Friday, March 21, 2008

Madame-X: Asset Allocation

I've done a rough computation of Madame-X's allocation by asset class. This is by no means precise, but my errors probably cancel each other out over the 22 funds :) She has 89% in stocks and 11% in bonds. The rule of 110 would suggest something closer to 75%, 25%. I think that is overly conservative, especially as in the long-term I don't expect bonds to perform as well as they have in the last 25 years. So probably this is a decent mix.

Overall her investments are split 73%, 27% between the US and foreign investments. This is pretty typical of U.S. investors. However the U.S. stock market is just under half of global capitalization and the US economy is maybe 20% of global GDP (depending how you measure it). On that basis you'd want more foreign investments. Personally, I am massively overweighted Australia - which is around 2% of global capitalization and economic activity but constitutes more than 50% of my portfolio. The argument for overweighting ones own country is that you need to spend money eventually in your own country. On the other hand, there is a strong case for diversifying away from own country risk.

Within her stock allocation, her exposure to large cap stocks is 53%, mid cap 30%, and small cap 17%. The benchmarks are roughly, 70%, 23%, and 7%. So she is very overweight the small cap end of the spectrum. There is a strong argument for overweighting small caps - most companies are not listed on stock exchanges, and most of those unlisted companies are small. So overweighting small caps, gives more exposure to a proxy for unlisted stocks. The downside is that at our current point in the business cycle, small caps tend to underperform (but maybe a good opportunity to buy more?).

The bottom line is there is nothing radically weird about this allocation, and as you can see I can make arguments for and against changing it. If she does decide to change the overall allocation I'd suggest just directing new contributions in the desired direction - e.g. contributing more to large cap funds and foreign stocks to boost those allocations.

2 comments: said...

Another reason for Australian-resident investors to be overweight Australian stocks is the tax benefit of franking credits.

I've never been convinced of the basis for using a countries share of world economic activitiy to influence your stock allocation. After all, the reason for investing in stocks from different countries is to gain the benefit of diversification, not to mimic world stock market index performance. For that reason I'd think having a large percentage in your home countries stock market, and then a large enough allocation to get some diversification benefits from either an international index fund, or some direct stock investments in 10-20 stocks from the major international markets would suffice.

mOOm said...

Australian dividends do have the lowest effective taxes for Australian investors followed by long-term capital gains for both foreign and Australian companies, so it is a good reason to overweight Australian stocks. There are plenty of academic papers on the puzzle of why investors tend to overweight their home market so much, tax reasons and better information on local businesses are obviously good reasons. The usual idea though is that the default is a portfolio invested in a proportional share of each of the world's assets and then you need a good reason to explain an overweight.