It was written a while ago, but Part I of our “So how do you actually do this investing thing?” series can be found here.

Now we have a brokerage, understand that we are buying ETFs and have considered taxes, now is time to think about what we are investing in.

Asset Allocation is the term for what you invest in and how it is allocated within your portfolio. Some people get so caught up in asset allocation trying to put together the most efficient portfolio possible. I understand why people are driven to try and get the best returns, but I think it’s best when starting out to keep things simple. To be honest, I think it’s probably best to keep things simple all the time! Remember, the more you play around, the more you are likely to fall into the various biases which can affect you. You are also likely to end up racking up more fees than you need to.

Stocks vs Bonds?

This is the first decision you must make. Stocks (or equities) are the heavy lifters in a portfolio. These are the bad boys you want to grow and make you money from your money. Bonds are for defence when things get rough. The Bogleheads have a few ideas on different portfolios – I love the idea of a lazy portfolio! There are many ideas about the percentage of your portfolio you should keep in stocks. This is all about personal tolerance to volatility. Personally, I recommend a 70/30 equity to bond split as a minimum. 80/20 is where we started, and we’ve moved to 90/10.

Some would consider this quite aggressive, but I feel that the main risk you are battling here is volatility. This isn’t a financial risk, it’s emotional, in that the market is not going to plummet to zero and wipe you out! If you understand that the market rises over time, a higher balance of equities is only risky in the emotional sense. As long as you can stay the course when your portfolio takes a battering (and it will from time to time!), an aggressive allocation is ok. This is where personal finance becomes personal – you must decide what will help you sleep at night!

Equities

You also need to decide which indices you will use to guide your portfolio. Some of my friends and colleagues just choose a global ETF. This is a pretty amazing proposition really – with a single ETF you can invest in thousands of global companies. This is probably about as diversified as you are going to get! However, some may want to bias their portfolio towards a particular region or country. The most obvious nation is the U.S.A. – still the dominant financial nation in the world. Our portfolio is biased towards the U.S.A (bring on the McDonald’s, Coca-Cola, and freedom).

You can do this in two ways – either a total US market ETF or the “classic” S&P500. The latter seems to have given such similar returns to the former that I’m not sure it makes a great deal of difference. The total market is (as the name suggests) all publicly traded companies in the U.S.A., whereas the S&P500 is it’s 500 largest companies.

There is an argument to suggest that the largest American companies are fundamentally international anyway – think Apple, Microsoft, Tesla etc. Thus, holding both a US-centric fund alongside an international fund gives too much overlap. In any case, it largely depends on how much bias you want – most All-World international ETFs are cap-based anyway, meaning that the larger the company, the larger the holding in the fund.

Our portfolio uses an S&P500 ETF as it’s “backbone” and an All-World international stock to supplement it. We also have Asia-Pacific and Developing Markets ETFs, although we regret buying these and have reduced their allocation over time. We value simplicity!

Bonds

Bonds are the defensive portion of a portfolio. Generally, they have an inverse relationship with equities, although this hasn’t been the case this year as inflation kicks the crap out of global economies. Bonds are like you giving out a loan – this can be to a government (or multiple governments), a corporation or other entities. Loaning to governments is generally the safest form of investment you can make. The US government is unlikely to default on its bond repayments as this would be very, very bad (as in, it probably indicates the US economy has collapsed). Corporate bonds can be potentially more lucrative than government bonds, but we can’t help but feel that the added risk (even if it’s low) defeats the purpose of bonds as a defensive element of a portfolio. Look to equities to do the money making when the economy is smoking!

Just like with equities, Bonds are available as indexed funds. Just selecting a US-centric bond is probably simple enough for most people, although international bonds are available too. Personally, we think the U.S.A. is a pretty safe bet for bonds so we just went with that.

REITs & other asset classes

• REITs are a method of investing in property without having to buy and manage property. Most funds have a mix of commercial and residential property holdings. Dividend income is supposedly very lucrative from these funds. We’re interested in putting some money into REITs at some point, although the number available to expats is a bit limited. Additionally, the performance of those we’ve looked at seem quite tied to the stock market. Dividend yields have been comparable to our S&P500 fund, so we haven’t taken the plunge yet as there seems to be a lot of overlap.
• Commodities – Might be a good idea. However, other FIRE bloggers seem to ignore them, and we’re not interested in them. Not recommended.
• Crypto/NFTs – just no. We’ve written about this previously. The fact is the value of cryptocurrencies can fall to zero. For us, this is not a risk worth taking on. If you see Cryptocurrency etc., as being more than just speculation, have at it (but we don’t agree with you).

Biases

You can be biased towards or against a region (like your home country) and this can cloud your judgement. We were initially biased towards Asia-Pacific and Developing Markets and away from the U.K. and Europe. This was, in part, due to things like Brexit. We figured that the Asia-Pacific region would be the place to be investing. Then Covid hit and made us realise we were just trying to predict the market and investing with a certain amount of emotion. Our holdings in our Asia-Pacific and Emerging Markets funds have been down for a quite a while now. We are going to hold on to them and sell them when (hopefully) they rise in value. We won’t replace them with anything – simplicity is the goal!

There is also an argument against market cap weighted asset allocations- small cap funds (e.g., funds consisting of smaller companies) often outperforms large cap. While there is some precedent for this, you have to decide the level of complexity you want in your portfolio. JL Collins says simplicity is best…and he’s probably right! Having lots of different funds provides greater temptation to play with allocations. This is a fast track to giving in to recent performance bias. If you are balancing as you are buying, there will be a temptation to pile more into the best performing assets. Simplicity removes some of this temptation.

2/3/4/5 fund portfolios

So, we have a choice of how complex our portfolio is going to become. The Bogleheads have written amazing documentation on everything financial so it’s worth reading. There are some great portfolio suggestions. I think the Bogleheads are a bit conservative sometimes; Jack Bogle himself suggested having your age in bonds, which is going to make FIRE increasingly difficult if you’re starting in your mid-thirties to forties and beyond! If you have less time to grow your portfolio, an aggressive asset allocation probably makes more sense (as long as you accept that volatility is normal).

Simplest

• All-World International equity fund
• All-World Bond Fund
  The simplest stock & bond portfolio. You only need to decide what allocation you want (as previously mentioned, we recommend an 80/20 equities to bonds allocation.) This will probably be fine.

Simple

• S&P500 equity fund
• All-World International (excluding the USA if possible) fund
• All-World Bond Fund / US Treasury Bond fund
  A simple three fund portfolio. You can decide how biased towards the U.S.A. you want to be by swapping out the S&P500 equity fund or the US Treasury bond fund. Bear in mind that the U.S.A. is still the economic powerhouse of the global economy, like it or not.

You could turn this into a 4-fund portfolio is you decided to go with both bond funds too. This is what we are moving our portfolio towards.

Some complexity

• S&P500 equity fund
• All-World International (excluding the USA if possible) fund
• All-World Bond Fund / US Treasury Bond fund
• REIT

This is similar to the simple portfolio, but with a REIT. This should probably be no more than about 10% of the portfolio, but it might provide some extra diversification.

Next up…criteria for selecting ETFs. We shall get to that later.