How to Know You've Found the Right Asset Allocation

(Graph Details:  S&P 500 since the inception of Sydney's retirement, March 1, 2008)

As some of you that have been with me since the beginning of my retirement know, I retired in March of 2008, right as the market was melting down and we were entering the worst recession in my lifetime.   I wrote several posts about my declining nest egg over that first year of my retirement.  But I never panicked.  I just hung on and kept rebalancing my portfolio to it’s 70/30 stock to fixed income ratio over the next five years.

And it took almost that long to get back to where I started when I retired.  It was a long and scary road, and I learned the hard way that my 70/30 allocation toward stocks was actually, in retrospect, too aggressive for my taste.  Going through the worst recession of your lifetime after you no longer have a job is a really great exercise for pinpointing your exact tolerance for risk.

At the beginning of 2013, I had the (incorrect) feeling that the market had probably run its course for the time being.  And since I had finally gotten back to where I started from, I decided it would be a good time to shift my portfolio to a less aggressive 60/40 allocation toward stocks.

Now you can look back over 2013, when the S&P 500 Index raked in almost 30% gain, and say, “Sydney, you made the exact wrong decision!”

But I made the exact right decision for my own tolerance for risk.  And the reason I know it was the exact right decision is because, even though I could have made more money last year if I kept my previous allocation, I feel a WHOLE lot better about missing out on that extra return than I felt in 2008, 2009, 2010, and 2011. 

The bottom line is, when you pick an allocation that you are comfortable with, and then keep rebalancing your assets to remain with that allocation, you will never do as well as the market does in a spectacular year.  You will also not lose as much as the market loses in a spectacularly awful year.  That’s the whole point.  Not to beat the market, but to keep yourself from doing something stupid, and to make returns that are good enough to meet your goals.

 

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Comments

[deegee]

Syd, I also did a slight change to my AA (in my IRA) at the start of 2013, going from 55/45 in favor of stocks to 50/50. I had to rebalance several times in 2013 to keep it near 50/50. But this also meant that I locked in lots of gains even though those gains could have been bigger. I won't lose any sleep over that.

Also, this AA applies only to my IRA, not my taxable accounts. In the taxable accounts, I have other considerations (and a different AA because I rely on it for income to cover my expenses in my early retirement) so I very rarely rebalance there (but it is likely I will make some moves in 2014). All of the IRA moves are without any tax consequences so it is a lot simpler to monitor and adjust.

[Bob Lowry]

Your key point resonates with me. I have a rather low risk tolerance, so over the years I have missed some of the key stock market surges. At the same time I have not lost as much as many others.

After losing about 25% of my investment's worth (on paper) during the 2008-9 meltdown, things recovered completely by 2012 and last year showed solid growth above where I used to be.

I trust my advisor to keep me on track and I am comfortable with my allocations and projections. I may be financially less well off than I might have been, but I sleep and live well.

[Tamara]

We have the same split comfort level that you now do - 60/40. In fact, when we met with our financial team last month, and they showed us results that indicated we were now at 80/20 with them due to 2013's stellar results, I told Mike I was very uncomfortable with that mix, even for a short duration, and that we needed to rebalance pronto.

The beauty of having planned properly for our retirement is we don't need to take crazy risks to make up for lost time. And, as you've pointed out here as being the ideal situation - we retired at the beginning of an upsurge in the market. No credit to us by any means, but nice to have those gains in our pocket nonetheless, as a buffer against future chaos.

[Tom Sightings]

Unfortunately, you have to pick your asset allocation ahead of time, and you never know if it was right until later on. That's the trouble I always have with financial markets ... and why I (almost) always carry too much cash.

But seriously, I do take a slightly different approach. I keep five years of my extra expenses (expenses not covered by current income) in cash. Then I feel that I can be a little more aggressive with my investments (and not get stuck in bonds, which I hate). I suppose in the end it's not a whole lot different from what you're doing.

[Retired Syd]

Tom: Actually, that's pretty similar. My fixed income side includes several years of cash cushion and is also weighted heavily toward short-term bond funds (for the time being). Neither of which earns much, if any return, but are very stable. So I know in a downturn, I've got plenty of liquidity to get me through to the other side.

Tamara: That would make me crazy to get that far from my target. I rebalance back to my target when it even gets a couple of percentage points off. Time to harvest those gains and get back into balance! Nice that your timing was so much better than mine was, it is nice to get that boost in the beginning, isn't it?

