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How does Early Retirement affect an Asset Allocation Plan
Old 04-06-2010, 11:52 PM   #1
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How does Early Retirement affect an Asset Allocation Plan

Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?
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Old 04-07-2010, 12:42 AM   #2
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Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?
The conventional wisdom is that an early retiring is going to live longer and there for needs a higher level of equities than a traditional retiree at 65. Now the lost decade of stocks may change this a bit but I don't think it will have huge impact.

You can use FIRECalc to explore the impact of different retirement age selecting a 40 year retirement for the 50-55 group and 30 year for the 60-65 retirees and see which AA performs the best. My guess is that higher equity allocation will increase portfolio survival.
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Old 04-07-2010, 07:54 AM   #3
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Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?
I retired in late 2008 at age 45. I had to greatly change my AA so that my portfolio would be more income-oriented instead of growth-oriented. I cashed in my large holding of company stock (ESOP) and put it into a high-yield (not junk) corporate bond fund to generate the income I would need to cover my monthly expenses.

The other parts of my portfolio [current taxable investments without the new bond fund, and 401(k) rolled into an IRA] have become somewhat more stock-oriented, partly due to the rising value of their stock component and partly due to mild rebalancing. This has partly offset the big shift from the ESOP cash-out but still leaves me with about a 63/37 bond/stock split overall.
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Old 04-07-2010, 09:39 AM   #4
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I'd go by age rather than retirement date, since your retirement will be long. I was thinking a date around my 70th birthday would be about right for me, since I'm risk tolerant. However, you might consider a stash of cash or conservative fixed-income to carry you through the first few years of retirement.
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Old 04-07-2010, 09:46 AM   #5
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Many studies have been done looking at portfolio composition and drawdown periods. Here is but one study based on a stock-bond portfolio and various durations. In this case the study (By Shiller) looked at optimal historical stock-bond portfolios. these portfolios withdrew an inflation indexed SWR and never ran out of money (or only ran out of money a fixed small percentage of independent drawdown periods).

Notice that for longer pay out periods that the portfolios contained more stocks. Notice also that to "never go broke" you need to withdraw less each year for longer payout periods. SO if you expect to live 30 years in retirement maybe you could safely extract 4% each year. For a 60 year retirement maybe you could only extract 3.5% safely each year.

These charts were made optimizing portfolios using historical data. The assumption (of course) is that market performance past is prologue. It goes without saying that your mileage may vary.

Also keep in mind what a safe withdrawal rate is. A SWR allows you to retire at a really bad time when markets are dropping. If you are fortunate enough to retire into a rising Bull market then your withdrawal rate could (in theory) be significantly higher. However since nobody knows the future taking more than a "safe" withdrawal rate isn't vary safe and your risk of going broke goes up.

The downside of a fixed SWR is leaving a huge stash behing at your demise. There is quite a bit of literature about withdrawl rates that are safe but that vary with market performance. The goal of a market-indexed withdrawal rate is to allow higher withdrawals.
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Old 04-07-2010, 12:23 PM   #6
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Originally Posted by lilly View Post
Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?

For me, to adjust for age, I use the 100-age formula.

More specifically, 100-age = amount in equities. Age = amount in fixed income/cash. That way, as each year goes by, I have a little less in equities and a little more in fixed income/cash.

BTW, I do keep some cash back to last about 2 years that I don't put in the asset allocation as this is my emergency reserve.
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Old 04-07-2010, 12:32 PM   #7
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Originally Posted by lilly View Post
Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?
I define my portfolio and the risk I take based on stages as it pertains to amount invested, yearly deposits and the gains of the portfolio measured against my expenses and my contributions.

1) Starting out
this means my contributions are higher than my account balance
or my contributions are a significant percentage (think 10-20%) my account balance.

2) Accumulation
this means my deposits on an annual basis (like a $5000 Roth deposit) are higher than the dollar gains in the portfolio (meaning $50k earning 10% is 5k). My contributions increase my portfolio as much or more than my portfolio gains.

3) Growth
Growth (to me) means that my deposits are a fraction of my portfolio gains each year. If my annual contributions to 401k+Roth are 20k, and my porfolio generates more than 20k of growth on its own (think 200k-300k earning 10% which is 20k-30k).

4) Stability
This means the annual portfolio gains are more than I spend each year. This phase needs to occur before retirement can be considered. Once this stage is reached, a person has true financial independence. If I spend 40k per year, this means my portfolio is generating more than 40k.

5) Draw down
this is what I call the point of no return. This means I need to sell assets in order to meet income needs. If I need 40k of withdraws, and the portfolio generates only 35k of gains, then the 5k difference is "draw down".


I point this out in phases because as far as asset allocation goes, phases 4-5 have a much different allocation than 3 and 3 has a different allocation than 1 and 2.

When starting out and accumulating, asset allocation matters little. Over any 1-3 year period a portfolio will be highly volatile. A person has little control over markets at all, so when starting out, if person started in 1996 vs 1998 they would see lots of different behavior in both the markets, and their reactions too it. Most people starting out will not truly know their true risk tolerance either.

