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Logic behind Stock/Bond allocation
09-07-2017, 08:15 AM
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#1
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gone traveling
Join Date: Oct 2016
Posts: 255
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Logic behind Stock/Bond allocation
The rule you always see for asset allocation is always "Subtract your age from 100, and invest that percentage in stocks, the rest in bonds". I understand the general reasoning behind that, but the rule seems so simplistic that I doubt there is much detailed logic behind it. Among other things, it ignores the role early retirement, expected withdrawal rate, expected longevity, etc. might play in determining the proper mix at any given point in time.
For example, it seems a better approach would be "Assume any major market downturn is unlikely to last more than 10 years. Therefore, keep 10 years worth of living expenses in non-volatile investments (bonds), and the rest in stocks".
Any flaws with this approach? Any approaches that make more sense than the Rule of 100?
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09-07-2017, 09:18 AM
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#2
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Thinks s/he gets paid by the post
Join Date: Mar 2017
Location: New York City
Posts: 2,838
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Quote:
Originally Posted by Curmudgeon
The rule you always see for asset allocation is always "Subtract your age from 100, and invest that percentage in stocks, the rest in bonds". I understand the general reasoning behind that, but the rule seems so simplistic that I doubt there is much detailed logic behind it. Among other things, it ignores the role early retirement, expected withdrawal rate, expected longevity, etc. might play in determining the proper mix at any given point in time.
For example, it seems a better approach would be "Assume any major market downturn is unlikely to last more than 10 years. Therefore, keep 10 years worth of living expenses in non-volatile investments (bonds), and the rest in stocks".
Any flaws with this approach? Any approaches that make more sense than the Rule of 100?
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Other than the mostly obscene wealthly in here, I dont know many that have 6 months in living expenses saved. let alone 10 years.
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Withdrawal Rate currently zero, Pension 137 % of our spending, Wasted 5 years of my prime working extra for a safe withdrawal rate. I can live like a King for a year, or a Prince for the rest of my life. I will stay on topic, I will stay on topic, I will stay on topic
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09-07-2017, 09:50 AM
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#3
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Thinks s/he gets paid by the post
Join Date: Dec 2005
Location: Lake Livingston, Tx
Posts: 4,203
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Blue Collar, the op is, I believe, referring to those here that retired largely on savings and not pensions. If so they are using a SWR of some sort in hopes of making their money last through retirement. Therefore, I would hope they would have at least 10 years in savings.
Curmudgeon, I don't depend on savings for retirement, however, I believe you idea makes since. Looking forward to other comments.
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If it is after 5:00 when I post I reserve the right to disavow anything I posted.
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09-07-2017, 09:51 AM
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#4
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Thinks s/he gets paid by the post
Join Date: Jan 2017
Location: Hog Mountian
Posts: 2,077
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After factoring pension $$, we keep 1+ year in cash, 2 years in stable value fund. The rest of our portfolio is about 80/20 E/A. We're both at, or north of, 60.
Nothing invested in monitor lizard futures (that we know of.... could be buried in index funds, I suppose)
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Never let yesterday use up too much of today.
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09-07-2017, 09:56 AM
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#5
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2005
Posts: 10,252
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The '100 - age' is a ridiculously stupid naive rule-of-thumb. I think it is mostly to get people off their butts and investing while they are young. Even Target Date funds don't use that rule.
A better rule is just follow what a Target Date fund does, but even that is not a rule I would follow myself.
Another rule I've seen is that one should figure out the biggest loss that they can stomach and assume the loss comes from equities dropping 50% (as in 2000 and 2007) while bonds don't drop.
So if one can stomach a 30% loss in the portfolio, then don't have more than 60% equities.
A more nuanced idea is that one needs the least risk in their portfolio during the time frame of plus-or-minus 5 years of their retirement date. So before that risk-on. And after that one should know how it is working out, so one could add risk if it has been working out well.
I was 90:10, then 70:30, and now I am at about 60:40 for the rest of my life which doesn't follow any of the above rules.
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09-07-2017, 10:14 AM
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#6
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Recycles dryer sheets
Join Date: Sep 2017
Posts: 61
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We need to be more precise in our terminology.80/20 is 80% equity, 20% debt instruments. Equity can be categorized into large cap, small cap, international etc. Debt can be bonds, treasuries, junk bonds, bond funds, CDs ... cash seems to fit better here.
Thing about bonds that is interesting, principle risk can be tamed with individual bonds held to maturity but you are then potentially exposed to liquidity and inflation risk.
