Simple Allocation is not for everyone - here's why
If you are on this page, it is likely because you could not answer "yes" to the questions below, and came here for more information.
This is not meant to be a complete tutorial on the above topics, but just enough information so that you can understand why being competent in these areas is important if you want to use a Simple Allocation strategy. You need other competencies as well, but these are the most critical.
Acting as your own financial advisor
If you found our website, you have likely already made the decision to be your own financial advisor. Please be advised that Simple Allocation is not a financial or investment advisor. We know nothing about our users, and thus are in no position to give any advice or recommendations. Simple Allocation is not designed to determine the "best" portfolio for you; you are determining that for yourself. Simple Allocation does not recommend you actually implement any of our allocation plans by trading any funds. If you proceed, you are doing so under your own guidance.
The role of Simple Allocation is very similar to that of a securities index. An index producer will publish the value of the index versus time, along with the constituents of the index. Users of the index decide must determine if, how, and when to use the information provided by the index. Simple Allocation produces a modeled theoretical historical value of many portfolios, where the weight of each constituent of the portfolio is frequently changed. If, how, and when you use this information is up to you.
Simple Allocation is not recommending the purchase of any security or group of securities, to any individual or group of individuals. Simple Allocation is publishing objective results of an analytic portfolio allocation model we have created. It is up to you to decide if you want to use this model output, and if those are sound investment decisions for you.
How to asses the affect of fees and loads on your investment decisions
If you have made the decision to be your own financial advisor, you need to understand how to asses the impact of anything that reduces your returns. This includes, but is not limited to: taxes (income and capital gains) or tax deferment, management fees, trading fees, loads, etc. All of these can reduce the amount you will earn on any given investment.
The Simple Allocation plans require frequent turnover of securities. Relative to a buy and hold strategy, you will be subject to at least the following: capital gains tax, trading fees, and mutual fund loads and redemption fees. (Please check with your financial advisor and/or accountant to understand the implications of frequent trading on your taxes.)
When considering a trading strategy that frequently trades securities, and you are trading in a taxable account (not an IRA, Roth, or 401K), remember to consider the affect of capital gains tax on your returns. Capital gains tax is currently 15%. That means that if you hope to gain 8%/year on your investments with a buy and hold strategy, you must gain at least 9.42%/year in a strategy that holds securities less than a year, and thus requires capital gains payments each year.
Your returns will be further reduced by sales commissions. Sales commissions apply to both the purchase and sale of a security. By using a discount broker, you can reduce the amount of the commissions to less than $10/trade. Some discount brokers even offer some ETF and/or mutual fund trades for free.
Here is an example of how trading fees, even low fees, reduce your returns. Lets say your broker charges $10/trade. (Please make sure you know the commission rate for your broker, and adjust the example below by the actual commission you will pay.) At the time this is being written, Simple Allocation plans will allocate to a maximum of 4 securities at one time. For a plan that reallocates each month, that means that the absolute maximum number of trades per month would be 8, or 96 trades/year. (That is an absolute worst case, as it assumes that all 4 securities you are holding need sold, and a different 4 securities purchased, every month of the year. The ETF_Group_001 has averaged 39 trades/year for years 2002-2012, while ETF_Group_002 has averaged about 38 trades/year over the same period.) The maximum trading fees are then 8 * $10 = $80/month, or $9,600/year.
If your total account balance were $9,600, and you were hoping to achieve a 10% annual return ($9,600 * 10% annual return = $960 annual profit), Simple Allocation plans are not for you, because your entire profit would be spent in brokerage fees. If your account balance were $960,000, the trading fees represent only 1% of your expected return ($960,000 * 10% annual return = $96,000 annual profit, $960 / $96,000 = 1.0% of return paid in fees).
That example applies for ETFs, but for mutual funds there can be even more fees. There can be extra sales charges at purchase, extra charges when selling, and even charges if you do not hold the fund for some minimum time period. The fees are clearly available in the prospectus, which can be found many places including at this link -> http://www.sec.gov/edgar/searchedgar/mutualsearch.htm. When trading mutual funds, make sure you read the prospectus, understand the fees, and calculate the fees into the expected returns.
Also consider the allocation plan type. For many mutual funds that do charge for early redemption, the charge is only for redemption within 90 days from purchase. That is one of the reasons we have allocations plans that reallocate quarterly. (See this calculator for the number of days between the final weekday of each quarter.)
Please check the prospectus of all investments you make, and understand the fees to which you are subject.
Modeled results and taxes/fees
Broker trading fees are modeled at $10 per buy or sell; even for stop orders. You need to know what your broker is going to charge you in trading fees, and account for those fees in your planning.
Mutual fund fees are NOT included in the Simple Allocation modeled results. You need to pay attention to the fees for the mutual funds in your portfolio, regardless of whether your are allocating your retirement plan or a self directed investment account. Some mutual funds charge additional fees if the fund is held less than a certain period. That is not to say you should not trade those funds, but that you need to be aware that any additional fees will reduce your return, and will prevent you from achieving the returns Simple Allocation models.
Capital gains and income taxes are NOT included in the Simple Allocation modeled results. These will reduce your returns. Please check with your financial advisor and/or accountant to understand the implications of frequent trading on your taxes.
How to assess the risks associated with security asset portfolio allocation
Portfolio allocation is a topic to which books are dedicated. This simple page can only offer an introduction to the topic.
Something to consider is the old adage "don't put all your eggs in one basket". This is fundamental in portfolio allocation; you don't want to risk too large a portion of your portfolio to any one security. That is one reason that mutual funds and ETFs are popular in investing; they significantly reduce the risk as compared to investing in individual stocks, as each fund is made up of many individual stocks.