When portfolio is in growth phase, a specific allocation is used. Probably highest equity exposure of all phases is in growth mode. Growth mode is also where other risks are taken- like starting a business, investing in riskier stocks (like owning company stock, micro caps or sector funds).

When portfolio is in stable phase, the risks taken in growth phase need to be removed or reduced. This might mean selling off a business, reducing equity exposure, or removing sector funds or overweighting of asset classes for returns sake to balancing asset classes for stabilities sake.

**MY main premise is each person knows when they need portfolio to be stable, and when returns are more important than stability or consistency of returns**

When in draw down phase, taking market risk out of the equation may help things.

If the phases are measured based on what the portfolio is doing for you... for example if in Growth mode, why "gradually" ratchet down risk over a period of 10-20 years? You will know when you need stability based on your life, your age, your expenses. When you enter that phase, you make the changes necessary you are comfortable with.

Same with draw down, if you see you have entered the "point of no return" and you need to sell off assets each year to meet income/expense needs, there are changes you will make to portfolio even though during stability or growth those same changes would have been "bad".

You adjust for your situation. I suggest defining it based on where portfolio is relative to current expenses, and how much you contribute each year.


Examples-

A person which wants to retire at age 50 and contributes 40k annually to a current portfolio of 400k with 60k of annual expenses sees the above situation much differently than a co-worker of same age who plans to retire at 65, contributes 10k annually to a portfolio of 200k with same 60k of annual expenses.

Because the retirement timeframes and portfolio values are different, its possible the person with a later retirement date takes more risks because timeframe in accumulation and growth phases is longer.
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Old 04-07-2010, 12:34 PM   #8
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Masterblaster,

Those stock allocations look real aggressive to me. Just an observation from a neophyte.
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Old 04-07-2010, 01:20 PM   #9
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Golfnut:

Keep in mind this was just one study - the grain of salt advice there. The reason I showed it was that one would change their allocation based on the duration that the portfolio must last.

Longer retirements need more stock as bonds alone lose out to inflation.

here's a link to the study for you to read:

The Retire Early study on safe withdrawal rates - Millenniam Edition.
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Old 04-07-2010, 01:29 PM   #10
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So many studies...

I don't have links, but here are some other concepts I have taken away from various studies

One study did an asset test.

Meaning did a test with 100% domestic equities
then added in bonds
then added in cash
etc...
foreign components too
commodities too

and by time portfolio had 7 asset classes, it had 100% positive 3 year returns- meaning it never lost money over any 3 year period... but its average return was not enough to grow on. If you had a decent pile of money, it would "last forever". It did not tie into withdraw rates (for example) which left me with some questions. Or if it did tie to withdraw rates, I don't remember the conclusion. In addition this study used an equal allocation among classes (so 1 asset=100%, 2 assets, each at 50%, 3 assets, each at 33%, 4 assets each at 25% etc... 7 assets was each at 14%).

14% large cap
14% small cap
14% foreign
14% cash
14% bonds
14% REITs
14% commodities

that is 42% equities for portfolio lasting a LONG time.

I read another study which suggested 10 years prior to retirement you want to put brakes on risk "hard".

Meaning go 80-100% equities up to retirement minus 10 years (plus or minus) then in bull market when retirement is within 10 years, sell (high), add bonds and take risk down 2 or 3 notches from the 80% equities you used to get there.


I intend to follow both patterns somewhat- highly aggressive when w*rking and accumulating, then sell when markets are up into 5-7 asset classes to preserve what I have worked so hard for.
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Old 04-08-2010, 10:41 AM   #11
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Isn't it true that portfolios that fail with relatively conservative extraction rates (3.5, 4, 4.5) will do so because they take a beating early on?

If so then why would someone take 3.5% for a 60 year retirement if 4.0% is okay for a 30 year retirement, given that you should be able to easily see the writing on the wall during the 30 year phase and make lifestyle adjustments like: go work part time, start liking ramen noodles more, moving to a third world country like Mexico, Thailand or Kentucky.

I guess I could not be lazy and go run firecalc, 'cause I'm curious how much your chance of failure increase over 60 years pulling 3.5 instead of 4, as that's a relatively large percentage of living expenses.
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Old 04-08-2010, 10:46 AM   #12
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I read another study which suggested 10 years prior to retirement you want to put brakes on risk "hard".

Meaning go 80-100% equities up to retirement minus 10 years (plus or minus) then in bull market when retirement is within 10 years, sell (high), add bonds and take risk down 2 or 3 notches from the 80% equities you used to get there.
That seems odd to me.

What if there is no convenient bull in those ten years? How do you know it's high, like if I was trying to do this right now would I consider current valuations high or do I figure it was once over 14k so this can't be high we're still down?

Huge abrupt changes in asset allocation based on perceived market conditions right before (and to enable) retirement just strikes me as a strange game to play.
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Old 04-08-2010, 11:18 AM   #13
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The concept Jimoh refers to is one of avoiding risk prior to when the money will actually be needed. I have seen articles along those lines also. The lifecycle funds also have a philosophy like that.

Some people state a stock percent allocation with an age based formula like 100 minus your age.

