Asset Classes for Early Retirement

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Asset allocation is the most important variable in your portfolio. The way you allocate your money to different asset classes will dictate the risk you take on. And it will likely prescribe the long-term returns you achieve. That’s conventional wisdom.

Modern Portfolio Theory says that by combining asset classes that have low correlation, you can reduce the overall volatility of your portfolio — even if the individual assets are more volatile. (Correlation is the tendency for two assets’ prices to move together, or not, as they stray from their averages.) And reducing volatility, while achieving the same returns, is a good thing — because it evens out your portfolio’s performance and helps you sleep better at night.

Rather than provide a basic introduction to asset classes here, if you’re new to the topic, I’ll point you to this excellent post over at Monevator: A quick guide to asset classes. You’ll find a simple chart showing the risk/reward positioning of the major asset classes, along with discussions of their relative pros, cons, risk/reward trade-off’s, and time horizons.

Note the iron-clad relationship between reward and risk. You can’t get more reward without taking on more risk. There is no magic asset class that can deliver more of the former, without also requiring more of the latter.

But many do believe there are optimal asset allocations for certain goals. There are as many model portfolios demonstrating different asset mixes as there are finance writers. At the low end are Scott Burns’ wonderful Couch Potato Building Block Portfolios. At the high, complex, and expensive end, there are numerous hedge funds and active management strategies, all chasing some optimal asset allocation.

It isn’t hard to find financial writers who have back-tested some personal brew of asset classes to demonstrate it would have outperformed the market in the past. I don’t dispute that your asset allocation will dictate your returns. But I do question whether any of it can be optimized or predicted in advance.

Some maintain that by rebalancing among different asset classes you can increase returns. I’m dubious whether that pays off in the real world. Vanguard legend Jack Bogle reported on a 2007 study showing that a portfolio of 80% stocks and 20% bonds earned a 9.49% annual return over 20 years without rebalancing, and a 9.71% return with annual rebalancing. He concluded that the difference was the equivalent of investing “noise.”

More recently, author, advisor, and passive investing champion Rick Ferri writes, “In the real world, the excess return from rebalancing among two asset classes may not exist at all in the long term. Whatever benefit there is from the exercise likely gets eaten up by fees, commissions, trading costs, cash drag and poor portfolio maintenance.”

Candidate Asset Classes

In identifying the key asset classes for retirement or early retirement, what should be your guidelines? Here are my simple criteria:

  • the asset class should behave uniquely in response to economic cycles (growth/recession, inflation/deflation)
  • the asset class should be easy to buy or sell, without high transaction costs
  • the asset class should be inexpensive to hold, without high expenses or maintenance costs
  • the asset class should be transparent and not require special expertise to manage or value

The first point above is what makes a certain set of assets an “asset class.” They are fundamentally different from other kinds of investments, giving them individual risk/return characteristics. What do we mean by “fundamentally different”? Rick Ferri explains this best: “Stocks and bonds are different; one is ownership and the other is loan. U.S. stocks are different from international stocks in base currency and government policy. Real estate and commodities differ from common stocks in collateral structure. In contrast, U.S. mid-cap stocks are not fundamentally different than large cap and there is very little unique risk.”

The hallmark of different asset classes is that they are “uncorrelated.” For example, the correlation between the U.S. stock market and 5-year Treasury notes was only +0.07 from 1926 to 2013. That’s useful to know because it confirms that, over very long time spans, stocks and bonds will perform on their own, mostly unrelated, cycles.

Just be advised that while correlation makes for interesting data, in the short- and mid-term it is not terribly helpful for predicting behavior. Turns out there is no assurance whatsoever that we’ll see those same correlations going forward, and, in general, we won’t see the average long term correlations holding at any given point in time. Why? Because asset correlations are dynamic: they fluctuate constantly.

Harvesting Early Retirement Income

Retirement generates new urgency around the choice of asset classes. Now that I’m living off my assets full time, the value of holding potentially uncorrelated assets is crystal clear to me. If diversification among asset classes was important to dampen volatility in your accumulation portfolio, it’s even more important in retirement, especially an early retirement. Why? Because, if you are taking a total return approach to living off your portfolio, consuming both income and some growth for living expenses, then you aren’t so concerned with predicting what your portfolio will return years hence. Rather, you are focused on optimizing how you consume from it today.

The future is uncertain as always in retirement. But one thing is definite: you need to withdraw some living expenses now. The short term is just as important as the long term. So, if you happen to be holding damaged assets, you cannot wait for losses to be recovered. You need to withdraw living expenses continuously! Your goal is not some far-away target that is insulated from fluctuations en route. Your objective is yearly, monthly, daily, cash flow. So it doesn’t help as much if stocks are expected to outperform over the decades. Because, if you can’t get the cash to make it through a current downturn without damaging your portfolio, you won’t be viable long enough to enjoy those future returns!

