The first significant question you have to answer is how much do you allocate to equities and cash/fixed income. There are many approaches to answer this question, but the vast majority of investors use one of these two approaches:

I. Fixed Income % = Age
This approach by far is the most popular among conservative investors. One of its most prominent proponents is Vanguard Group’s founder Jack Bogle. It is very simple to implement. Each year year you increase your allocation to cash/fixed income one percentage point to match your age and decrease your equity allocation one percentage point.

II. Equity % = 120 – Age

Many of the more “aggressive conservative” investors choose this approach.  The theory here is that equities have out-performed fixed income historically and this formula keeps you in a higher percentage of equities over your life cycle. Using this formula, you would have no fixed income allocation until you are 21 years old. It too is easy to implement; simply subtract your age from 120 and the resulting amount is the percentage that is allocated to equities with the remainder going to cash/fixed income.

For my allocation, I have chosen to implement option II.  However, when I retire and begin to receive large lump sum distributions from various plans that I participate in, I will strongly consider shifting to option I.

After determining your equity/fixed income split. The next step is to decide what type of investments belong in the equity portion of your allocation.  Traditional splits are based on capitalization (large/mid/small cap), origin (domestic vs. international) and sectors such as financials, healthcare, energy, etc. I chose a mixture of all the above. I look at 12 sectors as defined by Morningstar, plus real estate. In addition, I look at origin and capitalization. I review my allocation on a quarterly basis (Q1/2009 review).

From the above link, you will notice the targets are not clearly defined.  After much modeling, I have recently finalized my allocation. As I am apt to do, I put together an Excel model (D4L-Calc-Asset-Allocation.xls) for illustrative purposes of modeling my asset allocation over time. You may want to use it as a starting point for developing your asset allocation.  Here is a quick overview of how to use the model:

Input Section

• Year of birth: What you were you born?
• Fixed/Cash Status: Enter 1 (age) or 2 (120-age) here to select one of the two fixed income options described above.
• Age Override: Let you see what your allocation looks like at any age.
• Equities-Domestic: Percentage of the equity portion allocated to Domestic Equity
• Equities-International: Percentage of the equity portion allocated to International Equity
• Employer Equity: Percentage of the equity portion allocated to Employer Equity
• Small/Mid-Cap: Percentage of the equity holdings allocated to Small/Mid-Cap Equity

The sum of Equities-Domestic, Equities-International and Employer Equity should equal 100%. The sections in the model below the Input section calculate the allocation percentages. For example, given that I am 47 years old, the Asset Allocation – Origin section calculates as follows: My allocation to equities is 73% (120-47), leaving 27% (100-73) to cash/fixed income.  Equities-Domestic is 39% (73% x 53.3%), Equities-International is 24% (73% x 33.3%) and Employer Equity is 10% (73% x 13.3%).

Looking at the Asset Allocation – Capitalization section, Cash/Fixed Income at 27% and Employer Equity at 10% are as calculated above.  Small/Mid-Cap at 15% is input, leaving Large-Cap as a plug to make the section total to 100%. Periodically, you will need to reevaluate the appropriateness of the Small/Mid-Cap allocation since it does not automatically adjust annually.

Let’s consider some sample investments that would fall into each of these categories:

Cash/Fixed Income:

• Money Market Accounts such as ING for your emergency fund
• Vanguard Long-Term Bond ETF (BLV)
• Vanguard Intermediate-Term Bond ETF (BIV)
• iShares Investment Grade Corp Bond ETF (LQD)

Equities-Domestic (U.S. for me):

• S&P Index ETF (SPY)
• Johnson & Johnson (JNJ) – Analysis
• The Coca-Cola Company (KO) – Analysis
• 3M Co. (MMM) – Analysis

Equities-International:

• iShares MSCI EAFE Index (EFA)
• Vanguard Emerging Markets Stock ETF (VWO)
• Vanguard FTSE All-World ex-US ETF (VEU)
• Vanguard Total World Stock Index ETF (VT)

Large-Cap:

The securities listed above under Equities-Domestic are all Large-Cap.