That's the concept in a nutshell.
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Old 04-08-2010, 11:57 AM   #14
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Otar's book showed that over a broad range of asset allocations, it just didn't matter. If you don't have enough money, you are simply hosed and no amount of clever asset allocation is going to save you.
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Old 04-08-2010, 12:02 PM   #15
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That seems odd to me.

What if there is no convenient bull in those ten years? How do you know it's high, like if I was trying to do this right now would I consider current valuations high or do I figure it was once over 14k so this can't be high we're still down?

Huge abrupt changes in asset allocation based on perceived market conditions right before (and to enable) retirement just strikes me as a strange game to play.
If you are at retirement=2 years away, you missed the curve by 8 years.

The goal is brakes on with retirement 10 years away. As in maybe 12 years, maybe 8 years, certainly by 5 years and if its 2 years away, the brakes need to be on fully.

For example if my retire date was 2018, 2008 was the wrong time to sell equities, so you wait out a high equity allocation for 1-3 years, looking to both buy some equites at the relative low of 2008, as well as try to sell after a decent upswing.

Within any 12 year span, there is "always" a bull. You usually know it when you are in it. If you don't know if you should put brakes on, you might be taking too much risk already.

My plan is to be about 90-95% equities until about 10 years before retirement. I know to put brakes on when one portfolio double gives me enough to retire on (so if I need 1.2 M and have 600k, brakes get put on immediately). My countdown would start once I put brakes on.

The article I read which suggested this technique was linked somewhere on this forum about 2 months ago.
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Old 04-08-2010, 12:06 PM   #16
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The concept Jimoh refers to is one of avoiding risk prior to when the money will actually be needed. I have seen articles along those lines also. The lifecycle funds also have a philosophy like that.

Some people state a stock percent allocation with an age based formula like 100 minus your age.

That's the concept in a nutshell.
Right

the study I read suggested the success rate was higher applying brakes at retirement-10 (as a general guideline- it might be retirement-12 or retirement-8 if you see you are in a bull market). Don't sell at retirement-10 in 1999 or 2008 (for example).

The point was 100-age (or 120-age) does work, and does work many times. However there are X number of Y year periods where that technique fails, where as retirement-10 worked many times in those same Y year periods (because the technique is not as rigid and does not buy bonds or cash at highs or sell stocks at lows).

Both techniques are using the same principles, with different triggers as to when to sell stocks for bonds or other stable assets.
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Old 04-08-2010, 12:30 PM   #17
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Do the basics of selecting asset allocation based on "retirement date" change if you are retiring early? For example, do you pick a target retirement based on your early retire date, or based on a normal age 65 retire date so you do not become too conservative too early.

I do realize that the bottom line is selecting asset allocation based on your risk tolerance, but how do you adjust for age?
Disclaimer: I FIREd at age 48 with 2 stable income streams independent of my retirement portfolio. I am using half of one income source to continue building my "golden years" nest egg. I am a more conservative investor because this is all I have (besides my good looks ) unless I go back to w*rk.

It all depends on the person and their appetite for risk.

I used the "chickenfeathers" method. I changed my AA from 60/40 to 50/50 for the first year of FIRE as a "wait and see" approach. When 2008 happened, I learned my REAL risk limits with a 25% unrealized loss, and migrated my AA to 40/60. There it shall remain unless I win the lottery. There is plenty of long term growth potential in the 40% equities stake.

I do not recommend this "careful" approach to anyone. It simply w*rks for the continued stability of my personal sleep patterns.
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Old 04-08-2010, 01:43 PM   #18
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Masterblaster,

Those stock allocations look real aggressive to me. Just an observation from a neophyte.
golfnut - this is not meant to 'pick on' your statement, but just to shine some light in there, so please don't get defensive if this sounds too direct, it isn't intended that way (I have trouble beating around the bush):

It really isn't a matter of whether they 'look aggressive' or not. It is simply reporting the historical data. If we ask twenty people to guess how heavy a big boulder looks, we will get 20 different answers, and none of them will change the weight of that boulder. It is what it is. Same with AA and historic survival rates.

But I know what you are saying - many people seem to be frightened by these higher stock allocations. But if you turned it around and asked them which survival rate looks better (w/o seeing the AA), I don't think they'd have trouble giving an answer. Yet, one leads to the other (with all the normal caveats, YMMV, etc).

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Old 04-08-2010, 02:15 PM   #19
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ERD50:

Picking a data point, for a 30 year retirement the indicated chart uses around a 74 % allocation to stocks.

to be fair(er) to golfnut, many other studies conclude that for this same retirement an optimal allocation would be 60 % or even 50 % stocks.

It's all in the data used, the indices and the methodology.

In support of golfnut, I would have to concur with his observation.
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Old 04-08-2010, 02:45 PM   #20
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OK, thanks MasterBlaster, more data is always a good thing. Though I'm actually a bit surprised that a study would show a 50% AA for a 40 year portfolio, but as you say, it depends on the methodology.

I guess I'm thinking mostly about FireClac runs - they seem pretty insensitive to a pretty wide range of AA, the worst being the ones where you get too conservative (< 30% stocks, IIRC).


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