Choosing An Asset Allocation, Step 1: Deciding On The Stocks/Bonds Ratio

Last time I did a really simplified overview of Modern Portfolio Theory. Much of the credit for this is due to a fellow name Harry Markowitz, who figured out that if you combine two assets with the same return that aren’t perfectly correlated, this diversification can result in reduced risk without reducing return. Even if you don’t combine two assets with the same return, combining two assets that have low correlations (don’t move together) will get you a better reward/risk ratio. Markowitz later won a Nobel Prize for his work in this area.

Stocks vs. Bonds
Studies have shown that somewhere between 77% and 94% of the variability in portfolio returns are determined by asset allocation. So our goal is to use asset classes with low correlation to get the best reward/risk ratio. One of the most popular examples of assets that have low correlation is stocks and bonds. Accordingly, adjusting your ratio between stocks and bonds is one of the most basic ways to adjust the amount of risk you wish to take in a portfolio.

The chart below shows the risk/return trade-off between bonds and stocks for 1980-2004. The stock portfolio is represented by the S&P 500 index, while the bond portfolio contains 60% five-year Treasury notes and 40% long-term Treasury bonds. The portfolios range from 100% bonds, to 95% bonds/5% stocks, 90% bonds/10% stocks, all the way to 100% stocks. (via this AAII article)

altext

It’s interesting to note that being 40% stocks/60% bonds actually ends up with the same level of risk, but almost 2% more in average annual return. I think this is a big part of why you won’t see many model portfolios with more than 60% bonds. Also, I would note that as you get near 100% stocks, the slope of the curve gets flatter and you start taking on more risk without getting as much higher return.

How Much Risk Should You Take?
Now, actually deciding on how much risk you need to take is very difficult. You need to be able to keep your asset allocation in both good years and bad years, so in on one side you have to measure how much risk you can take – risk tolerance. On the other side, there is a certain amount of risk you need to take in order to outrun inflation and reach your investment goals. Finally, you have to take into account that risk also decreases over time:

Correct Outlook

You can see here why stocks are considered a good long-term investment, but a horrible short-term investment. This chart shows that for any 25-year period within 1950-2005, the very worst you would have done was +7.9% annually while the best was +17.2%. However, for a 1-year time horizon, the possible returns vary wildly.

One way that people try to determine risk tolerance is via risk questionnaires. Personally, I hate them. They only measure how we think we should act, not how we actually will act. I also don’t like charts that say “If you have 80% stocks, be prepared for a 30% drop. If you have 90%, be prepared for a 35% drop”. Really, am I supposed to see a difference between losing 35% or 30%? Both would make me sad. Really, what I want is a set plan to follow that automatically decreases risk gradually over the proper time periods. That takes emotion out of the pictures, and will help keep me on track.

Some Possible Guidelines
An old rule of thumb is that your stock allocation percentage should be 100 minus your age (this is the same as “own your age in bonds”). More recently, others have altered this to a more aggressive “110 – age” or even “120 – age”.

What about all those Target Date Retirement Funds? Their whole purpose is to decide an asset allocation that works for as many people as possible based on their retirement date. If I assume that people retire at 65 years old, here is what the asset allocation versus age looks like for three of the more popular fund families: Vanguard, Fidelity, and T. Rowe Price (via a previous post):

Target Retirement Fund Asset Allocation vs. Age

If you force a linear fits for all three fund families, it would correspond roughly to stock percentage of 119 – age. However, they don’t really adjust linearly with time. If I use a 2nd order curve fit instead, I can make a little tool that estimates their stock percentages for any age:

Input Your Age: Years
Percentage in Stocks
Vanguard Model:   %
Fidelity Model:   %
T. Rowe Price Model:   %
120 – Age:   %

My Decision
In the end, I haven’t found any precise analytical way to make this decision. Some people view anything higher than 80% stocks as unnecessarily high, and mainly a byproduct of performance-chasing due to high stock returns over the last 20 years or so. I don’t know about that, but I do believe as a whole people greatly overestimate their risk tolerance.

