Advice For a Young Robo-Investor on Asset Allocation

A young investor with robo-advisor Wealthfront is seeking advice based on his 2014 performance. Here’s what he posted on the Bogleheads forum:

I have aggressive profile on wealthfront (9.3 out of 10).

My return for 2014 is paltry 1.3% compared to S&P.

Wondering if I should ditch them or stay with them.

Then he shared his portfolio allocation:

The S&P 500 was up over 13% in 2014 and this guy is looking at a 1.3% gain. What gives?

First of all international stocks (VEA) were down nearly 6%. Emerging markets (VWO) were more or less flat. Dividend stocks (VIG) underperformed by nearly 3% and energy stocks (VDE) got hammered, down almost 10%. When one market, U.S. large cap stocks, dominates every broad investment class, it’s easy to feel like a sucker for having anything else in your portfolio. But this is just one year.

Our investor may have felt differently during past cycles:

2014: Why am I invested in emerging markets? They were down 3 out of the past 4 years.
2009: Why don’t I have more of my portfolio in emerging markets? They were up 75% this year.

2014: Why would I invest outside of the U.S.? U.S. stocks are up almost 22% a year since 2009 while my portfolio is only up 16.4% per year.
2002-2007: Why am I so heavily invested in U.S. stocks? My portfolio is up 21% per year, mainly from international stocks, but my U.S. shares are only up 13.8% per year.

2014: Why didn’t I hedge the U.S. dollar in my foreign stocks? The dollar led to a 10% loss in my international stocks last year.
2003-2005: Why would I ever hedge the foreign currency impact on my international stocks? The dollar is down 40% over the past three years.

You could play this game every year, but you’re never going to have the best performance with a diversified portfolio. You’ll also never have the worst. To see the other side of this story, from 2005-2007, this portfolio would have been up 16.6% per year, against an annual return for U.S. stocks of just 9%. Even extending this portfolio back a decade, which includes the financial crisis, it would have yielded an investor a 7.7% annual return. Not bad.

The point is that there will always be periods you can point to where your portfolio will trail certain markets, sectors or funds. Worrying about that type of short-term performance is never helpful. It only causes unforced errors, poor market timing decisions and unnecessary stress.

You also have to remember that when you’re young and in the accumulation stage, your performance is bound to be affected by your contributions. When the markets move higher, your returns are going to look worse if you’re making contributions throughout the year because you’re continually buying at higher prices. In the down years this will work the other way to your advantage as you buy shares at lower prices.

If you’ve decided that a diversified, low-cost asset allocation approach is right for you, you have to get used to the fact that not every year is going to be gangbusters. There are going to be certain asset classes that lag. You’ll hate at least one — and quite often more than one — of your funds or asset classes in any given year. But this is to be expected. Diversification is about the long game.

Could you quibble with this young gentleman’s portfolio allocation? Sure, you could make some changes here and there that could make a difference. But over time, by consistently making contributions to a globally diversified stock market portfolio at low costs, you can’t help but build wealth over time.

Every single year you’ll be able to play the ‘what if?’ game with your allocation no matter where you have your funds. There are always going to be parts of your portfolio that you are uncomfortable with at times. To paraphrase Keynes, it is the duty of the long-term investor to accept periodic losses and underperformance and act accordingly. You should only judge your results over the long-term, not a single year.

Source:
Bogleheads

Further Reading:
The Danger of One Year Performance Numbers
In Search of the Perfect Portfolio
The Robo-Advisor Challenge