3. The Dividend Guy’s Guide to Building a Dividend Portfolio: Asset Allocation

Here we go with post #3 in the series, The Dividend Guy’s Guide to Building a Dividend Portfolio. In this post I am going to discuss Asset Allocation.

Keep in mind that I am not going to go into too much of the theory behind asset allocation. Most of the reading I have done suggests that asset allocation is very important. However, there is a school of thought that suggests asset allocation is not important and one should be in all stocks. The argument here is that bonds barely keep up with inflation and really do not provide any growth. If you really want to learn about asset allocation as it relates to the Modern Portfolio Theory, check this pretty good explanation here.

Asset Allocation Defined

Asset Allocation is the process of dividing an investment portfolio into various investment vehicles (stocks, bonds, cash, real estate, etc.). The two factors that greatly affect asset allocation are your Investment Timeframe and your Risk Tolerance

• Investment Timeframe: Your Investment Timeframe is how long you will be invested until you need to start pulling money out of your investment portfolio. The longer you have, the more risk and investor can afford to take. A person who needs access to their investment funds in 5 years will have a much different looking portfolio than a person who is going to retire in 35 years.
• Risk ToleranceRisk tolerance is a pretty simple topic.
  It is your comfort with the potential for investment loss in exchange for a potentially greater return. However, it is much more difficult to determine. What you think is your risk tolerance may be completely different once tested. For example, if you decide that you are very risk adverse and you go 99% into stocks and the market crashes and you end up having a heart attack then you probably were not as risk adverse as you thought. Think seriously about this.

In summary, asset allocation is a balance between the amount of risk you are willing to take for a potential return. All investing holds some degree of risk but it can be managed.

Let’s look at how I have chosen my asset allocation.

Choosing Your Asset Allocation

I am of the firm belief that to make life easier, one should try to keep things as simple as possible. Further, the more complicated things are the harder it becomes to execute a particular strategy. With that in mind, I simply use the following calculation to determine my allocation:

100 - age = % of portfolio to invest in equities (stocks)

For me, this calculation is 100 - 31 = 69%. This suggests that I should have 69% of my assets invested in stocks. That’s it…that simple.

Keep in mind that this number is a guideline. You can increase or decrease it based on your own particular comfort with risk. Increase it, and you are taking on more risk. Decrease it, and the opposite occurs - you are reducing your risk.

If 69% is supposed to go to equities, where should the rest go? That is up to you, but the thing to keep in mind is that it should be investments that are considered to be “safer”. These include such investments as bonds and cash.

A real basic portfolio would potentially be (remember - this is not advice - use your own judgment):

Notice that I have split up the “safer” investments into bonds and cash. I could have also done this with the equity portion. In fact, in my own portfolio I have done that. The only “tricky” thing that I did was include a Trust component to my equity allocation. Trusts throw off income, but I don’t like to include them in the safer fixed income section as trusts have much more risk. The allocation that I personally use is presented below:

Disclaimer: Remember, nothing in this post, or any other post on this blog is to be considered as investment advice.

My cash component moves up and down as I add money to my accounts. However, I like to be fully invested at all times so I shoot to keep this at 0%.

So, now your role is to figure out an asset allocation that you are comfortable with. As I mentioned, a great and easy place to start is the 100 minus your age formula. If you want to do a bit more research, there are a whole bunch of sites out there that can help you. I have provided some of these below:

Path to Investing
The Asset Allocator
Vanguard Investor Questionnaire
Vanguard Asset Allocation
Investor Home

Where to Put New Money

Keeping track of your asset allocation is an important component of investment management. My goal is to keep my allocation as close to my target allocation as possible. My method for doing this is to simply create a Microsoft Excel spreadsheet that includes a chart that looks like this:

Once you have set this up, keeping track of your asset allocation is easy. So what do I do when new money comes into my account?

I simply look at the chart and decide what assets are “low” and invest in assets that will bring my allocation better in line with my target allocation. For example, my Fixed Income target is 25%, yet my portfolio only has 15% fixed income, so my next purchase should be directed to fixed income type investments. Pretty simple.

Well, that about wraps up this post in the series. Stay tuned for post 4 where I will go into my methodology for selecting my investments. Please feel free to comment on this or any of the other posts in the series. I appreciate your feedback.