Right now I have 90% Stocks/10% Bonds at age 29, which is about 120-age. I chose this partially because like the idea of being 100% in stocks at age 20, and going from there. But to be honest, I don’t feel like I need to take quite as much risk now as I used to. I think I can save enough that I don’t need the trade-off of a little bit more expected return for a little bit more stomach churning. So I am going to shift 5% more conservatively, and follow a 115-Age plan. So 86% Stocks/14% Bonds is where I’d like to be at. But that’s just me.

Read more: Index of Posts On Building My Portfolio

Comments

  1. i suggest two books to fine tune your asset allocation: the four pillars of investing and the future for investors (siegel). both analyze thousands of models portfolios and report the results.

    i chose, after reading those and many others, to not invest in bonds at all. my asset choice instead was a REIT index that the sun financial diary recommended. it is 36% domestic and the rest int’l. i figured this would be a great balance to my domestic S&P 500 index.

    i am at

    42.5% vangaurd S&P 500 index
    42.5% vanguard all Int’l index
    10% vang. small cap index
    5% dom/ int’l REIT index

    my $.02

  2. I recommend highly visiting http://www.ifa.com (purveyors of DFA funds) and taking their risk assessment and then either copying (as best you can) their recommended portfolio (or, heck, buying theirs). They take MPT risk/return to a whole new level…

  3. This was a very timely post for me. Like you, I’m 29. I’m a graduate student and have ~9K in a Vanguard 2045 Target Fund that I’ve been contributing to over the last 2 years since returning to grad school. I’ve actually been thinking that 10% bonds was too much for me– given the small amount I currently have invested a total market crash might leave me with $900… big deal. However, this post makes me just hold tight can keep the allocation as is.

  4. Steve Austin says:

    Why equate volatility with risk? Within 5 or 10 years of retirement, I can *begin* to see the equation, but then that’s dealt with via a slow conversion of portfolio assets to cash and cash-equivalents. With retirement many (15+) years off, why is overall portfolio volatility risky? I want as much volatility as possible, so that I can sell high and buy low at the expense of overreaction (in both directions) on the part of other asset allocation players.

  5. Current Planner, Future Advisor says:

    The rule of 100 is a good tool to use. As you get closer to retirement it is even good to put your ‘bond’ money (% based on age) into something that can never lose money, such as a fixed-index annuity (just make sure it is a strong company, since money isn’t FDIC insured, but stocks aren’t either). Some of these vehicles have averaged 7-9%, and it’s tax deferred.

    I guess I am curious to know your views on annuities, they seem to get a lot of bad press.

  6. My approach mirrors yours. I am a fan of the 120 – age rule. I manage my allocation through investing in dividend stocks – the dividends continue to come in which I invest/compound in my bond fund.. so by default over time I will slowly increase my bond ownership since I am not reinvesting the dividends in stocks. I have done better in my ROTH (buy/hold portfolio of individual dividend securities) over the years vs. my 401k (invest in an index and reallocate to bonds every year)?. So I will more than likely roll this strategy over to my 401k plan to avoid all the fees I am spending.

    Great find on the ASII chart?

  7. Steve Austin says:

    I have a follow-on comment (in the spirit of the constructive debate you encouraged in your general philosophy post). Since you have said that “past performance is all we have”, then why not use all available past performance? That Burt Malkiel chart you included tells only half the story of the available performance data. Shiller and Siegel have 100+ years of performance data in their books and on their websites, which put the yellow dot (of the Malkiel chart) below the 10% mark for the longer time frames. One might accuse Malkiel of cherry picking, but I believe that it’s a case of not having the data available for his book then. i.e. I doubt it was a malicious omission on his part.

