S and P and forget about it and you’re doing pretty good. I would point out that Warren Buffett doesn’t actually do that for himself. I think his advice was like, whenever my wife inherits my billions or however much he’s going to bequeath.

To her, assuming that she lives longer than him, like she should do that. And I think, there’s something to that obviously. And he knows enough to know that what he says you should listen to. and I think, you know, Jack Bogle founder of Vanguard [00:11:00] similarly said, Oh, you know, 40 percent of the S and P.

Profits are sourced from international companies anyway. So it’s all baked in and you can make a good argument for that. And the fact is to go back to another previous episode where we’re talking about what are the big things for financial success? Like if you have a high savings rate and you got 30 percent of your income every year that you’re stuffing into a S and P 500 fund, is that going to work for you?

Like, yeah, it is. And does international developed versus emerging markets versus, us large, None of that is going to matter because the most important variable that you have identified is going to dominate all the others. But the science of asset allocation is something that there’s a lot of data out there that we can use to build portfolios intelligently and to control the things we can control.

So long winded way, Jimmy of me saying, yes, my clients are exposed to international equities on a 70 30 ratio where the 30 percent of our equity portfolios are international and of the international portfolios, it’s about three quarters developed. [00:12:00] Emerging and that ratio is a strategic ratio to which we rebalance over time.

Jimmy Turner MD: Yeah, I always find an interesting question to see where people are at because there’s lots of data and studies and all sorts of things out there. you know, famously, right? The French and Fama small value tilt on investing where you invest in small cap companies and value companies. And, yeah, the data and the studies that showed that 20 years ago or 30 years ago, or however long it’s been, they were pretty compelling.

And so a lot of people bought into that. I think dimensional being one of them. And it’s interesting because like over the last 20 years, like small value hasn’t done what the data, the studies suggested that it would. So So your point earlier about the retrospective look. Yeah, we’ll know what was best 20 years from now.

But moving forward, we have to make the best case guesses, you know, educated, thoughtful, Ways of making decisions. But at the day, they’re going to be guesses on what the [00:13:00] proper, most prime and, perfect asset allocation is. We’re not going to know that until time tells us 20 years from now.

Justin Harvey CFP: Yeah. And another one of the bedrock principles that informs the way that we invest for clients is mean reversion. So for the sort of self renewing components like international economies, yeah, once you’re out of favor for 20 years, Or 15 years. And I think I might’ve told the story, Jimmy. I remember when I was, I just started in the industry.

It was like 2009, 2010, which was a very tumultuous time. But I remember being young and thinking like, I got a long time horizon. I’m going to invest every penny in emerging markets, which is the most volatile of the asset classes. So I bought like an EM, index or a mutual fund thinking that this is the way I’m going to like over a full market cycle, really just crush it.

And the irony is. And I, you know, I did that for like a year or two. And then I kind of, my, my investing ADD kicked in the 24 year old version of myself, and I flipped it around. But the point is EM has actually [00:14:00] underperformed for a very, very long time since then compared to even a bigger, more established asset class like us large cap, which is arguably in terms of equities, the most, the most Durable, stodgy, dependable, which you would think that would underperform a more like high growth opportunity, like emerging markets markets can be irrational for a long, long time, including a decade plus.

And so, yeah, I’m going to continue to hold international equities and. I think that over a long time, it’s going to pay off. But I also think that because of the planning we’re doing for our clients, if that never comes to fruition, and if us equities continue to dominate and us equities only for forever, my clients are still going to be okay.

Cause we’re doing enough other things, right? With the things we can control that I don’t need international to outperform ever for the plan to come to fruition.

Jimmy Turner MD: Yeah, so I think that is maybe more into the gears in the springs as you alluded to earlier in your analogy, but I think that something that’s not, it really is kind of [00:15:00] big picture. Stuff is. stocks to bonds that ratio right and what your risk tolerance is and I always think this is a really interesting discussion because people always point out two things.

They’re like, hey, what is your risk tolerance? And then what is your time horizon? It’s like, okay, both of those things make sense, right? If you’ve got a high risk tolerance and you’ve got a longer time horizon, you should be much, much, much more heavily weighted in riskier assets like equities. Uh, and the opposite is also true.

