This is a long post mostly so I can look back and remember what I did, but I’m posting it publicly in case anyone is in a similar position and could benefit from my research.

About a year ago I became eligible for my employer’s retirement plan, and at the time I was completely overwhelmed by this whole new world of mutual fund investments. Not only was I given a large selection of funds to choose from, but I was also given the choice of providers: Fidelity and TIAA-CREF. I did a little research, but couldn’t really decide what to do, so I just selected the defaults, Fidelity with the 2050 target fund, and let it sit.

Then, over the Thanksgiving weekend, I started reading the long-term investment thread at Something Awful where it quickly became apparent that (1.) choosing assets to invest in doesn’t have to be that hard, (2.) expense ratios (what a fund costs) matter a lot, and (3.) high-cost actively managed funds in general don’t perform better than their lower-cost index-based equivalents.

So I took another look at what was available to me in Fidelity, and I didn’t like what I saw. Two stock index funds, each tracking the S&P 500; one REIT index fund, and one bond index fund. The rest of the funds available were actively managed with expenses around 0.8% or more. Even the few Vanguard funds available to me through Fidelity seemed obscure and expensive.

Then I remembered about TIAA-CREF. I pulled up a list of their offerings, and it made me a little more optimistic. Not only are their options cheaper overall, but they also have index funds available for more market segments. Really the worst thing that could be said after an initial look is that they could have more international representation, but it would turn out that, for me, it doesn’t really matter.

I started reading TIAA-CREF’s literature and taking their asset allocation (AA) quizzes, you know the ones. Well, considering I’m only 25 and I have a good 40 years until retirement, I would consider myself more willing to take on risk than someone a little older. Their quiz would have me put 86% into equities, 9% in real estate, and 5% in bonds. Why 9% real estate? Why not ten, or eight? And can 5% of your portfolio really affect anything?

At this point, I should note that TIAA’s Real Estate Account (TREA) is a unique investment vehicle among providers in that it invests directly in commercial real estate, rather than in companies that manage real estate as the more risky REIT funds do. There is really nothing else like it, and that made it hard to reconcile with other popular AA tips I found on the internet, such as having a simple three-fund portfolio. I wanted to know whether I should include real estate, if I should follow TIAA-CREF’s advice for AA, why they chose the numbers they did, and also why the Bogleheads advocate slightly more conservatives allocations. I may be young, but I don’t want to turn the risk up to 11 just because I can. I want managed risk that I can understand.

So I picked up a copy of The Intelligent Asset Allocator by William Bernstein, hoping it would shed some light on my questions. To be honest, I was hoping it would have The Answer in it, that it would point me to The Optimal Asset Allocation. Thankfully, it did a whole lot better than that. It stated in no uncertain terms that there is no such thing as an optimal asset allocation (except in retrospect), and anyone claiming to have one is conning you. The book started off by providing useful metrics for measuring the performance (in terms of annual return) and risk (in terms of standard deviation) of different asset classes. It was an easy, quick read that gave me a few techniques for understanding the behavior of different asset classes, and how they’ve historically interacted with each other in portfolios. Best of all, it gave me the confidence to tackle the same sort of research on my own.

I sat down and took another look at the asset classes available to me with TIAA-CREF:

Asset Class
Domestic Equities
International Equities
Real Estate
Bonds
Money Market
TIAA Traditional

TIAA Traditional is fixed annuity that guarantees at least 3% interest which, like TREA, is a unique offering that complicated things for me. More on that later. Money markets are, as I understand them, good places to keep cash for liquidity purposes, and they’re currently returning 0.0%. I could scratch that off my list right away—I’m in this for the long haul. The next step was to decide which assets were “high risk” and which ones were “low risk.” Bernstein says that you control the risk of your overall portfolio by your total allocation of low risk assets. Typically people consider equities as high risk and bonds as low risk. TREA was a bit of a mystery which required more investigation (and believe me, I read every document, article, and forums topic I could find about it), but ultimately my gut told me the answer. Anyone who owns a house or has watched the news in the past few years could tell you, real estate is a risky asset. And one look at the account’s growth in the past decade makes it clear:

All I had to do was ask myself, “if I were nearing retirement and that dip happened, would I be okay with it?” Because, if I classified it as a low risk asset, then in the future I would own more of it than I do today as one increases the total allocation of low risk assets to control risk approaching retirement. Clearly I would want to own decreasing amounts of real estate as I age, so it belongs in the high risk category:

	Asset Class
High Risk	Domestic Equities
	International Equities
	Real Estate
Low Risk	Bonds
	TIAA Traditional

Now I could take on the actual asset allocation by process of simplification. First I looked at domestic vs. international equities. As an aside, some people will further break down equities into the various classes of stock (large vs. small-cap, value vs. growth, etc.), and though Bernstein clearly shows that the different sub-classes have different behaviors and play different roles in a portfolio, he also makes it painfully clear that past performance is no guarantee of future performance, and that the behaviors of the different sub-classes have changed over time, so it makes the most sense to own the whole market as it is rather that weighting it. There are funds which track indices that represent the whole market, such as the Russell 3000 or MSCI EAFE. Makes things a lot simpler.

Back to the task at hand, I downloaded the annual returns for the Wilshire 5000 (an index similar to Russell 3000) and the EAFE all the way back to 1971 and plotted the risk vs. return for all of the different allocations of domestic and international equities:

The endpoints on the left of the curve represent portfolios of all domestic stock. The right endpoints represent portfolios of all international stock. Each point in between going from left to right represents replacing 10% of the domestic stock with international stock in the portfolio. The position of each point on the X-Y grid shows the amount of risk vs. return of that portfolio during the specified time period.

Looking at the first time period (in green), the plot would suggest I own a larger chunk of international stock for my level of risk tolerance; however, the next time period (in red) shows that that would have hurt me. Bernstein says that a lot of the change in the behavior of international stocks in the late 80s can be attributed to the rise and fall of the Japanese stock market, and emphasizes that if the past shows us anything, it’s that you can’t predict what will happen in the future, and thus, why not just split the difference? Looking at the long-term picture, a 50-50 allocation of domestic and international equities probably wouldn’t hurt you, and considering that is also about the ratio of the US to international market caps, it fits with the philosophy of “owning the market as it is.”

As another aside, Bernstein’s book has similar charts, and I can’t tell you how satisfying it was to see how much my own findings matched his.

With a 50-50 equities allocation in mind, I can replace two asset classes with one, simplifying my table a bit:

	Asset Class
High Risk	Global Equities (50-50 Dom./Intl.)
	Real Estate
Low Risk	Bonds
	TIAA Traditional

My next task was to determine how much, if any, real estate in the form of TREA I should own. This was a challenge for many reasons. First, as mentioned before, TREA is a unique offering that is hard to compare to other asset classes. Second, it was created in 1995, so it is hard to get an understanding of how it might behave long-term. And third, while the account does track a benchmark index, the REA Composite Index, which could help me gain some insight into its long term behavior, it systemically underperforms it due to the way the account’s properties are appraised. The result was a little guess work and hand waving, but that’s investing, I guess.

I downloaded the annual returns for TREA since its inception in ’95, and the returns for the components of the REA Composite Index which go back to 1978. (The iMoneyNet money market index component is proprietary, so I substituted it with returns from the Vanguard Prime Money Market Fund, which goes back to 1977, and tracks the same index.) Then I plotted the performance of all the various allocations of TREA, the REA Composite Index, and my chosen allocation of equities, after subtracting all of the associated costs (such as the 1.01% expense charge for TREA).

The first thing to note is how wildly different TREA (in green) is from its benchmark index (in red). They’re highly correlated from 1996 on with a correlation coefficient of 0.98, so I don’t think I’m out of line to use a linear approximation between the two to extrapolate what TREA might have looked like from 1978 (in teal). The second thing to note is how stable the REA Composite is. Look at how close together the two REA Comp endpoints are compared to the equities endpoints.

Anyway, this chart, along with a couple of other calculations, was revealing. Should I invest in TREA? Well TREA and my choice of equities have demonstrated a very low correlation coefficient of 0.16 since its inception, so it should be a good candidate for diversification. This is apparent in the graph above. If you had invested in 40% TREA, 60% global equities in 1996, you would have realized the same amount of returns by 2010 as someone who invested 100% in global equities without as many, or as large of ups and downs. The long-term model shows, however, that the benefits of real estate drop off very quickly. In the end, all this can tell me is what has happened, and tells me nothing about the future, but it also says that real estate can be a good diversifier in the bear economy we’ve had the past decade, and if I expect there to be more bad economies in my future, then TREA should have a place in it.

