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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 time 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….

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