Thus, I feel, to bombproof your income stream in early retirement, you need a mix of asset classes that give you the strongest possible probability of holding one or more winners at any given time, in any possible economic scenario. For a simple, visual demonstration of this principle, see the Callan Periodic Table of Investment Returns. It shows the ranked annual returns for a number of asset classes over the past 20 years. Note how the asset classes (colors) at the extreme bottom and top of the table trade places regularly: This year’s winner can become next year’s dog, and vice-versa, on and on ad infinitum….

In my opinion and experience, the following are the asset classes that careful investors should consider for a retirement portfolio, along with a rough idea of their historical returns and their possible behavior in different economic scenarios:

Asset Class Return Growth Recession Inflation Deflation
domestic stocks 10% up down up down
international stocks 9% up down up down
bonds 5% up flat down up
real estate 3% up down up down
gold (commodities) 3% flat down up down
cash <1% flat flat down up

Note: The returns shown here are very rough estimates, in round numbers, based on my reading and compositing of miscellaneous historical data. Different sources give different numbers for different times frames and slices of the market. These numbers include inflation, so you would need to subtract about 3% for the real return. Thus real estate and gold have produced minimal real return over the long haul, and cash has lost value! Also, there is no guarantee we’ll see similar returns in the future. In fact, today’s most astute and impartial financial experts are calling for reduced returns across nearly all asset classes going forward. Finally, the economy and its cycles are too complex for snap answers to the question of a how an asset class will behave under certain conditions. Nevertheless I’ve taken a stab at some simple answers here, to acquaint you with the idea that asset classes likely will behave differently.

Asset Class Details, and Your Mix

Stocks, of all kinds, have historically been the best long-term investment. Going forward, there is the possibility of fading U.S. economic leadership, so I make a substantial commitment to international stocks too. For my purposes in retirement living, I don’t make a distinction between growth/value or large/medium/small cap stocks. I just don’t think the differences in correlation warrant managing different investments. I own broad-based funds of all stocks — domestic and international — and I’m done with it.

Stocks are the workhorses of your portfolio. They can deliver the long-term returns that will keep your financial base growing and ahead of inflation. But they are temperamental steeds: you need to protect them in bad times, with a fortress of more conservative holdings — bonds and cash at a minimum. There are many types of bonds to choose from: I lean toward higher quality, short- and intermediate-term government and corporate issues. But I see nothing wrong with holding longer-term, lower-quality bonds as a small portion of a diversified bond fund.

What about international bonds? Only recently has it been possible to buy these in low-cost index funds. Now they’ve started appearing as recommended components of balanced portfolios. I don’t have enough hands-on experience to say much, one way or the other. So far, I have not felt moved to incorporate international bonds into my own portfolio. I suspect that the diversification to be had will be less than what I already get by holding international equities.

Real estate has been a traditional store of wealth, with low correlation to the stock market. However it can easily fail my criteria for liquidity, low transaction costs, low cost of ownership, and minimal expertise. Unless you are a talented and committed property manager, the solution is simple: buy real estate or REIT mutual funds or ETFs.

In general, commodities, like gold, have been a speculative game, because they don’t generate income or growth, meaning they produce no real (after inflation) returns, in theory. Rather, you make money by selling them at a higher price at a later time in the economic cycle. However, this somewhat simplistic view ignores a long-term trend in today’s world: scarcity. I see the possibility that some commodities will experience a secular increase in value over time. But whether they do or not, the facts of retirement — that you need to liquidate investments over arbitrary future economic cycles — dictate that you will very likely experience conditions where the sale of commodities can be profitable.

Then there is cash. It’s the one asset class you must have on a daily basis, to live. And yet it is one of the least productive assets to hold. Sometimes it is critical, but there are almost no economic conditions in which you make a “killing” in cash. In my opinion, you hold enough cash that you can sleep at night, then you deploy all the rest of your assets in a range of asset classes that are likely to perform independently of each other. This gives you the best odds of being able to replenish your cash from something that is currently in favor.

Finally, there are a number of exotic asset classes that we’ve left out of this discussion: hedge funds, synthetic indexes, private equity, and collectibles, for example. In my opinion, these all fail the criteria for suitable asset classes for conservative retirement portfolios. Hedge funds and synthetic indexes are complicated and expensive and lack transparency. Private equity and collectibles are illiquid. That doesn’t mean you can’t do well with some of these asset classes — you might, particularly if you have specialized knowledge. But you won’t be able to take a passive approach to your investments, and the long-term odds will be against you.

