Passive index investors reject market timing and stock picking in favor of owning broad index funds. This simplifies most investing decisions, but leaves one very important one: asset allocation. How do you deploy your money across different asset classes such as stocks, bonds, cash, real estate, and commodities?
Of those asset classes, the allocation between stocks and bonds is the most important one for most investors. Why? Because those are the mainstream asset classes with the biggest differences in volatility and expected return. Over very long time spans, stocks and bonds will perform on their own, mostly unrelated, cycles.
So, for diversification, you want to own both stocks and bonds. After choosing a mutual fund company, the allocation of money between stocks and bonds is the first big decision most investors must make. And, for many investors, it can be the last….
What is the underlying driver for making the asset allocation decision? According to the experts, it’s all about risk versus reward and risk tolerance. How much risk do you need to take on? And, how much can you take on?
But, in my mind, the whole notion of needing to take on risk to achieve a certain investment return is dubious. When you go fishing, do the fish care how hungry you are?
A needy investor is a vulnerable investor. The markets march to their own tune and owe us nothing. Rather than targeting what you need in the way of returns, it is much more realistic, in my experience, to understand what you’re likely to get. Or, just wait and see, and then plan around that.
Ironically, those who most need high returns are least likely to have the capacity….
There are two aspects to your ability to take on risk: emotional and financial capacity.
Your emotional investing capacity gives you the strength not to panic out when an asset class is having a bad year, or worse. Emotional capacity is not necessarily a function of experience or age. For many people, the emotional capacity for risk is likely to be at a low when they are a young, novice investor, and when they are approaching or in retirement. The single best measure of emotional capacity is how you behaved in the last major downturn. If you had substantial stock market holdings during the Great Recession of 2008-2009, what did you do? Did you hold those investments, buy more, or sell in a panic?
If you don’t have that information about yourself yet, then assume your emotional capacity for risk is low. If in doubt, lean conservative with your stock allocation. Especially if you have yet to experience a real-world downturn.
On the other hand, your financial capacity for risk refers to your available liquid resources to outlast that inevitable market downturn. When the next one hits, how long can you generate cash flow for living expenses and avoid selling damaged assets? If you’re mid-career with a secure job in a recession-proof industry, or if you’re retired with a 7-digit net worth conservatively invested, then your financial capacity is very high. But if you’re young, in a new job with less than a 6-month emergency reserve fund set aside, or retired with few assets and little guaranteed income, your financial capacity is very low.
In the end, the appropriate asset allocation for you is going to be a function of the smaller of either your emotional or financial risk capacity.
If you hire a financial advisor to determine your asset allocation, you’ll likely be asked to fill out a “risk assessment questionnaire.” These are surveys, more or less based on psychological research, that attempt to determine your capacities for risk and then recommend an asset allocation.
If you want to experience such a tool for yourself, you can go through the initial sign-up process for any of the robo-advisors or try out free versions from Vanguard or CalcXML, or use the more sophisticated paid version at FinaMetrica.
In all cases, I would be dubious about the results, most especially if you’re a new investor. These tools are attempting to predict emotional behavior based on speculation in advance of events. Imagine filling out a form to predict who you will fall in love with, or how you’d react to losing them. It’s the head trying to forecast the heart. Good luck using those results!
Then there is the issue of the actual portfolio asset allocation recommended by these tools, and its supposed performance. The allocation allegedly matches your risk tolerance. How do they know that? Because they’ve back-tested the portfolio using historical data, maybe applying a fancy algorithm like “mean variance optimization” to enhance performance.
But there is always a problem with using past history to predict the future. As Mike Piper at Oblivious Investor writes:
“Asset allocation is not a particularly precise instrument, and I’m skeptical of attempts to treat it as such. (The only way to give it precision is to use specific assumptions about asset class returns — that they will look like historical returns, for instance. Of course, most assumptions we make will be wrong in one direction or the other.)”
As much as I’m fascinated by investment and retirement modeling, I maintain a healthy skepticism towards such tools. Yes, they are the best we’ve got. But, after years of using them, I’m not totally convinced they are any better than simple rules of thumb in many situations.
With that in mind, let’s review five simple ways to do asset allocation….
1. Put Your Age in Bonds
If you’re 40, own 40% bonds and 60% stocks. If you’re 60, own 60% bonds and 40% stocks. And so on…
This is one of the oldest and simplest asset allocation strategies. It’s sometimes attributed to the venerable John Bogle, founder of Vanguard, though I couldn’t find an example of him voicing that precise rule. Rather, he has been portrayed as increasing his own bond allocation as he ages, and has specifically written that “factors clearly suggest more bonds as we age.”
The argument against this asset allocation is probably that it’s simplistic and suboptimal for individual cases. And there has been other pushback: If you ever need evidence that savvy experts can come up with diametrically opposing advice, just Google for “rising equity glidepath in retirement” — the opposite strategy.
But “age in bonds” is one reasonable starting point for thinking about asset allocation. And, if it turns out to be your ending point, the results are still likely to be satisfactory for a wide range of scenarios.
2. Control Your Maximum Loss
Our next simple asset allocation strategy is one of my intuitive favorites. Though it essentially tries to predict your emotional risk tolerance in advance, the approach is simple, clear, and appealing.
