~10 years from ER, any reason not to be 100% equities?

[intent]

Have read several articles that say something along the lines of, "Mid-forties, you should have an AA of about 60/40 equities/bonds." I'm not sure I understand this line of thinking. If I'm still in the accumulation phase and don't need the money for at least 10 years, what would be the benefit of holding bonds?

Is this just a figure thrown out that, if followed, generally helps most people to sleep better, or is there something else I'm missing?

 

[MasterBlaster]

One guide/rule-of-thimb for asset allocation uses a stock-bond portfolio that changes with age. The thinking is that young people have lots of time for growth and for market recovery should the market tank. Older people have less time, hence the formula.

The asset allocation is stock percent = 100-age.

So a 40 year old would have 100-40 ==> 60% stocks and 40 percent bonds.

Others get a bit more aggressive and use 110-age or 120-age as the formula.

The benefit of holding bonds is... Bonds (historically) have been somewhat un-correlated with stocks. So when stock markets tank, interest rates drop and bonds go up. That works best when the Federal reserve isn't doing goofy things with rates.

The net benefit of holding uncorrelated assets (stocks and bonds) is that the portfolio risk of losing (lots of) money drops considerably with only a small drop in long-term appreciation of the portfolio. Pension funds and endowment funds all use this type approach.

 

[nun]

The closer you get to retirement the more you want to tend towards safety and lower volatility, hence the increasing percentage of bonds. Monte Carlo simulations for the range of market fluctuations and asset allocations show that 60/40, 50/50 etc at various stages of life produce the greatest probability of successfully funding retirement......not necessarily the greatest returns.

This is all subject to individual circumstances and opinions, but I've had good success loosely following the age in bonds rule of thumb.

 

[RunningBum]

Somewhere I read, I think it was at Vanguard, that an 80/20 allocation has only marginally less return than 100/0, with considerably less volatility.

If you don't have a sufficient emergency fund in place, you may find you need some of the money for unexpected expenses or a prolonged unemployment.

I'm using 115-age.

 

[MasterBlaster]

Somewhere I read, I think it was at Vanguard, that an 80/20 allocation has only marginally less return than 100/0, with considerably less volatility.

If you don't have a sufficient emergency fund in place, you may find you need some of the money for unexpected expenses or a prolonged unemployment.

I'm using 115-age.

They probably are referring to (efficient frontier) charts such as this one:

Note that holding some stocks gives lower risk and higher returns than only holding bonds.

Also note that holding some bonds brings the risk way down compared to only holding stocks, with only a small overall drop in expected portfolio returns.

 

[nun]

Those efficiency frontier charts, like all AA vs return metrics, are heavily dependent on the time period over which they are calculated, 2000 to 2008
would probably give lowest risk and highest return for 100% bonds.......2000 to 2007 would have seen equities giving the best return

But I think the error the OP is making is concentrating on returns rather than returns AND risk. I chose my age in bonds AA and couch potato approach as my high level of savings, my anticipated expenses and ER date didn't require me to take a lot of risk to get the necessary returns.

For me successful investing is not about maximizing return, it's about minimizing the risk to get the return you need to meet your goals. Of course knowing that risk can be difficult so you have to go by historical data and for me age in bonds looks like a good strategy. Once I get to 70 I'll probably won't increase my bond percentage as I think I'd be giving up too much growth potential and wouldn't be reducing risk at all.

 

[MasterBlaster]

Those efficiency frontier charts, like all AA vs return metrics, are heavily dependent on the time period over which they are calculated, 2000 to 2008
would probably give lowest risk and highest return for 100% bonds.......2000 to 2007 would have seen equities giving the best return

that's true, nonetheless the concept is valid. Notice that there are no numbers on the chart - it's just a schematic.

The concept of mixing uncorrelated assets to lower risk and improved returns is still valid.

 

[nun]

that's true, nonetheless the concept is valid. Notice that there are no numbers on the chart - it's just a schematic.

The concept of mixing uncorrelated assets to lower risk and improved returns is still valid.

Agreed, although this is all an imperfect science as we can't predict the future. The best we can do is to look back over a number of economic cycles and come up with our best estimate of what might be good for the future.

Any AA we come up with is our best guess at what we need. But there are plenty of things we know will be good for or investment success. Things like LBYM, saving regularly, increasing savings each year if you can etc. So doing those takes the pressure of your AA, you can be in that nice medium return for lowest risk area.

 

[In-control]

Here is what I did, to make me feel comfortable about ER'ing. Before I Er'ed, I;

> Paid off all debt
> Established a budget and managed it for two years
> Accumulated 5 years of living expenses in laddered CD's
> Built a portfolio around a 50% stocks, 30% Bonds, 20% Cash reserves(up to 5 yrs of living expense)
> Stocks funds have been, VG Total Market Index, VG Total Inter.Index, VG Small Index, (IRA)Fidelity Spartan Total Market Index
> Bond Funds, VG Total bond, VG TIPS, VG High Yld Corp.
> I route all dividends to a VG MM where I re-allocate as needed.


Sounds like a lot but during this recent economic challenge I have slept well. I try to maintain ~ 8% yield, allowing me to take 4% out w/o any problems.

 

[intent]

I guess the point I'm not understanding is "risk of what?" Reading between the lines, this line of reasoning seems to be telling me there is a higher risk of equity loss over a 10-yr time horizon than I might have realized.

* So, I guess with 100% bonds there would be very little risk of loss over 10 years, but also very little hope of gains.

* 80/20 equities/bonds - low risk of loss and moderate hope of gains

* 100/0 equities/bonds - higher risk of loss and higher hope of gains

I guess I'm just surprised that the risk of loss in equities over a 10-yr time span is great enough to justify lowering that risk (and possibility of returns) by shifting some to bonds. Still, I'm sure many who are much more knowledgeable than I have put a lot of thought and study into this so I have to assume it's accurate.

Thanks for helping a noob with this concept.

 

[nun]

* So, I guess with 100% bonds there would be very little risk of loss over 10 years, but also very little hope of gains.

You are still falling into the trap of just trying to maximize gains. The 100% bonds portfolio is probably too conservative, but something approaching it would be appropriate for an 80 year old looking for income and capital preservation, they don't need to emphasize gains. The 100% equity route will give the biggest gains for some market scenarios, but will also give the biggest losses in other circumstances. A portfolio of anti-correlated investments is used to give a desired return with the maximum probability. So you are balancing risk and return.....you need to be thinking about risk as well as return. Someone who just goes for return without regard for risk is a speculator, or a gambling addict. As I said before, a successful investor is someone who achieves the required return at the lowest possible risk.

 

[nun]

Here is what I did, to make me feel comfortable about ER'ing. Before I Er'ed, I;

> Paid off all debt
> Established a budget and managed it for two years
> Accumulated 5 years of living expenses in laddered CD's
> Built a portfolio around a 50% stocks, 30% Bonds, 20% Cash reserves(up to 5 yrs of living expense)
> Stocks funds have been, VG Total Market Index, VG Total Inter.Index, VG Small Index, (IRA)Fidelity Spartan Total Market Index
> Bond Funds, VG Total bond, VG TIPS, VG High Yld Corp.
> I route all dividends to a VG MM where I re-allocate as needed.


Sounds like a lot but during this recent economic challenge I have slept well. I try to maintain ~ 8% yield, allowing me to take 4% out w/o any problems.

There's an echo in here, that's close to my plan too. Very similar funds and very similar AA, although I intend to do bond plus cash percentage equal to age up to about 70.

 

[ziggy29]

Without knowing what you have in the way of pensions and retiree health coverage, it's hard to say. People with a significant secure pension with COLAs (more than enough for living expenses) and health insurance taken care of at least through Medicare eligibility are in a situation where they can take *any* level of risk from 0% equities to 100% equities because they don't need the money for their retirement (at that point risk tolerance and estate considerations come into play).

Frankly even if were that fortunate to not *need* retirement savings I'd probably only be comfortable between about 30/70 and 70/30. My mom doesn't need her IRAs or brokerage for retirement income and I have hers at 30/70. I'd consider anything less than 30% as too risk-averse and anything more than 70% as too aggressive, and within those parameters it's a matter of personal comfort and tolerance for market fluctuation.

 

[Webzter]

At some level, it's just a smoothing factor that helps keep the panic down when you see fluctuations. At another level, a balanced portfolio spread across asset classes can boost your return.. if you stick to your AA; which means you're selling your winners and buying your losers. Bonds doing well this year? You're selling your bond holdings and buying your stocks which might do better next year. Small-cap value doing better than large-cap equity? Same deal. REIT outperforming everything? You got it, same deal.

Just remember, bond percentage as a factor of age is a rule of thumb, not a rule. You pick whatever you're most comfortable with... which might be going 100% on a single tech stock and swinging for the fences.

I'm more comfortable with a 90/10 allocation, all in index funds, coupled with the fact that I'm only in my 30's, willing to move for a job if needed, and have a tech background that let's me treat some level of salary as more or less mostly a sure thing (over a given horizon).

 

[FUEGO]

I'm about 3-5 years away from ER and still about 98% equities. But I'm 30. So I can stomach the risk that stocks may do poorly the next 5+ years which would mean I will have to work a little longer.

Right now, I am allocating a portion of our savings to paying down the mortgage. The mortgage rate is under 3%, but that is still competitive with bond yields. And I avoid paying tax on bond interest by paying down the mortgage instead.

I still don't know where my ultimate asset allocation will be for FIRE, but I'm thinking it will be close to 80/20 stocks/bonds or 90/10.

 

[FinanceDude]

You are still falling into the trap of just trying to maximize gains. The 100% bonds portfolio is probably too conservative, but something approaching it would be appropriate for an 80 year old looking for income and capital preservation, they don't need to emphasize gains. The 100% equity route will give the biggest gains for some market scenarios, but will also give the biggest losses in other circumstances. A portfolio of anti-correlated investments is used to give a desired return with the maximum probability. So you are balancing risk and return.....you need to be thinking about risk as well as return. Someone who just goes for return without regard for risk is a speculator, or a gambling addict. As I said before, a successful investor is someone who achieves the required return at the lowest possible risk.

In these times, bonds may have more risk than large blue chip companies..........

 

[Gone4Good]

I guess the point I'm not understanding is "risk of what?"

Risk of not retiring.

NASDAQ 5,000 circa 2000 . . . eleven years later 2,800
Nikkei 35,000 circa 1990 . . . 21 years later 9,800
Nikkei 20,000 circa 2000 . . . 11 years later 9,800
SPX 1,500 circa 2000 . . . 11 years later 1,342

Stocks don't always go up, even over decades.

And, if I were evaluating periods to go 'all-in' on stocks, it wouldn't be a period of unprecedented global sovereign stress, nearly unprecedented federal deficits and debt, unprecedentedly low interest rates, coupled with valuations for the S&P 500 in the top decile of the last 130 years. None of that guarantees stocks will do poorly, of course. But it doesn't make them look like a sure bet either.

 

[clifp]

.

And, if I were evaluating periods to go 'all-in' on stocks, it wouldn't be a period of unprecedented global sovereign stress, nearly unprecedented federal deficits and debt, unprecedentedly low interest rates, coupled with valuations for the S&P 500 in the top decile of the last 130 years. None of that guarantees stocks will do poorly, of course. But it doesn't make them look like a sure bet either.

All true. I'd also add bonds are not a sure bet either. Corporate bonds yields are at historic lows. Treasury bonds yield are even worse. We have exceeded the debt ceiling so there is a tiny chance of default, and decent chance that all of the talk about default will permanently spook foreign bond investors. Meanwhile in the muni front, we are already seeing a number of defaults on weaker issues. Oh and did I mention that inflation is rising among commodities, and is a serious concern in emerging countries like China and India which provide much of the goods and services to US. Hardly a great time to put 40% or whatever your age is in bonds.

 

[Gone4Good]

All true. I'd also add bonds are not a sure bet either. Corporate bonds yields are at historic lows. Treasury bonds yield are even worse. We have exceeded the debt ceiling so there is a tiny chance of default, and decent chance that all of the talk about default will permanently spook foreign bond investors. Meanwhile in the muni front, we are already seeing a number of defaults on weaker issues. Oh and did I mention that inflation is rising among commodities, and is a serious concern in emerging countries like China and India which provide much of the goods and services to US. Hardly a great time to put 40% or whatever your age is in bonds.

I see this comment a lot. And as a stand alone argument it is fine, but as a rationale for stocks it is perplexing. What do we think dramatically higher rates will do to stocks? P/E multiples are nothing but the inverse of an earnings yield . . . currently at about 4%.

And a Treasury default? That would be bad news for sure . . . especially for stocks. If anyone is interested the Greek stock market is 75% off it's high. Greek bonds are down anywhere from 30% to 50%. The only thing is every month or so some Greek bonds get paid out at par . . . at least for now.

I agree that asset valuations for both stocks and bonds are high. That is not a reason to take more risk, it's a reason to take less. And it's a good thing I don't have to choose between overvalued stocks or overvalued bonds. Retail bank products offer treasury beating yields, identical credit risk, and nearly zero interest rate sensitivity.

 

[clifp]

I agree that asset valuations for both stocks and bonds are high. That is not a reason to take more risk, it's a reason to take less. And it's a good thing I don't have to choose between overvalued stocks or overvalued bonds. Retail bank products offer treasury beating yields, identical credit risk, and nearly zero interest rate sensitivity.

Ok we agree on this. I'd even say that despite being in the accumulation phase that 70-80% stocks, 20-30% CDs, G Fund, or some fixed income product that can't drop in price is superior to 100% equities.

It is just that for somebody that is currently comfortable with 100% equities, I see no reason for them to shift to 100 or 110-Age AA, given the interest rate risk and low yields of regular bonds.

 

[Gone4Good]

It is just that for somebody that is currently comfortable with 100% equities . . .

They should be in 100% equities.

But the question I responded to was "what's the risk of owning 100% equities?"

It's interesting that after two years of a nearly vertical stock market, which has more than doubled in value, we're starting to see threads again asking about 100% equity allocations. I don't recall any such threads in 2009 when valuations made far more sense to go 'all-in'.

 

[clifp]

Good point there clearly are risks to 100% equities even a decade before retirement and the examples you cites should give people pause.

As for the threads in 2009 urging 100% equities, you are right among new members of the forum there does seem to be a strong correlation for high equity allocations after recent stock market run ups and low ones after market crashes.

But I'll say many forum members are natural contrarions and/or disciplined rebalancers. So there were plenty of folks who either bought steadily during the decline like myself, and even more who gritted their teeth and said my AA is 50/50 and I need to rebalance by selling bonds and buying stocks even if it is scary to do so.

 

[ral3210]

Agreed. Depending on what about of money one has at risk very few people can tolerate 100% equity portfolio. If one had $1,000,000 in equities and lost 50% during a bear market, how many in the population would stay in 100% equity?

 

[Ed_The_Gypsy]

You don't 'lose' if you don't sell. If you pick reliable dividend-producing stocks, the price of the day does not matter. My dividends have been much more stable than my valuations.

I did a short eye-ball study a while ago using Vanguard funds that showed that a bond component smoothed total valuation fluctuations out at the cost of lower returns over the last ten years or so. I do not like to invest in things that have low long-term returns on investment.

Having said that, it has also been shown that having a buffer (say, 10 years) in bonds or equivalents improves overall results if you sell the bonds first, allowing the stocks to grow.

Full disclosure: I have not started regular withdrawals yet so have not committed to any particular strategy. Almost 100% equities (50/50 US/non-US today) for over 20 years and now paying off debt rather than putting new money into equities.

 

[Ed_The_Gypsy]

As I look at it, Social Security will be my bond fund. Bonds do not excite me as an asset.

If you decide that you want a 10-year fixed-income buffer, you could
a) move one year's worth out of equities to bonds every year,
b) wait until you retire, then move 10-years' worth all at once.
You could build a bond or CD ladder at any time.

You could take distribution from the bonds or the equities depending on which one is doing better that year, or you could take x% (3%? 4%?) out of both asset groups and rebalance every year.