Diversification To Five Classes Brings Further Benefits To Strained Retirement Portfolios (DBC, VNQ, VWO, BND, VEU, VTI)

We have previously highlighted the plight of boomers coming up on retirement with insufficient funds. There is a great deal of advice to get your portfolios in order. In this article we seek to quantify what moving to a portfolio with five different asset classes can do for you.

401K plans have moved from being an adjunct to a pension plan to being the mainstay of retirement income. In a study of over 800 mainly retirement plans, we noted that the majority of plans supported only three asset classes which is going to have a significant impact on the potential returns for the participant.

Asset Classes %age of plans
Three 59
Four  23
Five  14
Six 4

In the last article we found that  applying a tactical asset allocation strategy to a four asset class, historical simulations showed returns more than double over the longer time horizon. This is a significant jump and over a decade puts 60% more money in your pocket. Sadly only 23% of the plans have four asset classes and only 14% have five. Nonetheless, it is important to see what the difference is because it is always possible to create a more balanced portfolios with an IRA.

We are going to use a simple benchmark vehicle — SIB — simpler is better to show the potential difference in returns between the portfolios with different numbers of asset classes.

Each of the SIBs are built from one ETF per asset class. The ETFs we selected for these portfolios are as follows:

Asset Class Ticker Name
LARGE BLEND (VTI) Vanguard Total Stock Market ETF
Foreign Large Blend (VEU) Vanguard FTSE All-World ex-US ETF
DIVERSIFIED EMERGING MKTS (VWO) Vanguard Emerging Markets Stock ETF
REAL ESTATE (VNQ) Vanguard REIT Index ETF
COMMODITIES BROAD BASKET (DBC) PowerShares DB Commodity Idx Trking Fund
Intermediate-Term Bond (BND) Vanguard Total Bond Market ETF

So the three asset SIB has US, (NYSE:VTI), International (NYSE:VEU) and fixed income (NYSE:BND). The four asset SIB adds emerging markets (NYSE:VWO). The five asset SIB adds Real Estate (NYSE:VNQ). The six asset SIB adds commodities (NYSE:DBC)..

The three asset portfolio is really old school. The four asset SIB adds emerging markets which provides diversification and assistance when the developed world equities are under pressure. As we struggle back from the recent financial melt down, emerging markets have played a significant part in leading the way.

Now we add real estate which may have a bad name as one of the major causes of the great recession but this highlights the importance of having diversification. While consumer housing was hammered based on overstretched valuations and risky loans, real estate trusts managed to weather their way through the storm and remain an important alternative. They have been performing well lately.

Performance chart (as of Mar 4, 2011)

Performance table (as of Mar 4, 2011)

Portfolio Name 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate 2% 17% 3% 29% 4% 37%
Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate 16% 115% 4% 18% 4% 19%
Five Core Asset ETF Benchmark Tactical Asset Allocation Moderate 12% 87% 8% 63% 10% 69%
Five Core Asset ETF Benchmark Strategic Asset Allocation Moderate 17% 127% 5% 19% 6% 23%

We note that the five Asset Class SIB — which only differs from the three Asset Class SIB by having one fund in each of Real Estate and Emerging Markets — wins across the board. If we look over the five year horizon, buy and hold gives you an extra 2% and Tactical Asset Allocation gives you an extra 6%. Over a decade, that extra 6% puts 75% more money in your pocket than if you have three asset classes. This compares with an extra 60% with four asset classes.

How can  you do this if your plan only supports three asset classes? If you have an IRA, overweight the missing asset class (or two) in the IRA to compensate and create a more balanced portfolio that can deliver higher returns and lower risk.

Disclosure:  MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.

Written By The Staff Of MyPlanIQ.com

LTI Systems, Inc. is the operator of MyPlanIQ.com and ValidFi.com. The founders of LTI Systems have extensive technology and business background in computer and semiconductor industries. They have been using the strategies provided by MyPlanIQ for their own personal retirement and taxable investments. The mission of LTI Systems is to make wealth management investment strategies that are used to be only accessible to institutions and high net worth individuals available to private investors with a fraction of flat cost and ease of use. The founders of LTI Systems, investors themselves, take pride in creating such a system and service for investors by taking the perspective from the investor side. They are using the system and the strategies for their own investment and align their interests with their customers.  

MyPlanIQ’s blog provides periodical articles to discuss issues related to retirement plans (401(k), 403(b) and IRAs), deferred compensation plans (457), college savings plans (529), taxable brokerage investment accounts, variable annuities and universal life insurance plans. It also covers investment strategies, specifically strategic and tactical asset allocation and investment products such as ETFs and mutual funds. In addition, it syndicates daily articles that are related to retirement planning, personal finance, investment strategies, annuities, insurance, college savings and market/economic outlooks. It provides a comment and discussion community for readers.

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