how do you pick an asset allocation?

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nuisance

Recycles dryer sheets
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This must have been covered before but I can't find it...

I'm closing in on my retirement numbers, and should be going from the accumulation phase to the withdrawal phase in the next 2 years.
How do you decide what your asset allocation should be during retirement? I'm in my 30s so I have a long time horizon. FireCalc seems to default to 75/25 stocks/bonds, and that may be appropriately aggressive. If I go to 50/50 stocks/bonds the success rate goes down.
Are there any books I should be reading that help me figure this out?
 
There are many "formulas" out there to figure your asset allocation. The classic one says you should have (100 - your age) in stocks. So if you are 35 years old, you should have 100-35=65% in stocks. As you get older, you should therefore have less and less in stocks. Then people figured out that this formula may be too conservative, so now it seems to have become (110 - your age) in stock. Then, recently, a paper suggested that you should start your retirement with little invested in stock and then increase your stock allocation throughout retirement.

So, as you can see, there is no universally accepted approach.
 
I'm finally reading "The Four Pillars of Investing" by William J. Bernstein -- thanks to a tip on this forum, I was able to purchase the Kindle version earlier this month while it was on sale at Amazon for $1.99, suchadeal!

I think this book explains asset allocation very well.

(Alas, it's now back to $16.50 at Amazon, but maybe you can find it at your local library.)
 
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FIREcalc allows you to calculate probabilities based on varying AA.

Go to INVESTIGATE tab, then investigate changing my allocation.
 
There is an http://www.early-retirement.org/forums/f28/asset-allocation-tutorial-31324.html thread.

I would suggest Rick Ferri's book "All About Asset Allocation" and getting some experience. The reality is that one can simply take the asset allocation found in a Target Retirement or Life Style fund and tweak it. Those funds generally will have
a US stock fund
an Int'l stock fund
and a Bond fund
at a bare minimum and one can see the percentages of each fund. There are plenty of "rules of thumb" that one can adjust for their own personal beliefs.

For example, this "age in bonds" thing is something that I don't believe in. There is the "110 - age" in stocks thing, too. For some people that is just right, but for the risk averse (NOT adverse!), that might be too high in stocks.

The US:international split is something asked about, too. Anywhere from 50:50 to 80:20 is probably reasonable and may not even matter.

There's more, but that's a start.
 
pb4uski said:
IIRC from 40% to 80% equities the success ratio doesn't change much. Play around with https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf or other tools to see the impact of different AA on success. So in my view at the end of the day it boils down to what allows you to sleep best at night as long as you are in that 40-80% band. I use 60/40.
Click to expand...

+1.

If you are stretching for 4% withdrawals you might be better at the higher end of the equity range.

Also notice the ending portfolio average in addition to the SWR. That's why I sacrifice a tiny bit of SWR safety and go with 100% equities (even in retirement). Not many are willing to put up with that, but I was stressed in 2009 because I couldn't find more cash to buy more equities.

A few here also go with almost no equities. Why risk anything if you don't have to?

I'd start with 40% - 80% as a baseline and deviate from that only once you have experience and feel strongly about doing it differently.

A good example would be your favorite Vanguard Target Retirement fund. It has the minimal basic funds and you can see how much of each they use for each date.
 
Classic is good enough for me. Simple allocation, simple math :D
 
I really appreciate all your replies. Looks like I'll be reading some books and browsing the web more.
It does feel a little like people use their gut to pick the exact AA, but at least I can try and use an informed gut.
 
Long term it depends on (sequence of) real returns. FIRECALC (among other resources) can show what long term probability of success has been historically. Each of us has to then confront (and live with) for ourselves how history may relate to the future - more optimistic, pessimistic, other. There simply aren't any guarantees, only probabilities.

Short term (a year or less) it depends on how much you can afford to lose, mentally and relative to your probability of success (FIRECALC among other resources). IOW what kind of potential loss allows you to sleep at night - see chart below.

Many of the online risk tolerance quizzes will help individuals determine an AA that fits their individual needs. Here's one https://personal.vanguard.com/us/FundsInvQuestionnaire
 

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I have two different AAs, one for my IRA which I won't need to tap into for at least 8 or 9 more years, and one for my taxable accounts whose monthly dividends I use to cover my expenses. For the IRA, I was 55/45 for years but changed to 50/50 last year when I turned 50 (following the "age in bonds" principle I kinda like). For the taxable accounts, I am far more bond-weighted because I need the income. I am in the 37/63 range now although I will adjust it to meet my income needs, not any age or arbitrarily chosen AA.
 
nuisance said:
I really appreciate all your replies. Looks like I'll be reading some books and browsing the web more.
It does feel a little like people use their gut to pick the exact AA, but at least I can try and use an informed gut.
Click to expand...

There are tons of starter AA possibilities because for the most part, staying within the reasonable bounds, there are minor performance differences between them. No need to over think it.

One of the main benefits of using an AA is that it gives you the rebalancing targets and keeps you from trying to time the market. Those two things plus just being invested in the market get you most of the benefits.
 
Hopefully for the benefit of people who stumble on this thread in the future, here's what I ended up doing:

I read "The Four Pillars of Investing" by Bernstein. It seemed not very clear where asset allocations come from, but did recommend "Asset Allocation: Balancing Financial Risk" by Gibson, which I then read. It contains a lot of good background (and is the first thing I've read that talks about the efficient frontier). I got a trial version of Kwanti's Portfolio Analytics software, which was great for getting a feel for what the efficient frontier means in practice. (Big takeaway: It's pretty sensitive to the input assumptions, and those numbers feel like a guessing game.) Finally I read "All About Asset Allocation" by Ferri, which has some nice very specific suggestions.