So that leaves us with six candidate asset classes for early retirement portfolios: domestic and international stocks, bonds, real estate, gold or commodities, and cash.

How much of each should you hold? That’s an asset allocation question. Do you want an answer based on what mix will return the most, or on what mix will suit you the best? To be honest, neither I nor anybody else knows the answer to the first question. And, ultimately, only you can answer the second question, perhaps with a little guidance….


  1. Kevin Knox says:

    Good post, as usual.

    I still see the problem with this approach, which is certainly the common one out there, as using historical performance of asset classes and correlations to build a portfolio when the past is in fact no guide to the future, AND when there is far too short a history for many of the classes in question to be of any value even for those who buy into the past being a useful guide for the future.

    I know you’re familiar with Bob Clyatt and his “Work Less, Live More” book. He offers an all ETF version of his very thoroughly backtested Rational Investing Portfolio on his web site. The allocations are:

    20% VFINX S&P500
    8% VTMSX Tax Managed Small
    6% VGTSX Total International Equity
    10% VINEX International Explorer (small)
    6% VEIEX Emerging Markets
    30% VBIIX Intermediate Bond Index
    11% BEGBX International Bond
    5% VGSIX REIT Index
    4% Money Market Fund

    This allocation is about as sophisticed a slice and dice as you’ll find, IMHO, and reflects a great deal of DFA computer modeling. Here’s it’s performance over the period that covers the most recent major market crash:

    2007 7.58%
    2008 -20.34%
    2009 23.10%
    2010 13.36%
    2011 0.72%

    For comparison, here’s the performance of Harry Browne’s Permanent Portfolio (25% each Total U.S. Stock Market Index, 30 Year Treasuries, Treasury Money Market and Gold) for the same years:

    2007 13.3%
    2008 0.7%
    2009 10.5%
    2010 14.5%
    2011 10.5%

    I share this not because I believe the PP is “the” solution, but because performance during events like the ’08 crash when supposedly non-correlated asset classes all correlate is important to retirees. How smooth or bumpy the ride is matters greatly, and you have to ask whether you would really have the stomach to buy and hold in years like two shown above, where a conservative slice-and-dice portfolio loses over 20% of its value and then barely breaks even the next year.

    I think many of us are looking for the “holy grail” of real returns of 5% or more with few to no negative years. The search continues!

    • Thanks Kevin, those are useful numbers to have at our fingertips. I’m a long time Harry Browne fan, and I agree with many of your points. I don’t have the answer, but I am certainly living the question. 🙂

  2. I’ve been a DIY investor for the past 15 years and a 401k investor for much longer. Until 3 years ago, I kept up with a few investing or personal finance publications, invested in mutual funds or ETFs, dabbled in a few individual stocks here and there, and tried to keep some sense of asset allocation across all my accounts. All pretty standard and highly -touted tactics.

    When I adopted dividend growth investing as a style in 2011, my mindset began to change about how I was allocating. It switched from allocation based on market value of the assets to allocation based on income those assets produce.

    A DGI strategy does not dictate you must sell your assets to fund your work-optional period of life. You could sell assets if you really, really needed to, but the strategy revolves around growing income. An income stream that covers your expenses and grows faster than the rate of inflation will cure those asset-selling blues. In other words, I prefer to keep the goose.

    Asset size based on market value then becomes less important. I no longer have to worry about keeping pace with the market in hopes that I might reach some magic “number” that I may or may not outlive based on Monte Carlo simulations. I don’t equate market downturns with having to extend my working career. Thus, allocation based on asset size gets pretty close to meaningless for me.

    Of course, the safety of income is now what truly matters. And that’s where I try to maintain some balance. I happen to use M* stock sectors (yes, I invest my non-401k funds in individual businesses) to classify my income. I strive for equality across at least 10 different sectors (10% in each), but allow for up to 30% in any one sector. The intent there, of course, is to not be over-exposed to any sector that may see wide-spread dividend cuts (e.g. Financial Services).

    The end result is my annualized income doesn’t fluctuate wildly like the market does. I no longer obsess about market conditions. I do keep an eye on the businesses I own and am prepared to sell if fundamentals start to deteriorate. I smile when a dividend is announced and jump up and down when a dividend is increased. Heck, I’m even saving money on those financial subscriptions I let expire.


    • Hi Craig, great to hear from a committed DGI investor. There is a lot to recommend this investing style, and it appeals to me personally. In some ways, I wish I’d discovered and experimented with it earlier in my investing career. Main obstacles to me now would be the gains/complexity of switching over, and the management time/expertise required in choosing and monitoring those individual businesses. Still it’s an appealing style, and I wouldn’t discourage anybody who’s attracted from investigating. And I’d be interested to hear more about those 10 sectors — didn’t know you could find solid dividends in so many places. Diversification remains important. Thanks for the detailed comment!

