With respect to asset classes among equities, diversification is the most important objective. With that in mind, all three categories should be represented. Historically, the large caps are the most reliable of the three asset classes, with the lowest risk. These are companies with large markets and they operate in the U.S. so there is little information asymmetry with respect to these stocks. Since the other two classes are higher-risk, they should carry with them a premium. It is worth remembering, however, that most U.S. large caps have a lot of exposure to foreign markets. Rather than investing in a Chinese company you know nothing about to get access to China's growth, you would do just as well to invest in Starbucks or Wal-Mart, both of whom have tied much of their growth plans in the next few years on China. It is also worth noting that it is easier to invest in foreign stocks that have ADRs in the U.S., or in mutual funds, as this reduces the information asymmetry.
Given that reality of globalization in U.S. large caps, and the information asymmetry, not to mention foreign exchange rate exposure, the focus of the portfolio should be on U.S. stocks. Thus, a recommended allocation should be 50% large cap, 30% small cap and 20% foreign stocks. This is an aggressive asset allocation, but working with a fifty-year time horizon an aggressive allocation can be made. The risk is high for an all-equity plan, but the time horizon has historically been large enough that an average growth rate will be achieved. It would require the United States to enter a sustained period of economic catastrophe for this portfolio not to experience growth. It is worth remembering that during such a period interest rates on debt will be rock bottom as well, offering little or no gain in nominal terms, much less real.
This asset allocation delivers high growth potential. If we assume 7% as an average annual return for this portfolio, the initial...
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