It is widely accepted that asset allocation is the most important decision in investing. This refers to your portfolio’s relative exposure to domestic and international stocks, domestic and international bonds, alternatives and cash.
Those with high stock allocations will probably end up with more money over time—potentially a lot more money. But they are subject to bigger losses in the short to mid-term. And in the unlikely event the global economy fundamentally changes, stocks could suffer large long term losses.
Being too conservative early in life can cut your retirement standard of living by 50% or more. Your retirement years require a finely balanced asset allocation. Being too conservative can guarantee running out of money late in life, but being too aggressive means you may have to withdraw funds during a short-term market pullback. This also increases the risk of early depletion. Diversification is critical. Owning all available liquid asset classes on a global basis will reduce volatility without sacrificing expected return. Lower volatility not only provides peace of mind, it increases long term return.
For many of our clients, creation of a successful asset allocation strategy is the most valuable part of our wealth management service. We see a lot of mistakes. Here are four keys to success:
1.) Consider the Big Picture
You wouldn’t cross the street without looking both ways and checking the signal, but many people invest without considering two of the most important variables – future savings and the value of their home and mortgage.
If you are in the beginning or middle stages of your career, your future savings are likely to be significantly more valuable than your current portfolio. This leads many to overestimate the amount of risk they are taking.
The following table and chart illustrate a hypothetical example of someone who starts working and saving at age 25. Annual savings start at $10,000 and grow by 3% per year. A constant 75% stock and 25% bond allocation is assumed to return 6.25%.
Note: Any serious financial planning should avoid straight-line growth and account for taxes. To keep it simple, here we break both rules.
Early in one’s career, future savings and investment earnings (even more important), completely overwhelm the current portfolio. Conversely, just before retirement, the current portfolio is much more significant.
This means a high stock allocation early in life is less risky than it seems. In this example, a 20% loss at age 35 amounts to $30,930, but at age 65 it would be $502,451. The stakes go up significantly just as you approach retirement, when taking excess risk may be least appropriate.
Most people are more aggressive when they are young, but often not as much as they should be. During these early years you should take advantage of your increased ability to bear risk. Should you enjoy strong market conditions, investment returns will compound over longer periods of time and significantly boost your overall wealth.
Takeaway: Don’t be too conservative if you’re young. Potential losses are not as meaningful as you think. In retirement, or close to it, it is time to fine tune the level of risk you can afford and growth you need to meet your spending goals.
Your Home and Mortgage
For many people, their home is a big percentage of assets while their mortgage is a major liability. Just like your investments, these are part of your balance sheet. Don’t ignore them. When you buy a home with a mortgage, you are increasing your allocation to real estate and decreasing your allocation to bonds. When you buy a bond, someone owes you money and pays you interest. When you take a mortgage, you owe someone else money and pay them interest. This is the effective equivalent of shorting bonds.
This table compares two hypothetical individual’s balance sheets with the same net worth but different levels of mortgage debt.
|Jim||% of Networth||Bill||% of Networth|
Both have a net worth of $500,000. Both have full exposure to price fluctuations of their $500,000 dollar homes, but Jim also has stock exposure equal to 80% of his net worth. He is fairly highly leveraged, with $900,000 of assets (home plus stock) and a $500,000 net worth. Bill, on the other hand, only has stock exposure equal to 20% of his net worth. He is less leveraged. Leverage is often considered a dirty word, but used correctly it can be a blessing.
Based on historical returns, the expected future value of Jim’s assets after 30 years would be about four times that of Bill’s, even after paying the higher mortgage interest costs. The importance of this cannot be overstated. A simple tradeoff of stock vs. mortgage debt can mean a drastically different retirement.
Takeaway: Look at the whole pie. If you own a home, be cautious of allowing equity exposure to fall below 35% of your total net worth until you are within 10 to 15 years of retirement.