      • I’m with you Darrow. I wish I had discovered this approach much sooner. The next best thing is to pass the wisdom on to the children.

        This is my current non-401k portfolio to give you an idea of the sectors I’m spread across.

        Ticker “Stock Sector” “Stock Industry / Fund Category”
        T Communication Services Telecom Services
        VZ Communication Services Telecom Services
        HAS Consumer Cyclical Leisure
        MCD Consumer Cyclical Restaurants
        KO Consumer Defensive Beverages – Soft Drinks
        DPS Consumer Defensive Beverages – Soft Drinks
        WMT Consumer Defensive Discount Stores
        TGT Consumer Defensive Discount Stores
        PG Consumer Defensive Household & Personal Products
        GIS Consumer Defensive Packaged Foods
        KRFT Consumer Defensive Packaged Foods
        PM Consumer Defensive Tobacco
        LO Consumer Defensive Tobacco
        MO Consumer Defensive Tobacco
        KMI Energy Oil & Gas Midstream
        MAIN Financial Services Asset Management
        WFC Financial Services Banks – Global
        SBSI Financial Services Banks – Regional – US
        WU Financial Services Credit Services
        ERIE Financial Services Insurance Brokers
        JNJ Healthcare Drug Manufacturers – Major
        BAX Healthcare Medical Instruments & Supplies
        GE Industrials Diversified Industrials
        OHI Real Estate REIT – Healthcare Facilities
        DLR Real Estate REIT – Office
        O Real Estate REIT – Retail
        HRS Technology Communication Equipment
        CSCO Technology Communication Equipment
        INTC Technology Semiconductors
        MSFT Technology Software – Infrastructure
        WEC Utilities Utilities – Regulated Electric
        VNQ Real Estate

  3. Kevin Knox says:

    This post from Fidelity is making the rounds on the ER forum, and I find it very interesting that a leading investment firm, which you’d think would tend to be bullish, has these views:

    The previous poster’s DGI investing approach is looking better by the minute!

  4. Darrow, I may not have correctly understood your hesitation wrt rebalancing. Based on the Callan Periodic table I always consider re-balancing to
    1) help with selling high and buying low.
    2) Also if your asset allocation is out of whack with your risk tolerance.

    If you do not rebalance; how would you solve the above 2 problems?
    I do agree transaction costs could be an issue but could you not solve it by redirecting fresh money to the asset class that has not risen compared to the one that has risen (instead of selling the asset class that has risen)?

    • Hi John, good questions, and good answer on your part. I’ve written several posts on rebalancing so I won’t repeat all that here. But, in a nutshell, when it’s studied, as Jack Bogle did, it just doesn’t seem to add much to portfolio performance. And when you go to implement it, you run into expense and timing issues. That said, if your portfolio asset allocation doesn’t match your risk tolerance, then you’ve got to do something about it, no doubt. However in my experience over a couple of decades, my portfolio just didn’t drift more than 5-10% from my target, which isn’t that critical, and I was easily able to counter that by directing new money to the out-of-favor asset class. Now that I’m retired, I sell the in-favor asset class as needed. So far, so good.

  5. John Thees says:

    Using Jack Bogle’s numbers of 9.49% for a static 80% stock, 20% bonds portfolio versus 9.71% for a portfolio that is rebalanced once a year and running it out for 40 years, starting with an intitial contribution of $5000 and contributing $5000 a year, I come up with a positive difference favoring rebalancing of almost $150,000. That is nothing to sneeze at and one gets it for doing no more than an hour’s worth of work a year to rebalance.

    • Hi John. Kudos to you for running the numbers. I get a difference for rebalancing of about $118K, just 6% of the ending portfolio value, but still a sizable sum in absolute terms. What to make of this? Well, even a few tenths of a percent in return adds up to a lot over long time frames! That’s why most of us are so concerned about investment expenses. However expenses are a definite drag on your portfolio, whereas rebalancing is a hypothetical bonus, depending on future price movements. And it’s something you have to perform consistently over long time frames, and may be more work if your holdings aren’t very simple. Bogle’s secondary conclusion was that it is not worth paying an advisor 1% to do this, and we can all see the wisdom of that. If it’s something you can perform yourself, it might well pay off. For myself, I’m comfortable just doing my “background rebalancing” using new money and withdrawals. Thanks again for digging into the details and making us think!

  6. This is all very useful and important but one thing left out of all the equations must be added – don’t obsess about your finances. Yes, plan well, plan smart but above remember the problem isn’t really money, it is expenses. As Henry David Thoreau said, “we have become the tools of our tools”. Work for yourself, not your possessions.