  8. Danny Tsang says:

    First off, great post Jonathan. I love the use of the calculator and the graphs. I’m currently at 100% stocks, I’m 23 and I’m usually a real estate guy. I’m slowly getting into more paper assets. Your site serves as a great starting point for me to build my portfolio in a sensible way. I’m going to look into purchasing my first bonds sometime next week.

  9. Thanks for the timely post. I had been thinking alot lately about fine-tuning my 403b and this post helped alot. I used a combination of your thoughts and the make-up of the Vanguard 2045 fund to re-make my allocations and rebalance my existing funds.

  10. I’ve always used the 120-age rule. The only wrinkle I put on it is that the “bond” portion is further divided out to 2/3 bonds and 1/3 cash. So for example I’ll be 35 soon so my target portfolio will be 85% stock, 10% bonds, 5% cash.

    Some of this is due to some of the mutual funds in my 401k having a “cash” position but also having a small pool of cash on hand lowers my transaction costs as sometimes I can “balance” the stock/bond positions by simply buying whatever is lagging with the cash (or simply just selling out of a very well performing position).

    This post really helps as it seems the institutions are using a slightly more conservative 119 age and my small cash position should get it more in line with that.

  11. You can make the case that Siegel only tells 2/3 of the story. There is some data going back as far as 1860 or so.

    Time frames are time frames, and the time frame you choose always skews the data.

    The result stays the same. You should have a good portion of your portfolio in stocks. Stocks outperform bonds and real estate, but are riskier.

  12. Hey Jonathan;

    The big question that goes with this scaling of asset allocation is

    When do you want to retire?

    followed by
    Do you plan to live exclusively off of your investments

    Based on the chart, these guys have retirement ages in the 60-70 range, but that seems kind of bogus if the new average age is going to 90 by the time we get there. You can’t have a populace of 70-year old retirees doing “nothing” for 20 years. Maybe a small chunk of the populace, but you can’t plan for “everybody” to retire like this.

    Plus, in your case, you’ll probably have much more money than the norm by the time that you’re 50. How much would you need in the bank at 50 to retire? What about to just work half-time (and blogging the other half)?

    It seems to me that before deciding how to allocate your money, you’ll need to decide (or guess?) what you plan on doing with your life in “retirement”. Maybe that’s step 0?

  13. It has been my experience that when the stock market goes up that bonds lag. No surprise there. But when the market goes down or gets hammered, the bonds go down as well.

    Frankly I don’t see the pseudo-protection in holding bonds. How am I wrong here (and I hope I am).

  14. “what he plans to do for retirement” does not affect the level of comfort he has right now concerning a percent allocation to bonds.

    If you tell a financial planner that, risk wise, you’re not comfortable with less than 50% bonds in your portfolio, he’s not going to say “you’re wrong, you should have a lower percentage of bonds.”

    He’s instead going to say “Ok, here’s how much you’ll need if you retire at age X, so to get there you’ll need to save THIS much each year” which could be higher than the amount you had planned to save.

  15. Quick question how does one tell the difference between an active and passive index fund?

    I think I understand the difference in that an active index fund is actively managed by an investment manager(who charges nice juicy fees ) whereas an passive index fund just mimicks a stock index.

  16. sorry coldn’t make it clear, I just want to know how one can tell if an index fund is acvite or passive?

    for e.g. VANG VALUE INDEX INV and SPARTAN US EQ INDEX what we should look for tell whether it is active or passive?

  17. Perfect correlation is 1, no correlation is zero, and negative correlation means they actually tend to move in opposite directionos, which is awesome for diversification. But anything less than 1 can be good, and the lower the better.

    Historically the correlation between US stocks and bonds (by this I mean 25 years ago+) the correlation was consistently negative.

    Within the last 25 years, the correlation has varied from 0.8 to -0.4. I think I’ve seen averages listed around 0.4. So there is definitely still a diversification benefit to bonds, although it may not be as great as before. Who knows if it will be better or worse in the future, but I think there will still be some benefit. It is also still a good way to modulate risk.

