Asset Allocation: A Recommendation for Resolving the Collision between Theory and Practice

We examine the creation of a low-cost, optimal risk portfolio that individual investors can easily construct and manage. We consider five index mutual funds and three precious metals that are easily traded by investors. Collectively, the mutual funds track the returns of the entire U.S. equity market, 98 percent of foreign stocks, U.S. investment grade bonds, all domestic REITs and emerging markets. The three precious metals are gold, platinum and palladium. Because these mutual funds are available in ETF form, we provide optimization results with and without short selling. Optimization results differ greatly from conventional wisdom regarding optimal asset allocation. This actual portfolio may be as close to the theoretical market portfolio as is achievable in practice.