But I think that what’s baked in there that they don’t talk about enough is that risk tolerance isn’t just based on personality. Like part of risk tolerance is based on financial literacy and your understanding that market history is a thing and that corrections and recessions will happen, that things will go up and they will go down.

But. On par over a long 30 year investing timeline it is going to go up into the right And if it doesn’t right and it comes crashing down Then we needed to buy guns and water and ammunition and canned food Because none of this stuff that you’ve been listening to on this podcast for four years matters and so, but I don’t want to leave behind that financial literacy piece because For people if you’re [00:16:00] sitting there listening to this show and you’re 35 or 40 years old Let’s say you’re 30 years old you’re in training.

because a lot of trainees that listen You And you’re like, you know what? I just can’t stand it. I just don’t have a very risk tolerant personality I’m gonna go 50 50 on stocks and bonds I would look at you and say hey I hear what you’re saying about your risk tolerance and that may or may not be true But what I can also tell you is that your asset allocation also suggests that your financial literacy May need some improvement now.

I’m not going to say it to them like that But I would probably try to spend some time explaining how the market works and how when the market goes down That’s actually a good thing you get to buy stocks on sale and how to frame things in such a way that when it Does go down you’re actually excited when you’re young because you have that long time horizon so I don’t think that Risk tolerance and time horizon like those two things capture it all, you know in terms of what your asset allocation should be

Justin Harvey CFP: Totally. And I would argue for that young doc who feels like 50 50 is a good fit. I’d say you’re not. Necessarily taking less risk. You’re just taking different risk. you’re protecting the asset value of your 401k today, but you’re risking the [00:17:00] 74 year old version of yourself who goes through a decade where we have 11 percent inflation for 10 years in a row, having significantly eroded purchasing power because of a lack of exposure to growth assets, that’s a more sort of a.

Subversive difficult to spot, not necessarily intuitive risk, but it is a risk nonetheless. And an insufficient exposure to growth assets is going to mean that erosion of purchasing power could be a real problem for you.

Jimmy Turner MD: Yep.

Justin Harvey CFP: and to what you were saying before, one additional sort of consideration in terms of risk tolerance.

There’s another piece to that, which we call risk capacity, meaning, so there’s the risk tolerance, which is how much risk do I think I can take? Which is. Very, very subjective risk capacity is according to my financial plan and my financial needs and what I need my money to do for me, how much risk or how much of my assets can I expose to risk asset classes and holding both of those together is an important part [00:18:00] of the process to say, okay, if you’re super risk tolerant, like, yeah, let’s mash down the gas pedal, but actually you’re going to need this money.

to pay for your living expenses starting in three years, then you don’t have the capacity and the plan needs to reflect that. But certainly, Jimmy, to your point, having a well informed risk tolerance that understands the historical perspective, that understands total drawdown, that understands in 2009, peak to trough, the S and P was something like 55 percent from high to low.

If your portfolio started at a million and it was all equities, it was all the S and P, it went down to 450, 000. How would you feel about that? Would you be losing sleep? That’s the tolerance. If the capacity piece says, well, I don’t need this money for two decades. The tolerance says fine. The capacity says also fine.

Then yes, an equity orientation, a 70 or 80 or 90 percent or even a hundred percent stocks might be a good fit for that type of person, but you’ve got to stare that in the face. That what is the worst that can happen? And I, in terms of [00:19:00] that investment blueprint conversation, I referenced, I, I like to do this cause it’s a little bit, it gets people off guard.

I love to say, you’re going to lose money with me. It’s going to happen if we’re exposed to the stock market. If you’re going to make money in the longterm, there’s going to be bad years. There’s going to be years when you say, Justin, what the heck are you doing for me right now? You need to be okay with that.

If you’re not okay with that, you should go somewhere else or buy an annuity or do a different thing. And you’re probably not going to be. That’s probably not a good solution, but those are options and you need to kind of understand the roller coaster You’re getting on here in order to be able to hang on for when things get a little dicey.