The bottom line is that I very much agree with Animorph's post above:
There are tons of starter AA possibilities because for the most part, staying within the reasonable bounds, there are minor performance differences between them. No need to over think it.
Click to expand...

Here's the asset allocation I ended up deciding on:
30% us stocks
10% us small value
5% european stocks
5% pacific rim stocks
5% emerging markets stocks
5% international small
10% us reits
30% us bonds

Thanks again for all your suggestions.
 
nuisance said:
Hopefully for the benefit of people who stumble on this thread in the future, here's what I ended up doing:

I read "The Four Pillars of Investing" by Bernstein. It seemed not very clear where asset allocations come from, but did recommend "Asset Allocation: Balancing Financial Risk" by Gibson, which I then read. It contains a lot of good background (and is the first thing I've read that talks about the efficient frontier). I got a trial version of Kwanti's Portfolio Analytics software, which was great for getting a feel for what the efficient frontier means in practice. (Big takeaway: It's pretty sensitive to the input assumptions, and those numbers feel like a guessing game.) Finally I read "All About Asset Allocation" by Ferri, which has some nice very specific suggestions.

The bottom line is that I very much agree with Animorph's post above:


Here's the asset allocation I ended up deciding on:
30% us stocks
10% us small value
5% european stocks
5% pacific rim stocks
5% emerging markets stocks
5% international small
10% us reits
30% us bonds

Thanks again for all your suggestions.
Click to expand...

When you get tired of managing the Europe, emerging markets, pacific rim and international small allocations, you can just roll it into international large and international small.
 
Anytime I see an asset allocation with international split up into those fine bits, I know someone has read an old edition of Bernstein or Ferri. Times have changed; new international index funds are now available; tax laws are different; these authors are recommending something different nowadays: simplification.

Here's another discussion on asset allocation that might be worthwhile reading:
http://www.bogleheads.org/forum/viewtopic.php?t=38374
 
I saw this a couple of times, but can't find my original source. That is, for a usual <4% withdrawal rate, the effect on asset allocation isn't huge except at the extremes (all or mostly bonds / all or mostly stock). Best I could find was this paper by Wade Pfau. Look at Figure 2 for the bottom two lines which are 3% and 4% withdrawal rates. Not much difference. The difference is larger for higher withdrawl rates, but then again, the percentage of years with no remaining wealth is large no matter what you do.

http://mpra.ub.uni-muenchen.de/34536/1/MPRA_paper_34536.pdf
 
We have 67% in equities using a simple three way lazy portfolio.

The approximate equality of the pie slices is very pleasing to the eyes.
 
tuixiu said:
We have 67% in equities using a simple three way lazy portfolio.

The approximate equality of the pie slices is very pleasing to the eyes.
Click to expand...

I like the way you think. Esthetics are important.
 
I think it's important to look at a variety of criteria when picking an AA. For example, some things I like to look at are

- FIRECALC style success rate (e.g. probability portfolio does not go to zero)
- final portfolio value at various quantiles (e.g. look at all of the runs in FIRECALC and see where the cutoffs are at the 25th, 50th, and 75th percentiles)
- expected return
- volatility
- maximum drawdown
- cost of investing in that AA (weighted average expense ratio)
- simplicity (total number of funds)

If you have well defined goals for investing, that will help you pick which criteria are most important to you. For example, if you want to maximize your legacy, then you should lean to portfolios with the highest expected return. If you are terrified by market crashes, then put more weight on volatility and max drawdown. If you want a portfolio that an uninterested spouse can manage then emphasize simplicity.
 
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nuisance said:
Here's the asset allocation I ended up deciding on:
30% us stocks
10% us small value
5% european stocks
5% pacific rim stocks
5% emerging markets stocks
5% international small
10% us reits
30% us bonds
Click to expand...

70/30 seems very aggressive to me for somebody w/ a 50+ year horizon, especially at the start of retirement, when a bad sequence of returns could wreak havoc.
 
Hopefully I am not raining on your parade, but here is my .02.

You are in your 30s. You need stable income for a long time, before you start drawing your assets. Your assets should be invested in something that provides that kind of income while you let your investment grow. The 4% rule is for people nearing retirement at 55+, not sub-40. You should be thinking 2-3% WR, or less. Even a $30K lifestyle would need at least $1M. A $30K lifestyle is not much after a mortgage or rent payment.

You will not have much in terms of Social Security, ever, as you will not have 35 years in. You likely do not have a pension. Your sole source of income, according to your posts, will be your investments. Therefore, you will need solid income producing investments. Stocks, rental income, CDs, bonds, etc.

Retiring in your 30s, with any kind of decent lifestyle, is extremely difficult without an inheritance, or large influx of cash. Some business owners can do it, and some employees of private firms that go public can do it. For the average Joe, in decent health, it is near impossible. The system is not geared for it, nor does it allow enough time for compounding growth of your assets. If you have another wage earner with you, it is more likely.

Having said that, your risks are inflation and out living your assets. Inflation is not an issue for now. Running out of your assets is your major concern. You may think that you can go back to your career if things do not work out. After a few years, you will be 50+, and have out of date skills. If you are over 50, it is difficult to get work; especially of you are already out of work.

Healthcare expenses will continue to increase as you get older, unless it becomes ‘free’.

Think hard about your decision, and do not adjust the calculators so that you have a ‘perfect path’. Go with general default parameters. Make sure you are 100%, and then some.

The market has been very good the past few years, and likely will be good for a few more. But just as it comes, it can go. Be sure to account for future market risk.
 
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