Asset Allocation
This section outlines the asset allocation of our portfolio and the reasoning behind the various decisions.
Cash and Cash Equivalents
Cash and cash equivalents (high yield savings, money market funds, certificate of deposits, treasury bills, etc) will serve the emergency fund and short-term purchases. The emergency fund is a fixed amount and is not treated as an investment. If we build up cash and cash equivalent holdings beyond the emergency fund, it will serve a short-term large purchase.
Fixed Income
Fixed income assets are an important piece of every portfolio. We understand that there is a diversifying benefit to holding bonds due to the unique set of risk factors not found in equities. Despite this, we will be deferring the decision to allocate fixed income assets until some future time. The following reasons may clarify:
- We run the risk of not meeting our future consumption goals due to the lower expected returns of fixed income assets.
- Duration matching is less practical. Duration matching over such a long time horizon is less practical.
Equity
The specifics to the equity allocation is done separately from the bond allocation. We apply the following for our stock allocation:
- 48% Capitalization-Weighted Total US Stock Market Fund
- 32% Capitalization-Weighted Global Ex-US Stock Market Index Fund
- 12% US Small Cap Value Fund
- 8% Developed Ex-US Developed Small Cap Value Fund
Our domestic to international stock allocation will be 60/40. We choose a globally diversified portfolio to increase reliability of outcome. Holding imperfectly correlated but high expected return assets will reduce the volatility of the portfolio as measured by standard deviation. We do acknowledge the domestic market cap will likely not stay at 60% forever. We take on a certain amount of tracking error if these true global allocations drift away from our chosen 60/40. The equity allocation is subject to revision in the future.
We choose to take on a 20% tilt towards small cap and value stocks. Ignoring the research on higher expected returns from small cap value stocks, we do this for the following reasons:
- Tilting towards size and value factors gives our portfolio a diversification in risk factors. Rather than only taking on the risk of the market, we choose to take on other independent sources of risk that are not weighted heavily in a market cap weighted portfolio. This may increase our reliability of outcome.
- We hedge against our human capital by tilting towards small cap value stocks. Our human capital is heavily tied to large companies.
The tilt towards small cap and value equity will take up 20% of the total equity portfolio, which is chosen arbitrarily.
Rebalancing Protocol
To ensure that the portfolio in aggregate matches the target allocations as closely as possible, rebalancing is done through contributions to the taxable account. If any asset has a 3% delta from its target allocation, we will begin rebalancing until the target allocation is met. To do this, we apply the target allocation to the sum of all assets invested and to-be-invested, to determine how we need to contribute the to-be-invested cash.
Investment Products
We have a strong preference towards Vanguard products, as they are low cost funds that are readily available to DIY investors. In particular, the Vanguard products we will use in our portfolio to do the capitalization-weighted allocation are:
| Ticker | Name | Expense Ratio |
|---|---|---|
| VTI | Vanguard Total Stock Market Index ETF | 0.03% |
| VXUS | Vanguard Total International Stock Index ETF | 0.07% |
To target the size and value factors, we will use Avantis products, as their funds are widely accepted by the community as being great at targeting these factors, while maintaining relatively low fees. They take on a rules-based approach to their funds rather than an index, as they target these factors more aggressively.
| Ticker | Name | Expense Ratio |
|---|---|---|
| AVUV | Avantis US Small Cap Value ETF | 0.25% |
| AVDV | Avantis International Small Cap Value ETF | 0.36% |
If the class of fund does not exist in an employer sponsored account like a 401(k), then the next closest low cost fund will be used to replicate the allocation (such as an S&P 500 fund in the place of a domestic fund). If there is no good alternative, then we will use our taxable account as the place to ensure our total portfolio meets our allocation.
To be low cost, we prefer a net expense ratio of 35 basis points or less. In general, we are more concerned with the expense ratio of the entire portfolio. The above construction using these funds gives a portfolio that costs less than 10 basis points.
We arbitrarily made the decision to prefer exchange-traded funds over mutual funds. Arguably, mutual funds are more aligned to our investing philosophy due to the way they are priced, bought, sold, and easily automated for purchases on many platforms. That being said, mutual funds are less tax-efficient in taxable accounts.
Liquidity Requirements
For our investments, we have no liquidity requirements. We will use our cash and cash equivalent holdings.
Benchmarks and Monitoring
We choose Vanguard’s Total World Stock Market Index Fund (VTWAX) as our benchmark. We are not strict about measuring our performance against this benchmark, but it will be a gauge for how we do compared to a globally market cap weighted index.
The state of the portfolio will be recorded by hand during the first week of each month for record keeping purposes.
Speculative Investing Policy
We minimize speculative investing, which includes individual stocks, actively managed funds, cryptocurrencies, and other such products. Speculation will never make up more than 5% of total liquid assets. We strive to keep this at 0% as the evidence has shown it to be irresponsible.