2.) Have a Long Term Plan
Most investors should seek minimum volatility for an expected level of return. In fancier terms, this refers to a point on the “efficient frontier”. But there are many efficient portfolios. Finding the right one for you (i.e. the right level of risk and expected return) is equally important. This depends on where you are in life and what you are trying to accomplish with your investments.
Early or Mid-Career
Most people who will be working and saving for ten years or more should maintain a high allocation to stocks. This usually means 70% or more. If you are in your 20’s or early 30’s, up to 100% stocks may be appropriate, depending on your tolerance for risk. The primary exceptions are if you have a short term cash need or already have more money than you need for retirement.
A high allocation to stocks requires faith the world will avoid massive catastrophe and capitalism will continue to function. If so, global stocks are likely to provide desirable returns over periods of greater than 25 years. We believe the real return of stocks over the next few decades will be meaningfully more attractive than bonds or cash, but lower than returns over the last century. From 1926 through 2012 stocks returned about 6% per year more than inflation. This was a remarkable period that is unlikely to persist.
Even so, the cost of being too conservative can be huge. An investor who makes 30 years of maximum 401k contributions and earns 7.5% will retire with a balance of around $1.8 million. The same investor earning just 4.0% will retire with about half of this value. This represents the difference between maintaining one’s lifestyle in retirement and being forced to make dramatic cuts.
This chart illustrates the incredible power of compounding returns in stocks. It shows the growth of a $1 investment in stocks, bonds and cash since 1926.
It is unlikely stocks will outperform by such a large degree in the next several decades, but even if they don’t, being too conservative while young is likely a big mistake.
Retired or approaching retirement
As you approach or enter retirement, you need to shift your mindset. Now the game is determining how much you want to spend each year and maximizing the likelihood of meeting these needs.
Stocks should still play a meaningful role, but to a lesser degree. Most people in retirement can’t afford to take as much risk because they have less time to rebound from losses. When you are adding new money to your portfolio, dips allow you to make new investments at better prices. But if you are taking money out, the withdrawal will exacerbate market declines and seriously eat into principal. This also leaves a smaller base and reduces your ability to fully benefit when the market rebounds.
Fine tuning asset allocation in retirement is complex with nearly limitless variables. However, the main ones to focus on include:
- Expected time horizon(s)
- Desired spending (withdrawal rate)
- Market expectations
- Interest rates
- Risk tolerance
- Legacy goals
- Non-liquid assets
If you have a long retirement time horizon and a withdrawal rate over 4%, stocks should remain an important part of your portfolio. More specifically, a diversified mix of stocks, bonds and alternatives is needed. The problem is inflation. Imagine you start out with an all bond allocation earning 4% a year, and you simultaneously withdraw 4% of your portfolio for income. Things look good for a while, but if inflation averages 3%, you will run out of money in year 28. Why? Earnings from bonds do not compound if spent, but inflation does. By year 28, you will need to withdraw nearly 10% of initial principal to maintain the spending power of your original 4%.
If you have a withdrawal rate of 2% or below, you can afford to be very conservative. This doesn’t mean you should. If you are willing to stomach some volatility, a larger stock allocation should provide greater returns over time. It really depends on your plans for the assets. If you won’t increase your spending and don’t have a desire to leave a bigger pile behind, there isn’t much reason to increase your risk.
If pensions or Social Security will cover your retirement expenses, your investment strategy is no longer dictated by your needs. Instead, it becomes a situation of what you want to accomplish. If you gain utility from growth and enjoy spending more money, a high allocation to stocks may make sense. If volatility makes you uncomfortable, government bonds should be the primary player in your portfolio. If you plan to leave your liquid assets to heirs, then your asset allocation should fit their needs. If they are young and working, this probably means more stocks.
If you have a long retirement time horizon and require a withdrawal rate over 7%, you will most likely deplete your assets. Having a high allocation to stocks gives you the best chance to maintain it longer, but also increases the odds of the worst case scenario. Remember, volatility swings both ways. This is a tough gamble, but most will find rolling the dice more favorable than ensuring they exhaust their portfolio with an overly conservative allocation.
