A Word About Asset Allocation

Retired At 47's comment to my recent post about being retired in this scary market, reminded me of an important issue I haven't discussed here yet:

"The only thing I'm doing now is re-evaluating my asset allocation to consider what percentages would have let me sleep better. Slowly, I may re-balance if the market ever stabilizes."

A couple of weeks ago, Super Saver mentioned an interesting (and kind of depressing) point:

"Unfortunately, I invested some cash in my retirement account right near the market peak in 2007. Back then I thought, the market is always up in 10 years. Of course, 2008 marked the end of the first 10 year period that wasn't true since the depression :-("

(Actually, it has happened again since the depression, from 1965 to 1975), but it's true.  If you had invested $1,000 in an S&P 500 Index Fund at the end of 1998, you would now have roughly the same $1,000 today after holding it for 10 years.  (This is a bit of an oversimplification, you would really have a bit more from dividends, but you get how sad that is.)

This discussion got me wondering what effect the conventional asset allocation wisdom would have had in this 10-year example.  If, instead of just investing $1,000 into the market and letting it sit for 10 years, you had allocated that $1,000 investment, 60% to stocks (S&P 500 index), and 40% bonds paying 5%, and rebalanced it each year, your results would not have been nearly so depressing.  (I don't really know whether 5% on bonds was really achievable during that 10-year period, but I'm just picking a number to illustrate the point.)  

I assumed the investment back at the end of 1998 when the market was roughly where it was last week, and then rebalanced that $1,000 portfolio each year to keep it in line with my 60/40 allocation. Instead of having a zero % return, that portfolio would be 25% higher than it was back in 1998. Granted, not a stellar performance, but much better than zero!  (Again I'm ignoring dividends and taxes to make this simple.)

What happens when you commit to an asset allocation and then rebalance each year, is you are forced to buy low and sell high.  As the stock market goes up, you must sell some stocks (high) and move the money to bonds to get back to that 60/40 mix.  As the stock market goes down, you are forced to buy stocks (low) by moving money from bonds to get your stock allocation back up to 60%.  

Not only does this keep your portfolio from getting out of whack, it takes your emotion out of it, which can be your own worst enemy in times like these!

Comments

[Kevin]

This is a great explanation of a very counter-intuitive property: that a stock/bond allocation (say 90/10) actually has a higher expected return than a pure stock allocation. What you say about forced buying and selling is apt. An alternative way of seeing it is that the bonds make sure that always have money ready to buy stocks during low points (like right now). If you're interested you can find a mathematical explanation for all this in Gibson's "Asset Allocation".

[Retired Syd]

Kevin: Thanks for the book recommendation--I'm going to go get that one at the library. I'm reading "Irrational Exuberance" right now, which is giving me calm perspective into the markets right now. I'll take any help I can get in this regard right now!

[RetiredAt47]

Thanks so much for the mention! Rebalancing to maintain asset allocation is a wonderful thing. I wish I had done it a year ago, when I first decided I needed to change up my percentages a bit.

I'd love to hear your thoughts on "Irrational Exuberance" - I've not read that one yet and am always looking for a good read. I just learned about another book I've not read yet - "The Intelligent Asset Allocator". I'm trying to get it from the library.

[Kevin]

I almost recommended "The Intelligent Asset Allocator" over "Asset Allocation." They cover the same ground, and both are excellent. A.A. is longer and more technical, while T.I.A.A. is a more entertaining read. I think both are worth your time if you're interested in this stuff.

[Bob Richards]

your comments about tactical asset allocation are right on for a sound mutual fund portfolio. Here are the guidelines to make it work
1. decide on your asset classes in advance (you may want more than just bond or S&P)
2. rebalance at regular intervals (e.g. every year) and never touch your assets in between
3. add to your worst performer and harvest gains foerm your best performer. 99% of investors wont be able to do this unfortunately as their emotions will get in the way

[Retired Syd]

Bob: I agree 100%. I just chose S&P 500 and bonds to illustrate the point. My portfolio includes allocations to U.S. Stocks (large- mid- and small-cap) as well as foreign markets (both developed and emerging), and a small portion to REITS and commodoties, and of course bonds and cash. I use mostly index funds and ETF's and am rebalancing quarterly. Just did my 9/30 reallocation today, as hard as it was too look at!

[Richard W.]

I'm so glad I googled this topic. Interesting to see what various folks do with this allocation thing. I was reading today, a comment from Jack Bogle, founder of the giant Vanguard Group, that in order to insulate themselves from the crazy market today, they do two things. "First, allocate your assets intelligently. If you're in over your head, on margin, you have to get some of your money out of the stock market."
"Second, have your bond position equal to your age. If you're 70 years old and have 70% bonds in this market, you're not bad off. If you're in your 20s and 30s and 70% in stocks, you're going to be investing for decades." - This is from the marketwatch website today (10-21-08)

Like most investors today, I'm going through this allocation business trying to figure out what's best for me. I'm 65, so Mr. Bogle's comments really got my attention.

[Retired Syd]

@Richard W: It is a very interesting subject. I intend to read both books that were recommended by commenters above.

I think that rule of thumb you mention is a good place to start, and then go less or more depending on your own circumstances and risk tolerance--I'll be interested to see what these books have to say about that approach.

Thanks for stopping by!

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