That argument can then be carried to the level of funds (ETFs or mutual funds), and the argument that you should have several funds of different types to even further reduce risk. This is where portfolio allocation gets very complicated. There are funds of stocks and bonds. WIth the stock funds, there are funds that represent large companies, small companies, specific sectors (technology, biotech, mining, etc.), domestic, foreign, etc. With the bond funds there are funds that represent treasuries, corporate bonds (high/low quality), municipal bonds, etc.
With all of these choices, how should you allocate your portfolio? A currently popular method is the so called "lazy portfolio". With this method the investor splits, not necessarily equally, their portfolio across a few funds that represent stocks (domestic), stocks (foreign), bonds, and maybe a few other categories. Each fund is picked to represent a large sector, and is very diverse in its nature. (I.E. a lazy portfolio might be allocated 33% to a total stock market index, 33% to a total bond market index, and 34% to a total international stock market index.)
The Simple Allocation method is different. With the Simple Allocation method, you pick a group of funds, and the software model picks a weighted allocation each month or quarter, based on recent performance. The software model does NOT try to create diversification. However, the model will only provide allocation to one security of any given category each allocation period. I.E. if an allocation plan has 4 funds that are all categorized as "Large Growth", then at most one fund of that category will be allocated each allocation period.
Prior to using a system like Simple Allocation, you need to understand portfolio allocation, the allocation group you will use, and the risk associated with the selection of securities from that group without regard to sector overlap.
(Note on Simple Allocation model allocations - The model will allocate to at most 4 securities, with equal allocations of 25% of account value to each security. The model does not necessarily allocate 100%; it will attempt to sell to cash during down markets.)
Using models, securities indices, or other tools, to evaluate trading strategies and make investing decisions
This is a topic generally referred to as "quantitative analysis". Again, this is a topic on which books are written. It is also a very controversial topic; similar to religion or politics. There are believers and non-believers, with few crossovers; the only people who fall into neither the believer or non-believer category are people who have yet to really investigate the topic.
It is easy to illustrate why there can be controversy. Our 401K based allocation plans are a great example. We model retrospective analysis of each 401K plan, using the current securities available in the plan. We do NOT model the plan with the securities that were available at each point in time. (The securities in 401K plans do change over time.) We don't model the plans using their historical securities, because we don't have the information of how the plans have changed over time. Why is this important? It is reasonable to think that over time, the 401K plan managers will select funds that have performed well historically. That means there were likely some "loser" funds that have been removed. The results could be quite different had we modeled the results using the plans securities, as they were historically available.
Another problem with quantitative analysis is "curve fitting". Historic price data is just data, to which a mathematical function can be generated which can, to some degree, fit the data. It is possible to create quantitative analysis models with many parameters, and optimize those parameters to create the "best" returns for a given security or group of securities. With such optimized models, the retrospective returns look great; in fact, near the best you could hope to achieve. But these models fail in the future. Why? Just because you can fit a curve to historic data does not mean there is anything predictive about the model. This is really no different than showing someone a chart of a security price, and saying "where would you have liked to buy/sell this security?". The answer is "I buy low, and I sell high".
The proponents of quantitative analysis software models will say these are limitations of which you need to be aware, but not something to prevent use of quantitative analysis. Specifically, our response to the first example issue (not modeling the 401K plans using their historic securities) is the model generally does better than most of individual securities in the plan, regardless of the plan or the components of any given plan. We believe this will hold in the future as well. (That is not guaranteed.)
To the second example issue, the Simple Allocation model has very few input parameters. The model will allocate a maximum of 4 securities, with allocations listed above. Besides those parameters, there is the reallocation plan interval (monthly or quarterly), and less than 5 other inputs. All parameters are fixed (not variable) parameters. The same parameters are used for all allocation groups, and reallocation plan intervals. Given the overall performance of the model, the number of allocation plans we have tested, and the small number of input parameters, we are confident that our model is doing more than curve fitting. But we cannot be sure.
So why is quantitative analysis controversial? The only way to "prove" a model is to let it run for years, maybe decades, without changing ANY input parameters, and see how it performs. That is the crux of the problem; we want to invest now, we want to use our model, and we believe (based on our arguments above) that the model will work. Others want proof. Our counter argument to waiting for a model to prove itself is this question; "what will you do in the meantime?". The alternative seems to be to guess what you think may work, without any model or testing.
These were some simple example of why quantitative analysis is controversial. There are other reasons for the controversy. Prior to using the Simple Allocation strategy, you need to educate yourself to the potential pitfalls of a quantitative analysis based investing strategy.
Trading in a 401k, the brokerage option and ETFs
Some 401K plans offer a "brokerage option". With a brokerage option, you are allowed much more flexibility than with a standard 401K plan; including the ability to place trades for any stock, ETF, or mutual fund. The fees may be competitive with discount brokers. Be sure and understand the fees associated with the brokerage option (annual fee, commisssions, etc.).
If the fee structure of mutual funds seems daunting, consider using the brokerage option of your 401K to trade ETFs. With ETFs you will only pay a commission to buy/sell the ETF; this simplifies the cost of trading significantly.
Like we said at the start; this is the beginning of your investment education. Please continue to learn, and only use the Simple Allocation strategy when you are comfortable you know enough to understand the risks involved.
We recommend two books to new investors: The Ivy Portfolio and The Little Book Of Common Sense Investing. The Ivy Portfolio details a system that, at a very high level, is similar to ours. The Little Book Of Common Sense Investing is the opposite approach; it recommends a "lazy portfolio" of index funds.
Our system was developed entirely without knowledge of the Ivy Portfolio, and differs in some fundamental ways. But at a high level, they are similar. Our system does differ some in some key ways that we believe give it an advantage over the Ivy Portfolio.
Reading these two books is a good start to understanding two different investing, and contradictory, strategies; a trading driven strategy versus a buy-and-hold strategy.