Logic behind Stock/Bond allocation

[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?

 

[Blue Collar Guy]

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?

Other than the mostly obscene wealthly in here, I dont know many that have 6 months in living expenses saved. let alone 10 years.

 

[Rustic23]

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.

 

[Red Badger]

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)

 

[LOL!]

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.

 

[ace8]

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.

 

[GravitySucks]

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.

 

[golfnut]

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.

 

[Corporateburnout]

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.

+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.

 

[Lawrencewendall]

Read an article about the 100-age being too conservative with life expectancy increasing. The article recommended 110-age.

 

[FREE866]

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.

 

[OldShooter]

... 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?

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.

 

[gayl]

Any approaches that make more sense than the Rule of 100?

I also thought it was 110 as we live longer active lives now? But I think the:

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.

Hadn't heard that but it makes more sense

 

[LOL!]

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.

 

[Curmudgeon]

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?

 

[RunningBum]

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?

Hmmm. Judging from http://www.early-retirement.org/forums/f28/age-based-aa-poll-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.

 

[REWahoo]

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%? ?

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."

 

[RunningBum]

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.

 

[LOL!]

..., which one of them is 'wealthier'?

I would answer, "Who cares?"

Because the answer will depend upon who is doing the asking.

 

[pj.mask]

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.

 

[FREE866]

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?

The idea that bonds are a "non-volatile" investment is a myth. Just like stocks , bonds can be very volatile, near term of course. 2009 10 year treasuries were down almost 10%! Stocks are risker short term , but thats because they much much better long term returns. It's all about your time horizon...if you have a long one stocks are clearly the better investment

 

[OldShooter]

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. ...

I'm not one that recommended that and I don't see the arithmetic, but I think I can answer your question: It depends on your emotional risk tolerance and you may not know that until after the fact. IOW life is like school except that first you get the test and then you get the lesson.

I've been through a few of these I know that I will react as you hypothesize that you will react, but you haven't said what your experience in big downturns has been. If you have the experience then great. If not, I'd suggest that you shouldn't be so confident in your prediction. Ref Your Money & Your Brain by Jason Zweig.

Those pointing out that a recovery is not guaranteed are right of course. But we live and die by inductive logic; using the past to predict the future. We have no choice, so we just have to keep remembering Taleb's turkey and keep looking over our shoulder. (Turkey Problem - Nassim Taleb)

 

[Curmudgeon]

It's all about your time horizon...if you have a long one stocks are clearly the better investment

Unless you're planning on dying soon, shouldn't you always have a long term perspective? I'm 55, and may live to be 95, or 125? So clearly I have a long time to go. But I'm also retired, and withdrawing NOW, and don't want to have to draw down an asset that has fallen 50%. So (not surprisingly) I need to look at both the short term and long term. Rule of 100 says I should have 65/45 split... Some would say more in bonds, because I'm already retired. Others would say more in equities, since I'm potentially in this for another 40 years or so.

 

[Curmudgeon]

I've been through a few of these I know that I will react as you hypothesize that you will react, but you haven't said what your experience in big downturns has been. If you have the experience then great. If not, I'd suggest that you shouldn't be so confident in your prediction.

I was ~100% in equities during the tech bubble burst and during the housing crash. I didn't flinch either time, because I've always been a long-term investor and didn't see retirement on the near horizon. I saw the drop in value as just a glitch, which didn't affect my investing strategy much at all. In fact, I was sitting on a lot of cash in 2009 and saw it as a great buying opportunity.

But it's different now; I'm retired and drawing down accounts, and a bad sequence of returns early on could put a serious damper on my plans.

 

[FREE866]

Unless you're planning on dying soon, shouldn't you always have a long term perspective? I'm 55, and may live to be 95, or 125? So clearly I have a long time to go. But I'm also retired, and withdrawing NOW, and don't want to have to draw down an asset that has fallen 50%. So (not surprisingly) I need to look at both the short term and long term. Rule of 100 says I should have 65/45 split... Some would say more in bonds, because I'm already retired. Others would say more in equities, since I'm potentially in this for another 40 years or so.

Well, if you NEEDED the money for something in maybe 5 years then that portion of money wouldn't be considered "long term"

I simply don't buy into this "rule" of any specific asset allocation...but yes if you're looking at a 40 year time horizon stocks are clearly the better investment...and by a landslide....even if you look at just 10 year time periods stocks have outperformed bonds 82% of the time, 15 year time periods 91% of the time...odds are woefully in your favor with stocks....source: global financial data, inc

also another caveat of bonds is inflation....people don't mention that but it can hurt as well...