Small/Mid-Cap:

• Vanguard Small Cap ETF (VB)
• Vanguard Mid Cap ETF (VO)
• Genuine Parts Co. (GPC) – Analysis
• Clorox Corporation (CLX) – Analysis

Employer Equity:

Obviously, this would include stock in the company you work for. It would also include stock options, SOSARs (Stock Only Stock Appreciation Rights) restricted stock and company match stock in your 401(k).

As Charlie Munger, Warren Buffett ’s long-time friend and partner said, “Allocate assets wisely. Proper allocation of capital is an investor’s No. 1 job.”

Full Disclosure: Long BLV, CLX, EFA, GPC, JNJ, KO, LQD, MMM, VWO . See a list of all my income holdings here.

On including bonds in your asset allocation:

I have been saying for more years than I care to count not to forget bonds. And start to think about it as a rule of thumb, having your bond holdings equal your age.

Investors come to me and generally say one of two things, either ‘Thank God I followed your advice,’ or ‘I really feel stupid for not having followed your advice.’

On the economy:

We can’t fix our economy now, today. We can move in a direction of fixing it, but when you think about what is happening it’s very obvious: We have to save more.

The old 3% real growth which is the rate the economy has grown at, well I think that is too aggressive. We’re looking at much slower economic times.

On what a slower economy means for investors:

We have had a stock market crash of the largest proportions probably of the last century, with the possible exception of 1929 to 1933. We have had a big stock market crash. Do we have to have another one? I don’t think so.

I would guess the market probably has it about right. I would guess that we have seen the low for the year and maybe the low for this cycle.

On having an international allocation:

Decide where you want to put your money. I would say U.S. stocks, because international will do well and then it will do badly, and the same thing for emerging markets, which will do well for a while and then do badly and then do well again. I just think you don’t need to go beyond U.S. stocks.

On the reported death of asset allocation and buy-and-hold investing:

I am really concerned when I hear people say buy-and-hold is over. Investors, as a group, are buy-and-holders. We own the stock market, all of us together, we buy and hold it. As a group, we all have the same asset allocation. So when you hear someone say ‘It’s a stockpicker’s market,’ well if you picked well, then I picked ill, and as a group it’s the same.’

You can read the entire article here. I don’t agree with everything Mr. Bogle says, but I do think there is a lot we can learn from him. So what can we do to put some of the above in practice?

First, don’t forget about bonds. As recently noted, treasuries and bonds tend to be less risky than equity investments, but have historically under-performed equities. When the market is climbing by double digits, it is easy to question why you are including bonds in your asset allocation. However, when the market turns down, the importance of bonds becomes very evident. I currently hold some old savings bonds (U.S.) and several funds/ETFs in my 401(k) and taxable accounts. My two favorite ETFs are Vanguard Long-Term Bond ETF (BLV) currently yielding 5.6% and iShares Barclays Aggregate Bond (AGG) currently yielding 4.7%.

Unlike Mr. Bogle, I think international investments play an important role in your asset allocation. Due to the complexities in this arena, I prefer to use indexed ETFs to meet my allocation here. In addition to a fund in my 401(k), I currently hold iShares MSCI EAFE Index (EFA) and Vanguard Emerging Markets Stock ETF (VWO). In addition, I am currently evaluating Vanguard FTSE All-World ex-US ETF (VEU).

As  Mr. Bogle alluded to in the article, there are many excellent U.S. stocks to invest in. In this area I prefer to focus on great Dividend Stocks like Johnson & Johnson (JNJ) [analysis],  Procter & Gamble Co. (PG) [analysis], The Coca-Cola Company (KO) [analysis] and 3M Co. (MMM) [analysis].

It seems that ever so many years the market turns down and someone declares the death of buy and hold. Even some go as far to say the Warren Buffett has lost his touch. The buy and hold investors and Mr. Buffett always seen to make a spectacular rebound, and they will once again. In the mean time, we need to focus on acquiring value and maintaining our asset allocation.

Full Disclosure: Long BLV, AGG, EFA, VWO, JNJ, PG, KO, MMM. See a list of all my income holdings here.