I recently had the pleasure of attending a Q&A session with a few Vanguard executives and fund managers. One of the questions asked was why the Vanguard Target Retirement funds have such a stock-heavy allocation for young investors (90% stocks, 10% bonds for investors more than 25 years from retirement).

John Ameriks (the head of Vanguard’s Investment Counseling & Research group) replied that the majority of a young investor’s total economic wealth is in the form of “human capital” (that is, future earnings from work), so Vanguard uses a high-risk portfolio to balance out the large, low-risk human capital asset.

Is Human Capital Low-Risk?

My problem with that line of thinking is that — if what I’ve seen from my friends, family, and classmates over the last several years is anything like normal — the typical 20-something’s work income is anything but low-risk. More often, it’s a relatively unpredictable rotation between periods of employment, unemployment, and underemployment.

If I were to suggest an allocation to balance out the human capital of a typical member of Generation Y, I’d suggest something conservative rather than aggressive.

Should Young Investors Have Conservative Allocations?

Despite my qualms above, I still think stock-heavy allocations make sense for many young investors. While the last decade has been lackluster for stock returns, I’m still convinced that the longer you hold stocks, the more likely they are to have positive returns, and the more likely they are to outperform lower-risk investments.

For a young investor trying to determine whether an aggressive allocation is appropriate, I think the two most important questions are:

1. How certain are you that the money in question will not need to be spent within the next 20 years or so?
2. What’s the most that your portfolio could decline before you started to get nervous?

If you know that the money will not be needed before retirement and you are confident that you would be comfortable with declines in the range of 40-50%, then I think a stock-heavy allocation is quite reasonable.

On the other hand, if you’re not comfortable with large declines, a stock-heavy allocation is a poor idea. One instance of panic-selling during a market low can be more than enough to offset any extra gains that you might get from allocating more to stocks.

Similarly, for young people with uncertain job prospects and little certainty that their investable money will ultimately be retirement money, a more conservative allocation makes a lot of sense. For money that’s a cross between retirement savings and an emergency fund, it makes sense to use an allocation that’s somewhere between the allocation you’d use for either one.

In other words, there’s more to asset allocation than just age. Conventional wisdom may say that most investors your age should be loading up on stocks. But that doesn’t necessarily mean that you should.

Dan writes in to ask,

“I have a portfolio with a large brokerage firm. It’s primarily invested in individual stocks, with a handful of mutual funds thrown in as well. The individual stocks have performed very poorly. The mutual funds have performed better, but (I’m now learning) they have very high expenses and they’ve underperformed the market by a wide margin.

I know that I want to move my money. I’ve been reading on your blog and in several books about using index funds to invest with low costs. But if I sell everything now, after a period of very poor performance, wouldn’t I be selling low? Isn’t that the opposite of prudent investing? