Question about asset allocation

[carlg1977]

I am a new member to this board, and want to run a quick thought/question by you. I have recently read a book by Gillette Edmunds called "How to Retire Early and Live Well...".

In this book, he really seems to downplay fixed income securities in general, and bonds in particular. He states that he does not invest in bonds, due to low returns and high taxes. The whole point of the book seems to suggest that you should invest in 3-5 noncoorelated asset classes, and that if you do so, you will have enough predictablility to not need fixed income securities. In short, he recommends something like 0-20% of portfolio in bonds for those living off investments.

Now, I am 29 and can retire before 50 if i invest 25% of my earnings and average a 8% return, which seems modest to me. Because I am conservative, I had planned to put 60-70% of my money into bonds, and a small percent into US stocks, REITS, and foreign stocks to reach my target investment return. After reading this book, and am under the impression that I should invest much less in bonds, maybe allocate like this:

20% Large US stocks
10% small US stocks
20% REITS
20% Foreign stocks
10% emerging markets
20% bonds and cash

Which way is better?? How stable would the portfiolio with less bonds be?? Is it acceptable for an individual in retirement, or is a portfolio heavy in bonds required??

Thanks

 

[wabmester]

Welcome to the board.

I'm a huge fan of bonds, but I'm retired.   At 29, you don't need much allocated to bonds.

There are probably three useful attributes of bonds:

1) Low volatility and preservation of capital.

2) Reliable income.

3) Low correlation to stocks.

(1) and (2) will become important to you *after* retirement.   And the older you get, the more important it becomes because you'll have less time left to recover from downwards stock volatility.

(3) is always nice to have.   In fact, historically bonds would have both increased your returns and lowered volatility with the right mix.

Stay short term, and a 10-20% bond allocation is probably about right for you.

 

[mathjak107]

if you got the stomach and a long enough time frame so you dont have to liquidate shares in a down market he's right,you dont need bonds ...generally whats good for bonds is even better for stocks and being an owner is far more profitable than being a loaner......just keep the stocks diversified and all different market capitalizations....dfa did a study and found nothing beat pure equities .a mix  of large cap value and growth ,mid-cap same and small cap same with some foreign mixed in .....at this age 53 now i cant tolerate the wide swings anymore so im about 60 % equity ...for risk vs rewards 60/40 seemed to be the best deal over-all ..almost as good as pure equities with only a monor drop in return...dfa says 14.1 all equity since 1970 11.6 60/40  11.1 50/50

 

[d]

at your age I'd reduce the bond % ... for many years I have used (age/100)^2 as my benchmark for non-equities (cash and bonds), in your case <10%

and while many will disagree, I think your RE and EM %s are excessive

 

[lazyday]

> Because I am conservative,

Those may be the key words.

It seems that most people buy into what has done well lately, and then after prices fall, they sell in a panic. Not because they are stupid, but because they are following normal human instincts which in most other cases, help instead of hurt us.

I wouldn't quickly and dramatically decrease bonds from 60%+ down to 20%, unless I was quite sure of myself in my ability to resist selling should the markets plummet, and everyone around me has sensible explanations for why I should sell too. Even people much smarter than me.

Similar for the 20% REIT position. And, maybe the 10% smallcap, depending which large and small indexes you pick.
And EM--although I still like EM even after the runup. Still, a 50% drop in EM wouldn't shock me. Would you really buy more?


On the other hand, when I was still working, I was 100% equity. I'm glad for it now. But, from what I've read, it seems I'm the exception. (This isn't bragging... the easiest way to be an exception is probably to be a sociopath! So anyone who is an exception is suspect... I do have the full range of emotions, but somehow am usually able to keep them from causing me to buy high and sell low. Also might help that I march to the beat of a different drummer, so don't have as much of a herd instinct as most people. Made for a painful childhood, but good investing.)

If you really can stick to it, even in the worst markets, then having 20% bonds when still working, and probably more when retired (a la wab) makes sense to me.

 

[d]

there is a real danger of being excessively conservative, especially at a very young age: at some point one might realize they should have been more aggressive, and in an attempt to "correct", become overly aggressive when they might then not be in a position to recoup from a down market.

 

[laurence]

At 31, my bond holding is ~7.5%, through Wellington. I think you have too much in REITs as well. But your asset allocation is better than mine was when I first got to this board, I think I was 75% large cap (thanks Wildcat, for fixing that!).

Have you handled the low hanging fruit of checking out the expense ratios of your funds? I also gained an extra 1% of annual return by getting out of some more expensive funds.

 

[wabmester]

I have to admit, I can empathize with the guy.   I was 29 in 1990 and I had put about half my savings into Japan.    16 years later, that market still hasn't recovered.

It's hard to stomach saving your money only to see it wiped out.    In fact, it serves as a real disincentive to saving anything.   You ask yourself: am I saving for retirement or am I pissing away part of my hard earned salary on something I have zero control over?

 

[laurence]

oooh, stupid me, re-read your post, that was your proposed portfolio, not your current.

I hear ya, Wab, I was 25 in 2000, and had socked all my money into hi-tech dot.com type stocks, watched my portfolio get cut in half over the next couple of years. It is tough to stomach and stay the course, my coping mechanism is to only look at my funds when I know the market has been doing well for a while. I haven't even logged on to my retirement accounts in the past couple weeks.

 

[brewer12345]

carl, I think you are missing the forest for the trees. Let's put the gurus aside for the moment and approach this as it pertains to you.

1) We know that you are conservative and do not have tolerance for a big loss even if it means potentially higher returns over time. Seems like a simple ground rule to me. If you exceed your risk tolerance (and there is no way to know until something blows up in your face or you are having trouble sleeping), you will be sorry.
2) You have already figured out a rough cut at what nominal return will get you to retirement at your target age. I suggest you figure this out in "real" (inflation-adjusted) numbers. For example, about 18 months ago, I sat down and figured out that I need a return of about 4.5% plus CPI (no comments from the peanut gallery for now) to hit my target date. Real return is better to have a grip on because inflation moves around a fair bit over time.
3) Once you know what real return you need to make your target, translate this into the returns offered by your base case allocation. If you start out with 60-70% bonds, can you realistically make your target date? If not, how much do you miss that date by? How much extra risk would you have to take to make your date? If you need to bump up your risk, is it an amount you are comfy with?

Obviously there are a lot of assumptions that go into this, so it isn't going to be exact. The point is to think this stuff through and understand it rather than just read what a guru says and blindly following it (possibly blowing up along the way) or staying too conservative and missing your target retirement date by a lot.

 

[brewer12345]

There are probably three useful attributes of bonds:

1) Low volatility and preservation of capital.

2) Reliable income.

3) Low correlation to stocks.

(1) and (2) will become important to you *after* retirement.   And the older you get, the more important it becomes because you'll have less time left to recover from downwards stock volatility.

(3) is always nice to have.   In fact, historically bonds would have both increased your returns and lowered volatility with the right mix.

I might quibble with #1 or #3, but rather than starting a pissing contest, let me add a fourth attribute of bonds: sometimes, certain bonds offer excellent risk-adjusted returns. If you evaluate individual junk bonds trading at a deep discount to par as equities with a high coupon, you can make some VERY nice loot.

 

[ats5g]

Hi Carl,

As to the taxation aspect of stocks vs. bonds, if you'll be investing in tax deffered/free accounts [like 401(k) or Roth IRA], the taxation of stocks and bonds are the same in both accounts.

As to the "stock returns more than bonds" you might ask "well, how much more?" Unfortunately, many books only look at return data in the 1900's, and only in the US. Stock and bond returns were a whole lot closer in the 1800's [see Only Two Centuries of Data].

If you look at the current expected returns of stocks and bonds, you might think that stocks aren't expected to return all that much more than bonds. For example, some think that expected returns on the total stock market are somewhere around 3-4% after inflation. This isn't that much higher than the current 2.40% after inflation yield [i.e. expected return] of longer term TIPS.

- Alec

 

[carlg1977]

First of all, thank you for all the replies everyone. I am a new investor and have not even begun a portfolio yet (should have mentioned this), all I really have is money in savings account and not much at that (I have just graduated medical school (yesterday!) and did not have much to save until now). Will have more to save in the next couple years then a lot more after that (at least 70000/year to invest).

I am basically trying to get a start here. I read one book (above mentioned) and here is how I got my numbers or target return.

First, I predicted my annual cost of living before retirement to be 120,000 per year. After retirement, I would no longer have student loans, mortgage, etc which brings my estimated cost of living down to 84,000 before capital gains taxes. I figure my personal inflation to be 2%, so I figure my required income would be 113,000 by the time I am ready to hang it up.

I would be comfortable if my income required was 5% of my nestegg. This comes out to 2,260,000 nestegg. Using a compound interest calculator, I determined that if I saved 70000 a year in addition to my current savings for 15 years and averaged an 8% return, I could make that goal. Then I would require a 7% return on my investments (5% to live and taxes, 2% for inflation). I can live with this.

I had planned the following:

60% bonds (corporate and treasury) at average return of 6.5% = 4 %
40% equities at average return 10% = 4.0 %

This would give me 8% targeted return, but again I did not know if it was ok to put that much into bonds after reading that book.

But I am really lost here. Thank you for your help everyone. Does the above way of figuring out my nestegg make sense, or is there a better way (brewer how did you get your number??). I figured salary would increase with inflation, so I did not figure inflation in my nestegg calculations. Also, after I figure out what percent to put into equities, which equities are best for me?? Is there a good book anyone can recomend to educate myself??

Thanks,
Carl

 

[AltaRed]

I had planned the following:

60% bonds (corporate and treasury) at average return of 6.5% = 4 %
40% equities at average return 10% = 4.0 %

This would give me 8% targeted return, but again I did not know if it was ok to put that much into bonds after reading that book.

Thanks,
Carl

Lots of people here smarter than me, but I think you are being a bit too rich on both bond and equity return assumptions. I would suggest you take at least one point off... 5-5.5% for bonds and 8-9 for equities. That might flip your allocation requirement to 60/40 equity/bond to reach targeted 8% return.

 

[lazyday]

Congratulations on the graduation!

Is there a good book anyone can recomend to educate myself??

I really like W. Bernstein's The Four Pillars of Investing. Though I personally wouldn't have as much of a small or value-index overweight as the book suggests, it is an excellent book overall, providing a good long term background on investing.

 

[brewer12345]

brewer how did you get your number?? I figured salary would increase with inflation, so I did not figure inflation in my nestegg calculations. Also, after I figure out what percent to put into equities, which equities are best for me?? Is there a good book anyone can recomend to educate myself??

Thanks,
Carl

I think that you need to start out with living expenses, not salary as a basis for retirement planning. There is a lot of fluff (taxes, especially) that you capture in salary that is gone or greatly redced in retirement.

What I did was take current expenses and drop out the extraneous stuff that will be gone when I retire: most income taxes, all SS and Medicare taxes, commuting costs, mortgage, student loans, and some of the extra costs caused by having not enough time (buying lunch at work, hiring repairmen for simple jobs, etc.) Then I added back a guess at the cost of health insurance, and some extra budget for leisure/travel. I took this number and stuck it in a spreadsheet and compounded it by a 4% inflation rate. The inflation rate doesn't really matter; just pick one. I then took my current assets and stuck them in the sheet, then compounded them by 4% (inflation) plus a variety of real returns. When assets X 25 equals my future/inflated expense estimate, it is FIRE time. It wasn't hard to see that to hit my target date (mid 40s), I need about 4.5% over inflation.

 

[youbet]

I think that you need to start out with living expenses, not salary as a basis for retirement planning. 

Yes!

 

[unclemick]

Hmmm

There is a counter argument - put the max you can into Vanguard Target Retirement - 2045 or similar as early as you can.

Faith in De Gaul and the Norwegian widow, time in the market, low expenses, indexing will do their thing irreguardless of your level of education.

Too much education, male hormones and the mistaken illusion that I actually knew more than I did - really slowed my early progress in investing. Luckily I generally ignored my 401k - DCA, plunka, plunka indexing which ended up funding 90% of my ER.

heh heh heh heh - Warning! - individual results may vary and this be my first cup of coffee post.

 

[cute fuzzy bunny]

Yep, read "the four pillars" (check it out at your library...get that LBYM stuff going!). Be prepared to read it in chunks over time unless you've got a PhD in finance or think like the average PhD. Lots of data building up to a conclusion.

Then take a hard look at stuff like the target retirement series unclemick suggests, or if you'd rather a static allocation, some of the lifestrategy vanguard funds. Or split your money between one of each type.

 

[carlg1977]

Thanks again for the input!

I was actually researching the target retirement funds by Vanguard over the last week or so. They seem like a good option, I thing Vanguard is a good broker for someone like me in general (I am leaning more towards indexes and bonds). Can anyone else recommend other brokers to look at??


Carl

 

[ats5g]

Hi Carl,

Vanguard isn't a broker, like E*Trade or TD Ameritrade. They are a mutual fund company. You can buy Vanguard's funds directly from them. Broker's are middlemen. I like buying directly from the fund company because there are no extra purchase fees.

- Alec