It is easy to do better than 100-age but you have to stop and think about what your objective is. The FAs that came up with 100-age were probably trying to find a simple rule that salesmen could remember and apply to as many sheep people as possible.
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09-07-2017, 10:21 AM
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#7
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Thinks s/he gets paid by the post
Join Date: Feb 2014
Location: Syracuse
Posts: 3,501
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Curmudgeon, your 10 years expenses in bonds makes more sense than 100-age. Wonder where that rule ever came from. I keep a CD/bond ladder that covers essential expenses till SS kicks in plus some total band funds.
The overlooked part of AA is your personal risk tolerance. I thought I was cool at 80/20 until the China fear in 2014 market drop, then thought I was good with 70/30 till Brexit drop. Now I'm good with 60/40.
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“No, not rich. I am a poor man with money, which is not the same thing"
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09-07-2017, 10:22 AM
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#8
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Full time employment: Posting here.
Join Date: Dec 2006
Location: chicago burbs
Posts: 806
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I thought Joh Bogle came up with this idea (100 minus age). I know he is a proponent of it or 110 minus age. He's as good as anyone to listen to, imho.
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09-07-2017, 10:25 AM
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#9
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Thinks s/he gets paid by the post
Join Date: Sep 2006
Posts: 1,743
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Quote:
Originally Posted by LOL!
Another rule I've seen is that one should figure out the biggest loss that they can stomach and assume the loss comes from equities dropping 50% (as in 2000 and 2007) while bonds don't drop.
So if one can stomach a 30% loss in the portfolio, then don't have more than 60% equities.
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+1.
That's exactly my rule. My equity allocation of 50% is based on a market loss of 57% as happened in the 2007-2009 downturn. My portfolio would lose 27% of its value and I can still sleep well at night.
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09-07-2017, 10:26 AM
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#10
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Full time employment: Posting here.
Join Date: Feb 2017
Location: Severn
Posts: 947
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Read an article about the 100-age being too conservative with life expectancy increasing. The article recommended 110-age.
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09-07-2017, 10:40 AM
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#11
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Thinks s/he gets paid by the post
Join Date: Dec 2016
Posts: 1,305
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What an awful "rule" to live by. Age is just one factor in determining AA.
More important are time horizon, return expectations, and cash flow needs.
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09-07-2017, 10:53 AM
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#12
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Mar 2017
Location: City
Posts: 10,336
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Quote:
Originally Posted by Curmudgeon
... For example, it seems a better approach would be "Assume any major market downturn is unlikely to last more than 10 years. Therefore, keep 10 years worth of living expenses in non-volatile investments (bonds), and the rest in stocks".
Any flaws with this approach? Any approaches that make more sense than the Rule of 100?
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Nope. Nothing wrong with it. You have re-invented the "bucket" approach: Keep enough liquid assets to support your needs for the next "x" years and invest the balance with a long-term horizon and as governed by your sleep-at-night criteria.
An "x" of 10 is longer than most people talk about. Except for 1929, market recoveries don't usually take 10 years. Our "x" is 3-5 years.
If you like 10, though, you might want to consider two buckets for that period with the near-in bucket invested very conservatively and the second bucket taking a little more risk and looking for a little more return.
Formulas for AA based on age are IMO brain-dead. One size fits none. A 70YO with $200K to last her life needs a totally different AA than a 70YO wit $10M.
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09-07-2017, 11:36 AM
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#13
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Thinks s/he gets paid by the post
Join Date: Jun 2004
Location: Diablo Valley (SF Bay Area)
Posts: 2,705
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Quote:
Originally Posted by Curmudgeon
Any approaches that make more sense than the Rule of 100?
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I also thought it was 110 as we live longer active lives now? But I think the:
Quote:
Originally Posted by LOL!
Another rule I've seen is that one should figure out the biggest loss that they can stomach and assume the loss comes from equities dropping 50% (as in 2000 and 2007) while bonds don't drop.
So if one can stomach a 30% loss in the portfolio, then don't have more than 60% equities.
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Hadn't heard that but it makes more sense
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09-07-2017, 11:48 AM
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#14
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2005
Posts: 10,252
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Yet another idea is to have liability matching portion, non-discretionary expenses, or essential expenses or floor in something that will always be there such as a combination of Social Security, pension, annuity, TIPS, CDs, or whatever depending on one's personal circumstances. And once that is covered, then one can do anything they want with the rest of their portfolio.
So folks who don't have a pension do something different than folks who do.
So folks who get a decent amount of social security do something different than folks who don't.
So folks who .... You get the idea.
There is so much mental accounting with all these "rules-of-thumb" that people just overthink it.