Jimmy Turner MD: Yep. No,I completely agree. And it’s, I just think it’s interesting to watch people as they go through their financial literacy journey. Like having taught a bunch of doctors at this point, both at the medical school, the residency, and obviously on here at Money Meets Medicine. And, and watch people transition from the, I’m scared to lose money to, you know, The realization of exactly what you just said but like you’re not really like what you’re losing money for by having that Risk tolerance that you think is okay and like as safe as you’re you’re actually losing money [00:20:00] for future you as you put it I think that’s a great way to talk about it And and maybe one thing I want to just touch on before we head out Justin is kind of this idea of rebalancing, right?

so maybe you’re 90 percent stocks or 10 percent bonds when you’re 30 and then you’re 80 20 when you’re 40 and then you’re 70 30 when you’re 50 60 40 when you go to retire You Let’s just say you have that plan in place. Every year, your assets are going to change. And so, let’s just spend a second talking about like band rebalancing versus time based rebalancing.

And,I know that we’ve, you and I have talked about this before. But I think it’s worth putting out there on the air as well.

Justin Harvey CFP: Yeah Rebalancing helps rebalancing reduces portfolio volatility over time and increases your Return and I can actually send you Jimmy a couple different studies that look at different types of rebalancing I think depending on the time horizon depending on the band if it’s a 5 percent or 10 percent or a percentage of the bait there’s a million different ways to do it.

It’s better to do than not do And [00:21:00] in the real world, especially for clients of mine who are accumulators who are adding five to fifteen thousand dollars a month Into investment accounts. You can actually use those new additions of capital and add them to whichever asset classes are selling off. And in some cases, like you never have to rebalance because you’re just buying the, asset that has sold off along the way, but understanding this principle, what rebalancing accomplishes is it, it keeps a consistent composition of growth versus stable asset, and it also will at any given time, reduce the.

It will prevent an unexpected amount of volatility from being manifest in your portfolio. And here’s what I mean. in a year when the stock market is just doing awesome, kind of like 2024, this would actually be most pronounced than a year when the bond market was doing bad. But if you were say 6040, we’ll just have a baseline example.

And the stock market doubles and the bond market halves that 6040 is going to get [00:22:00] way out of whack. And you’re going to be, 80, 85%. Stocks now, if you’re 80 20, you feel great because you’ve made a bunch of money potentially, but Your peak to trough potential drawdown in the event of an equity sell off is going to be significantly higher meaning the ride down the roller coaster is going to be a much higher peak to trough because you have 20 percent more equities than your target allocation.

If you agreed that 60 40 was a good fit and that the volatility associated with the 60 40 portfolio was a good fit, then you need to over time, return to that 60 40 portfolio to make sure that whenever that economic downturn happens, that you have sufficient, uh, sufficient amount of the stability asset bonds in this case to buffer that ride.

So. it reduces the bumpiness of the ride over time.

Jimmy Turner MD: Yeah, and so, so, the, um, Options are band based. So five or 10%, like you said, so if you’re 60, 40, and it’s a 10%, then [00:23:00] when your stocks get to 71 percent or they get to, whatever it is on the side, 49%. Then you would rebalance. Time based is just saying, Hey, I’m going to rebalance once a year.

and simplicity being King in my life. That’s what I do. Not because it is the optimized, most efficient way to invest, but because one of the table stakes that I’ve put down is simplicity when it comes to finances for my family. and so, I might be losing a little bit on not rebalancing by bands.

and so that said, that’s one of the things that an advisor can help you out with, right. is the rebalancing so that you don’t have to have your, your, you know, Not in the weeds all the time or the gears in the springs and the watch analogy we’ve been using. So if you want help with determining your asset allocation, maybe you want help with managing those assets or creating a financial plan Don’t forget to check out justin over at moneymeetsmedicine.

com slash justin. You can check out apm wealth his financial advisory firm Everybody, thanks for tuning in sharing the show with everybody. Thanks for being a part of the community If you have questions comments things you want us to talk about on the show, please email me jimmy at moneymeetsmedicine.

com You We are always happy to bring your ideas and [00:24:00] thoughts on the air. Thanks for being here. Cheers