  18. With a time horizon of possibly 30+ years until retirement, why not go all stocks for a while longer? Do you really worry about a major collapse in the next 10 years that won’t be more than made up for in the next 20+ years? If stocks dropped 90% tomorrow you wouldn’t be able to live off of your 10% bonds anyways. Basically, if things were that bad between now and 30+ years from now, I think we would have much greater things to worry about!

  19. When it comes to being able to ride out long depressions in markets, ’tis easier said than done. The only people that can really say with some confidence are those that rode from 1996-2006 without changing their asset allocations at all. I’m not one of those people. ;)

  20. Nate,

    The market can lag for years without necessarily meaning things are that bad. Take Japan, for example – the market there has been down since 1990 (way down!).

    Since we only really have limited history of the US markets, and since we are speculating on a perhaps 50-year investment time horizon, perhaps it is a good idea to bring in other (non-emerging) markets as well, such as Japan, Europe, and perhaps Russia? This would give a larger sample size of possible outcomes.

  21. @@Stephen
    ?what he plans to do for retirement? does not affect the level of comfort he has right now concerning a percent allocation to bonds.

    Of course it does! Your Financial Planner will say:

    ?Ok, here?s how much you?ll need if you retire at age X, so to get there you?ll need to save THIS much each year?.

    But if you’ve noticed, Jonathan doesn’t mention when he wants to retire or how money he wants in retirement. So we don’t have a need number AND we don’t have an X number.

    It seems to me that you should be allocating your investment selections based on need. Your post seems to implicitly agree, but then you completely miss the fact that we’ve both failed to assess need and failed to assess the X from your very example.

    @@Nate: where did you get the “time horizon of possibly 30+ years until retirement”. I personally read the post twice and saw nothing about his target retirement age.

  22. Very nice post!

    Current Planner, Future Advisor, annuities suck because they have crazy high fees.

    Jack S, I feel the same way. I think the point is that when stocks plummet, people jump into bonds. So that’s when you should rebalance by selling some of your expensive (now low-yield) bonds to buy cheap stocks.

    hem, I think the answer to your question is that all index funds are passive. They just follow an index, so no active decision-making is required. Non-index funds are active.

    I have a big pension, which is very bond-like. So all my other long-term money is in stocks and might always be. (Except I couldn’t resist a tiny amount of I-bonds when they were still nice.)

  23. These 1×0 – age “rules” are merely guidelines. They needn’t and shouldn’t be followed as gospel. Your asset allocation should be determined by your willingness and more importantly, need to take risk.

    For example, I recently switched to a 80/20 stock/bond split from what was 90/10 for 6 years. At 28, this may seem rather conservative. However, recent returns from the market over the past couple of years have grown my assets to the point that I’m now much farther ahead than I thought I would be at this stage.

    This has thus reduced my need to take risk significantly. I can, therefore, afford to go with a more conservative AA that allows me to lock in the gains and sleep better at night.

    Also, one should be careful about equating risk with std deviation or volatility. Time can reduce your volatility but not your risk. Historical market returns can provide us with guidance, but you can’t fully model your portfolio on them. The market does not have a normal distribution (bell curve). It has way more significant outliers (or “fat tails”) than a normal distribution would lead you to believe.

  24. One thing nice about the 1×0-age guidelines is they do take into account a certain amount of need to take risk – by ramping down the risk as you get older. All you may be doing is just changing the starting point, going from 120 to 110 in Peter’s case.

    Johnathan, for some of us 1996-2006 is a bad example. I can safely say I stuck with my AA through that time period but I started working in 1996 so needless to say I didn’t have as much to lose when things started to tank around 2001. The ride back up has been swift though, definitely a believer of dollar cost averaging.

  25. “@@Stephen
    ?what he plans to do for retirement? does not affect the level of comfort he has right now concerning a percent allocation to bonds.