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09-07-2017, 12:08 PM
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#15
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gone traveling
Join Date: Oct 2016
Posts: 255
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Thanks for all the great replies! One consistent theme that I've heard, though, and don't understand, is something like "So if one can stomach a 30% loss in the portfolio, then don't have more than 60% equities". Why would I care, or be able to stomach, one percentage loss over another? If I have enough money in a stable-value fund to cover my expenses during a market downturn, why should I care whether the remainder (temporarily) drops 20, 30, 50, or 80%? I'm assuming I'm not going to sell from that portion until it recovers.
One other thing: If Al has $2 million in the bank from which he plans to withdraw 4% a year (80K) to fund his retirement, and Bob has $0 in the bank but has pensions and SS which will pay him a total of 80K a year, which one of them is 'wealthier'? I would argue Bob, since he has guaranteed income whereas Al is subject to the whims of the market. But mostly, I wonder why people with big bank accounts are considered 'wealthy', but those with pensions are not?
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09-07-2017, 12:14 PM
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#16
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2007
Posts: 13,202
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Quote:
Originally Posted by Curmudgeon
The rule you always see for asset allocation is always "Subtract your age from 100, and invest that percentage in stocks, the rest in bonds". I understand the general reasoning behind that, but the rule seems so simplistic that I doubt there is much detailed logic behind it. Among other things, it ignores the role early retirement, expected withdrawal rate, expected longevity, etc. might play in determining the proper mix at any given point in time.
For example, it seems a better approach would be "Assume any major market downturn is unlikely to last more than 10 years. Therefore, keep 10 years worth of living expenses in non-volatile investments (bonds), and the rest in stocks".
Any flaws with this approach? Any approaches that make more sense than the Rule of 100?
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Hmmm. Judging from http://www.early-retirement.org/foru...oll-88258.html I recently started, only 25% of respondents were using an age based asset allocation plan.
Your approach is interesting. If your portfolio starts to dwindle as inflation causes larger withdrawals, you'll get a more conservative mix, but if the market does well and beats your withdrawals+inflation, it will actually get more aggressive.
What is your trigger for withdrawing out of bonds. Any downturn? What is the trigger for replenishing the bond allocation? When it fully recovers?
The Japan Nikkei is still down nearly 50% from some 25 years ago. A first world economy, in recent times, doesn't seem like an example to ignore. Would you have stayed 100% stocks for an extended time? Obviously you could throw out that huge run up in the late 80s, but I don't like to guess the market. I'd prefer to keep to rules to take my emotions out of it.
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09-07-2017, 12:15 PM
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#17
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2002
Location: Texas: No Country for Old Men
Posts: 50,004
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Quote:
Originally Posted by Curmudgeon
One consistent theme that I've heard, though, and don't understand, is something like "So if one can stomach a 30% loss in the portfolio, then don't have more than 60% equities". Why would I care, or be able to stomach, one percentage loss over another? If I have enough money in a stable-value fund to cover my expenses during a market downturn, why should I care whether the remainder (temporarily) drops 20, 30, 50, or 80%? ?
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That "temporarily" qualifier is the key. When it happens no one knows if it really is temporary or if it is going to get worse, or never get better (see Japan). That's why some people sell at or near the bottom - they want to "cut their losses."
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Numbers is hard
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09-07-2017, 12:20 PM
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#18
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2007
Posts: 13,202
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The pension and SS factor is also interesting for those of us not there yet. Assuming the 10 year cushion is what I need over and above what I get for those once I start taking them, I'd actually get more aggressive with stocks once I hit 65 and whatever age I take SS? I guess 62 for that, because in a downturn I'm probably going to start taking SS. So at age 55 I'd figure 3 years of SS at the early rate, and no pension yet, and bonds for the rest. Next year I can reduce the bonds by another year of SS and a year of pension. Is that right? Finally at 65 or maybe 70 those will be fully included.
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09-07-2017, 12:21 PM
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#19
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jun 2005
Posts: 10,252
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Quote:
Originally Posted by Curmudgeon
..., which one of them is 'wealthier'?
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I would answer, "Who cares?"
Because the answer will depend upon who is doing the asking.
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09-07-2017, 12:39 PM
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#20
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Full time employment: Posting here.
Join Date: Jun 2017
Posts: 504
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Curmudgeon & LOL!,
It does depend. Firecalc says frequently 4% ends with more money after 30 years? Who is wealthier just matters based on what year it is.
Personally, I would rather have savings from LBYM vs pension after living paycheck to paycheck. To me that shows more flexibility.
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