It goes like this: Assume that stocks could fall by 50% at any time. That’s roughly the worst-case drawdown for equities in all but the most severe depression. Then ask yourself how much of a drop in your entire portfolio could you stomach without panic selling: Could you lose 10%, 20%, 40%, or more?
Next you compute your bond allocation like this: Take 100% minus twice the maximum percent drop you could handle for your entire portfolio. (Your stock allocation will then simply be 100% minus that bond allocation.)
So, for example, suppose you could handle a 20% drop in your entire portfolio, but no more. That implies a 60% bond allocation (100 – 2 x 20), which implies a 40% stock allocation. So if, in a downturn, the value of those stocks is temporarily cut in half to 20%, then, when added to your 60% bond position, your overall portfolio declines by only 20%, as you specified.
Note, you might want to think in absolute dollar terms, as well as percentages: A 20% drawdown in a newbie investor’s $10K savings ($2,000) could feel very different from the same drawdown in a near-retiree’s $500K nest egg ($100,000)!
3. Ration for the Worst Case
This next asset allocation strategy is another intuitive favorite, specifically for those in or nearing retirement. It’s focused on your financial capacity for risk. How long could you live off your relatively stable cash and bond investments in an extended downturn, before having to dip into your potentially damaged stock holdings?
To answer this question, you need to know both your annual living expenses, and the average length of stock market cycles. Start by estimating what it costs you to live each month, including taxes, and multiplying that number by 12. As for market cycles, my second book Can I Retire Yet? discusses the topic in depth. It concludes that “to outlast a run-of-the-mill bear market, you should have three years of cash on hand. And for a worst-case recession/depression, you’d better have close to a decade worth of cash, plus other conservative investments you could rely on once cash runs out.”
So, for example, if you spend $5K/month on your retirement lifestyle, that adds up to $60K/year. At the conservative end of this strategy, you’d want about 10 years times that $60K or $600,000 in cash and bonds. So, if your portfolio was $1 million, then you’d be at least 60% in cash/fixed income and 40% in stocks.
Of course this is a very crude calculation. It doesn’t address the potential growth of your assets or rebalancing over time. But the strategy is extremely simple to understand, and scores highly for “sleeping well at night.” The next time we experience another extended market downturn or stagnant period in the economy, I doubt anybody who follows this asset allocation will be disappointed with the results.
4. Split the Difference
Unsure about stocks versus bonds? Want to follow your own asset allocation path, but don’t know where to begin? Here is a commonsense starting point for new and old investors alike: Just split the difference — allocate 50% each to stocks and bonds.
This is the same strategy most people would use if presented with two unknown foods to try: Sample both! And, as reported in his 2015 interview, this asset allocation is good enough for John Bogle.
And it’s been good enough for me. I’ve used a 50/50 allocation for most of my investing career, including right now in my current portfolio. Over the last 12 years, including the Great Recession of 2008-2009, this portfolio of mine has delivered safe, reliable returns averaging about 6% annually.
Despite the simplicity, most of the research I’ve seen shows that a 50/50 stock/bond allocation will not only reduce volatility, but will also generate enough growth to support a safe withdrawal rate in the range of 3-5%.
But this allocation isn’t just for retirees. It could be a good starting point for a new 20- or 30-something investor as well. At that age, investors don’t really know their own risk tolerance. They don’t have the experience yet for an intuitive grasp on how stocks and bonds will behave in different market conditions, or how they’ll react. So, newcomers can start out by splitting the difference, 50/50, then adjusting their asset allocation as they age and develop experience.
5. Use an All-in-One Fund
Maybe the above rules of thumb still require too much decision-making for you? Maybe you’d feel more comfortable letting somebody else make the call, but you don’t want the hassle and expense of hiring a personal financial advisor….
Well, your next option could be an “all-in-one” mutual fund that provides one-stop shopping for most of your assets. There are at least three flavors to understand:
Many large mutual fund companies now offer target-date retirement funds. These are “funds-of-funds” that adjust their asset allocation each year, becoming more and more conservative as you approach retirement. In practice, these are the logical descendants of the “age in bonds” strategy, but with a bit more refinement and complexity. You can review Vanguard’s target-date offerings here. To choose one, all you need to know is the years until your retirement.
Similar to target date funds, but without the time-based asset allocation adjustment, are life-strategy or life-cycle funds. These are funds-of-funds that maintain a constant, though highly-diversified, allocation over time. Choose your risk tolerance, and then just stick with it through whatever comes. The fund won’t change its allocation, but its built-in diversification will insulate you, to varying degrees, from market volatility. You can review Vanguard’s LifeStrategy offerings here. To choose one, all you need is a rough assessment of your risk tolerance, from low to high: Conservative, Moderate, or Growth.
Finally, there is the common ancestor of these “all-in-one” approaches, the humble balanced fund. These are basic mutual funds that maintain a fixed stock/bond allocation. They were designed to be simple, all-weather choices. Typically, though not always, they hold a mix of conservative blue-chip stocks and investment grade bonds. I’ve written more about balanced funds here. It is hard to go very wrong choosing a low-cost balanced fund from a major player. In fact, just such a fund makes up more than one-third of my own portfolio.
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