The next question, how much TREA, is a little easier. If I look at the past 15 years, I might be tempted to choose 40%, but I also expect (rather I hope) equities will return to historical levels of performance, so I should choose a much smaller allocation of real estate. Looking at the long term graph, by 20% TREA I would have sacrificed about 1% return compared to a portfolio of all equities. 10% seems to be a good compromise between the portfolio stabilization effect of TREA and the loss of returns. One of the most reassuring lines in Bernstein’s book is:

There is plenty of margin for error available in asset allocation policy. If you are off 10% or 20% from what in retrospect turned out to be the best allocation, you have not lost that much…sticking by your asset allocation policy through thick and thin is much more important than picking the “best” allocation.

So what does it mean to stick with your AA through thick and thin? Well first, I think it means having a rational basis for your choices in the first place, as I hope I’m establishing for my choices here. That should reduce the temptation to make major changes down the line. Second, I think it means that you should maintain your chosen allocations by rebalancing once a year.

Rebalancing is the process of moving money from assets that did well for the year to others that did not. If stocks did really well, it would weight your portfolio more towards stocks than originally planned. Rebalancing brings your portfolio back in line with your accepted level of risk and reinforces the idea of selling high and buying low.

That brings me to my comments about the TIAA Traditional Retirement Annuity, which I am eligible for under my 401(a) plan. As I said it’s a unique opportunity that delivers a guaranteed 3% interest (based on TIAA’s stellar claims-paying ability) and has delivered additional earnings over the guaranteed minimum every year since 1948. A lot of people really like this annuity, and for good reason. It delivers performance similar to that of an intermediate bond fund with even lower risk, historically. It also has a very low correlation with the performance of stocks, bonds, and real estate (a very rare thing), so it could make it an excellent diversifier, and one that I wanted in my portfolio. Unfortunately, that performance comes at the cost of reduced liquidity. Once your money’s in, for all intents and purposes, it’s in until you retire. And even that wouldn’t bother me, except that you can’t even do what you want with the interest. That means, you can’t rebalance its earnings into lower performing assets which makes it a non-starter as a diversifier.

The TIAA Traditional Group Supplemental Retirement Annuity, which I am eligible for under my 403(b) does not have the same liquidity restrictions, but it comes at a reduced interest rate. If I were to include any Traditional under my 403(b) plan, it would make it harder to analyze and compare to my 401(a). Also, because I can’t move money between the plans, the same limitations on rebalancing would apply.

Based on all of its complications, I decided not to include any TIAA Traditional in my portfolio. My table is looking a whole lot simpler now:

	Asset Class
High Risk	High Risk Pool (90-10 Equities/TREA)
Low Risk	Bonds
	TIAA Traditional

All that’s left is to figure out the ratio of my chosen high risk assets to bonds. For the purposes of my analysis, I use “bonds” to mean the entire bond market as tracked by the Barclays Capital US Aggregate Bond Index and available to me as the TIAA-CREF Bond Index Fund. Just as I want to own the entire stock market as it is, I want to own the entire bond market as it is.

I downloaded the annual returns of the bond index back to 1976 and generated a graph similar to the ones above, showing different allocations of bonds and my chosen mix of high risk assets.

I did this over two time periods because, for one thing, the recent data (in green) more clearly shows the behavior of the allocation in our crappy market, and the long-term data (in blue) includes that TREA extrapolation I did earlier. I just wanted to make sure I didn’t miss anything.

A lot of literature would suggest young investors go all in with high-risk equities, and that is the sentiment among a lot of posters at Something Awful. Bernstein suggested the same thing in the first edition of his book, but changed it to a 20% bond allocation in the second edition. The Bogleheads suggest having your age in percent of bonds (25% for me). My findings confirm the recommendations of Bernstein and the Bogleheads. Clearly, a person who invested more heavily in bonds the past 15 years was rewarded with the same returns and significantly lower risk than a person more in invested my chosen mix of high risk assets. But I should really be looking at the long term picture, where a 20-30% allocation of bonds can reduce the portfolio’s risk without affecting returns by much. Since I am more willing to take on risk, and I like nice round numbers, I will choose 20%.