Bob: Exactly, it sounds like you learned the easy way what your tolerance for risk was--without having more than you were comfortable with in stocks during the worst of it.

deegee: I also keep most of my stock funds in retirement accounts, although my target allocation is for everything all added together. But my taxable accounts are more weighted toward liquid investments and cash to get me through to at least 59 1/2 when I can get into my retirement accounts. (Which means my retirement accounts are more than 60% stocks actually).

[dgpcolorado]

Syd, You are far more meticulous in managing your portfolio than I am. Mine is a bit too complex to balance in the traditional way. But as I sell off assets to generate money to live on, I do it by percentages so the funds that did the best take a larger hit. Crude, but it works ok for me. I just can't bring myself to totally revamp my portfolio so that it would be easy to do a proper re-balancing the way you do.

Back when I was still working my retirement nest egg was pretty much all in stocks. I was young enough to make it up if I hit a bear market, so why not? But once I retired I sold a big chunk of those stocks and bought TIPS and, a bit later, Series I Savings Bonds. This was in the days when they were new and few knew what they were, so yields were terrific (now that they have been "discovered" I don't ever expect to see those high yields again). That damped down the risk of my portfolio considerably. Now I just try to protect those inflation-indexed bond positions because the remaining ones have 15+ years to run and you can't get anything remotely like those yields anymore. But they are there if I need the money in an emergency.

Like you, I also learned long ago to not panic in bear stock markets; I've been through too many of them, including two since I retired. I've long been puzzled by those who panic sell at the bottom and then start buying again AFTER the huge rebound rally. I understand that it has to do with risk tolerance, but it still seems perverse to me.

But unlike you, and pretty much everyone who plans a retirement living, I am thrifty enough to live on Social Security alone, especially if I wait until age 70 to collect it. So my plan was to spend down my nest egg to delay collecting Social Security. If it happens that I have something left by age 70 — as now appears certain — so much the better. It is a wildly unorthodox approach to retirement planning.

One last random thought. I've discussed this with you privately but I will mention to the readers of your blog that Social Security (and other pension payments for the few who are fortunate enough to have them) is an annuity that is essentially a very large fixed-income investment. So, that 60/40 portfolio, or whatever mix one chooses, is actually a whole lot less risky than one thinks, if SS is factored in. As an accountant I'm sure you could calculate the net present value of a Social Security annuity. Perhaps there is a website that already does that. Knowing just how large the SS "asset" is might help some rethink their risk tolerance when it comes to the rest of their portfolio.

[Retired Syd]

dgp: That's a great point, the greater percentage of your income needs that Social Security or a pension meets, the more risk you can afford to assume on your investment portfolio.

Your allocation approach appears to get to the same place (harvesting some of the winnings each year) even without being as bean-counterish as I am.

Great article in the NY Times about that issue of people buying high and selling low: http://www.nytimes.com/2014/01/13/your-money/stocks-and-bonds/why-we-buy-in-a-marked-up-market.html?nl=your-money&emc=edit_my_20140113

[dgpcolorado]

Thanks for that link Syd: that's it exactly! I guess I'm glad that I'm immune to the phenomenon.

I've had severe financial reverses over the years, mostly in poorly thought out investment schemes. But I learned from my mistakes and try not to make the same mistake twice. And, eventually, my ability to scrimp and save and invest simply overwhelmed my ability to lose money on poor speculations. And I ended up with a boring portfolio of stock mutual funds — mostly index funds — and my TIPS, Savings Bonds, and some munis from a district that I, personally, created for my community. (I HATE bond funds because they never mature, they just fluctuate in value in perpetuity.) I also have a few individual stocks that are toys and barely a rounding error in my portfolio.

When it comes to investing, boring is better IME.

[Tamara]

Syd, my husband will be horrified if I don't clarify that only the portion of our portfolio managed by this firm got out of whack. As a reflection of our overall portfolio balance, it was much less significant. Still, it was no longer in my comfort zone, which is what my response clearly reflected.