    Of course it does!”

    I do not believe it does. If someone asks me the usual question: “How much of your portofolio can you lose before you freak out?” then says “that’s not good enough, you’ll need to take on more risk to meet the goal”, my answer doesn’t magically change. My comfort level is still my comfort level.

    If your answer DOES change, perhaps you didn’t think about the question enough the first time.

    Now, if you’d like to change the risk factor in the NON BOND portion of the portfolio, that’s a different matter.

  26. Listening to your advice, I like 120 ?age Rule more. At the moment I am only investing in stocks and gathering information about investing in bonds. I will use your article when considering balance stocks/bonds.

  27. This is an excellent post. The article you refer to in the AAII is basically a distilled version of a first year MBA finance class (well, ok, the first 5 lessons of that class, minus all the mathematics).

    I have recently posted an article about a recently released academic study that tests the long term correlations (and variance in correlations) between different asset classes. Bonds and Stocks are good diversifying assets, but even better diversifiers are global bonds and commodities. Other asset classes that have a diversifying effect that sometimes disappears are emerging market stocks and real estate. You can look up the article on my blog if interested. The title is “Advanced Portfolio Building”. It is a three part series.

  28. Jonathan,

    While I still believe this was an excellent post of yours, it’s interesting that it was made just about at the peak of the stock market.

    I’m curious whether you still feel, after such a crazy ride, that 86% stocks is where you want to be.

    (FYI – I’ve been 84% stocks, and rebalanced last fall, but am really wishing I had followed William Bernstein’s advice and not gone higher than 75% stocks.)

  29. Great article. Like 120 rule but prefer 110 for my circumstance.

    Here is my take. Nobody knows future so you can and should make educated guess.

    Current age 37. (fact)
    My retirement 60. (for all practical purposes should not vary more then 1-2 years).
    My predicted life expectancy 72 years (based on current health, family history and other factors).

    Bond % should be at least 50% or more around retirement. It can be more or less based on how many years you are expected to live after retirement. Therefore, 110 rule will work best for me.

    Just my $0.02.

    Again article.

  30. I’m guess you took a big time hit a few months after writing this. Pity. I almost followed this advice too, here in 2010.

  31. Hey @bob remember, it’s not Jonathan’s advice, just his guess based on his specific circumstance.

    Remember, this is the same Jonathan that bought a $600k+ California home at the height of the bubble (April 2008 or so). Also remember that he’s built an incredible cash cushion and that he and his wife both make $100k year each (at around this time).

    Jonathan has a lot of leeway to be wrong with his decisions and still be OK.

  32. This is a great post, and discussion following it. However I am shocked that a critical component hasn’t been discussed at all yet. That would be the effects of rebalancing on a portfolio. Without a bond component, there is no money in which to buy stocks when they are cheap, and likewise, to lock in gains when stocks are high. I read an article once (which I wish I had saved), that argued for a 60/40 mix being the best performing when rebalancing is considered, because you will actually get more than the return of the stock market out of the stock component, as you will be passively buying low and selling high, without resorting to market timing.

    Interesting stuff to be sure, and while there is a lot of math needed that I don’t have, I am confident that an 80/20 portfolio rebalanced quarterly or annually, will beat out a 100% equity portfolio for the reasons mentioned above.

  33. I work in the computer systems of the banks that target the richest 1% of the population. They invest mainly in bonds.

    I think that the models are flawed, and that bonds outperform stocks on a risk adjusted basis.

  34. @matthew: to be fair, much of the top 1% of people are heavily invested in some form of stocks via their jobs. Whether via business ownership, stock options, or big stock-based performance benefits.

    To be in the top 1.5% of incomes, you need a household income over $250k/year. That basically puts you in “options” range.

    If you can earn “stock-like” growth from your salary, then you’re probably investing the rest in bonds.

Trackbacks

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