Let’s take another look at my table:

Asset Class
My Asset Allocation (80-20 High Risk/Bonds)

Wow! It has been simplified down to one line. I think that means I’m done! Let’s blow it back up and see what we’ve got:

	Asset Class	Allocation
High Risk	Domestic Equities	36%
	International Equities	36%
	Real Estate	8%
Low Risk	Bonds	20%

TREA itself contains up to 25% low-risk liquid assets, so in my portfolio there is more like 20 + 0.25 * 8 = 22.5% lower-risk assets, but that’s a technicality. I only mention it because it is exactly between Bernstein’s recommendation and the Boglehead’s recommendation of “your age in bonds,” and it was nice to arrive about the same figures independently.

Speaking of “your age in bonds,” that is something I will try to do every year when I rebalance. I will increase my percentage of low-risk assets by 1% per year. That way, by the time I retire, my allocation would theoretically look like:

	Asset Class	Allocation
High Risk	Domestic Equities	18%
	International Equities	18%
	Real Estate	4%
Low Risk	Bonds	60%

Remember, the ratio of high-risk to low-risk assets is how you control risk, not the allocation of assets within those categories. If you think of that ratio as a volume knob, I would say I’m at an 8 right now, and I want to be around 3 or 4 when I retire.

One other thing I want to mention is that when I said the bond index represents the entire bond market, I lied. There is a fairly new invention of the US Treasury called the Treasury Inflation-Protected Security (TIPS) which is not represented by the bond index. It is a type of government bond which guarantees its principal will rise and fall with the consumer price index. They are a great way to hedge against the risk of inflation, but as they’re so new, and a bit complicated, I’m having a hard time understanding the way they work and how they might behave in the long term. For now I’ve excluded them from my portfolio (with my long time horizon and a large allocation of equities, I’m reasonably protected from inflation), but I hope to gain a better understanding of them soon to see where they might fit in.

Now that I’ve decided on an AA, let’s match them up to their low-cost index fund equivalents where possible:

	Asset Class	Allocation	Fund	Symbol	ER
High Risk	Domestic Equities	36%	TIAA-CREF Equity Index Fund	TCEPX	0.24%
	International Equities	36%	TIAA-CREF International Equity Index Fund	TRIPX	0.25%
	Real Estate	8%	TIAA Real Estate Account	None	1.01%
Low Risk	Bonds	20%	TIAA-CREF Bond Index Fund	TBIPX	0.28%
Weighted Expense Ratio (ER)					0.31%

My portfolio will cost me 0.31% per year which is less than half of the 0.80% I was paying Fidelity. To see just how much of a difference that makes, let’s assume I put in $10,000 per year for the next 40 years and average an annual return of 8% and that the costs of the funds stay the same. At the end of 40 years, I would have $2,388,152 with TIAA-CREF and $2,102,199 with Fidelity. That is a difference of $285,953! Expense ratios matter a lot.

So what did I actually get out of all this complicated analysis? Well, as I just demonstrated, my portfolio will have provably lower costs. Beyond that, it put me in control of my future. I now understand the behavior of different asset classes, the indices that represent them, and the funds that I am putting my hard-earned money into. Because I know how they’ve performed in the past, I have an idea of what to expect in the future. So when shit hits the fan again, I will be able to sleep soundly knowing that in the long-run it will work itself out, rather than endlessly fretting about whether I made sound investments. Isn’t that worth a few days of your time?

Stray Thoughts

• Obviously, none of this matters one bit if you aren’t contributing enough to meet your retirement goals. There are tons of calculators out there that will tell you how much to be saving based on how you want to live in retirement. TIAA-CREF has a good one. Thanks to my employer’s generous matching program, I am on track to meet my goal of retiring at 65. I could be doing better, but I think I’m probably doing better than most other people my age.
• Since this is a post about TIAA-CREF, I would be remiss not to mention how pleased I’ve been with their customer service so far as I’m transferring my meager sum from Fidelity. They’ve assigned me an advisor who helped me fill out all of the necessary forms, and who will keep me up-to-date on the status of the transfer until it is complete and then get out of my hair.
• The MATLAB code I wrote to generate the graphs is available from my GitHub account.
• This investing stuff is addictive. Maybe I’ll look into taking some classes next fall.
• And I have to say thanks to my girlfriend who barely saw me last week and dealt with me staying up until 2 or 3 AM every night researching this.