[Angela]

I have a unique problem, in that I retired at age 43 and am living off the sale of my business, which I owner-financed for 20 years. I'm able to let my savings grow without touching it, which is a large part of my strategy. Call me crazy... My asset allocation is 90/10. I was one of those people throwing as much money in index funds as I could when they were 'on sale.' But I am wondering at what point I need to go to that 60/40 allocation. I still have 17 years left on my financed loan, assuming the new owner doesn't pay it off sooner. (So far, he shows no sign of doing that.) I have always been a buy-and-hold investor. And that 30% gain is clouding my judgement even more. But I have the words 'popped bubble' floating around in my head on occasion now. Hopefully I will have the right instincts when it's time to get more conservative. Thanks for making me rethink this strategy yet again...

[Retired Syd]

Tamara: Much better!

Angela: Well this is much above my pay grade, but I will tell you what I would probably do. I probably would't do it all at once--that's like timing the market, trying to decide the best time to get more conservative. I would pick a time frame to shift over, and then do it somewhat ratably over the years, like dollar cost averaging. Since you have the 17 years of a fixed income-type situation, maybe you do something like shift 1% per year so that in 10 years you're at 80/20, then shift to 1.5% each year for the next 10 so you're at 65/35 when you're 63 and all done with that buyout. Then you can see how you feel about that allocation and decide whether to keep shifting, etc. Something like that?

[Jacq]

I realized this last couple of years that I really hate selling stocks (unless it's a good gain and they're coming close to 52W highs) and drawing down my balance. For some reason, having dividends coming in like a magic money tree makes me feel so warm and fuzzy that I can't see going any other way - even if I could make more by not investing in moderately high yielding dividend stocks. I set all the dividends in my taxable account to auto-deposit into my chequing account and it just feels like magic to me that money shows up twice a month like clockwork with absolutely no effort on my part. It makes me want to squeeee every time I see a deposit to be honest. :-)

OTOH, it also makes me want to see the deposit get bigger or to see how big I can make it grow. LOL

[Angela]

BRILLIANT advice, Sydney! Thank you so much!

[John Of Late]

I am sure that rebalancing is great advice, but when I look at the bond funds in our portfolio, they all seem to be losing ground over the last 12 months. Given this lackluster performance, it is difficult for me to feel smart about moving money out of stocks or equity funds. With several blended (stocks & bonds) funds in our portfolio, it is hard to calculate just what our current asset allocation is, but I suspect that we are more heavily invested in stocks than your 60/40 split. I will look to our financial adviser for suggestions about fixed income investments, but I would welcome any suggestions you my have about the type of fixed income investments that you look for.

[Retired Syd]

John: Well predictions are so hard, especially when they are about the future (who said that?) But I think experts are in agreement that interest rates are likely to head up. As they do, bonds and bond funds with longer durations get hit the hardest, so in rising rate environment you're better off with shorter terms. This rise started in 2013 which is what you are seeing.

But think about your question. If you were asking the same question reversed back in 2009 when stocks hit rock bottom--"given this lackluster performance, it is difficult for me to feel smart about moving money into stocks or equity funds."

Over the long term asset classes go in different directions and rebalancing forces you to sell winning classes and buy losing classes as those shift over the years. It's always hard to sell the winners and buy the losers, we want to do the opposite (see NYT link in my comment above).

P.S. For the record, I don't think it's bad to be more heavily invested in stocks than 60/40--that part has to be tailored to your own individual risk tolerance. But once you figure out your desired balance, I do think it's best to stick with it by periodic rebalancing.

[deegee]

Jacq, I do the same thing with my monthly dividends, at least most of them. I have been living off them for the last 5 years. I have one bond fund which generates nearly $2,000 per month which covers my monthly expenses. The other monthly dividends are smaller so they get reinvested. I, too, love it when POOF the money appears in my account without having to do anything for it LOL!

It is also nice to see these funds generate occasional cap gain distributions which also get reinvested, enabling me to buy more shares which, in turn, generate a little more diivdends each month. I have a stock fund which generates quarterly dividends (reinvested) so every 3 months I get an extra boost in shares.

All without having to do anything, especially commute on the trains anywhere, which is the best part!

[Jacq]

deegee, it's not the commute that gets to me - it's the sometimes incredibly boring nature of the job. Although the commute has become significantly worse the last few years - an hour plus every day times two. But I read or talk with friends, so not too bad and sometimes enjoyable since I ride much of the time with a fellow FIRE oriented person and we talk escape strategies. Yay on the dividends for you though!

Syd - I read a good article recently on hedged dividend investing that I can see someone like me, who doesn't see an upside in bonds following:
http://www.marketwatch.com/story/hedged-dividend-investing-for-retirement-2014-01-25