3.) Avoid Market Timing
Almost everyone wants to time the stock market. It is human nature and a hard urge to fight. But market timing hurts a lot more people than it helps. DALBAR conducts an annual survey comparing average mutual fund returns to the actual returns people earned investing in those funds.
Investors lagged badly. As of 2012, the average 20 year return for those investing in funds benchmarked against the S&P 500 was less than half of the index return. Most of the difference is poor market timing. Investors, attempting to buy low and sell high, let emotions dictate their decisions and instead buy high and sell low.
There is of course a chance you can add value through market timing. But the odds are not in your favor. It is a high stakes game. The best strategy for most people is to determine a good long term asset allocation and stick with it until your life situation changes.
4.) Diversify, Diversify, Diversify
Not only is volatility uncomfortable, it costs you money. Imagine you start with $100. In one scenario you make 10% in year one and lose 10% in year two. In the second scenario you make 20% in year one and lose 20% in year two. Your average return in both scenarios is zero, but in the first one you end up with $99 and in the second one you are left with just $96. Volatility is even more problematic in retirement if you are withdrawing money.
Diversification is achieved by owning multiple asset classes with a positive expected return but low or negative correlations. Negatively correlated assets are hard to find. Certain “alternative” assets like gold and oil are often negatively correlated with US stocks. That’s why, in small proportions, they can be such valuable elements of a properly diversified portfolio. But even lowly correlated asset classes can do wonders for reducing risk.
It is also important to diversify at the sub-asset class level. Within equities, we recommend about 30% international exposure for most investors. Size, style, sector and industry are important factors. We recommend aiming for a well balanced mix within each. For bonds, the issuer, duration and credit quality are key factors. Inflation protected bonds also provide important diversification, helping shield returns against rising prices.
Once constructed, a properly diversified portfolio must be maintained. Periodic rebalancing ensures the portfolio remains consistent with its original goals. It can also boost returns by reducing volatility from sector and style bubbles.
Asset Classes 101
Investors have a better chance of creating and sticking with a good portfolio strategy if they understand what they own, how it can make them money, and the associated risks. Most individual investors have four major asset classes to choose from.
Stocks represent ownership of publically traded companies. Owners of stock make money through dividends and potential increases in price. The long term return should roughly equal the dividend yield plus the earnings growth rate. The beauty of owning stock is that every day, the employees of the companies you own are working to increase the value of your investment. Stocks have provided strong long term returns because earnings growth compounds over time. As long as earnings growth maintains a positive trend, this effect is very powerful. However, stocks are volatile because they are subject to short term swings in supply and demand. When economic conditions worsen, liquidity dries up and people are less willing to pay high share prices and may even be forced to sell shares.
Bonds are debt. Bonds can be issued by governments, companies, municipalities, agencies and other organizations. Bonds pay interest periodically and the original principal value is usually returned after a pre-determined period of time. Some bonds are callable, meaning the issuer can pay the owner back and cancel the bond at certain times. Bonds tend to be more stable than stocks because they have predictable income streams and guarantee a return of principal, unless the issuer defaults. In the case of corporations, bond holders must be repaid before stock holders receive compensation. Bonds are not without risk. Companies and governments do default. Also, bonds are subject to interest rate risk. When interest rates rise, existing bonds paying lower rates become less attractive and lose value.
Cash is essentially very high quality, very short term debt. Cash tends to be very stable but offers low returns.
Alternatives come in a variety of forms. People often think of hedge funds and private equity. For most individuals, however, these funds are either not accessible and/or come with prohibitive fees. Most investors should focus on liquid real estate investments (in the form of REITs) and commodities (including gold) for their alternatives exposure. Historically, commodities appreciate at about the rate of inflation, but with significantly more volatility. This is inferior to the expected return of stocks and is why commodities should be a smaller percentage of portfolios. Their true value comes in their low correlation with stocks. REITs have historical returns similar to stocks because they benefit from rental income and use of leverage in addition to basic real estate price appreciation.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.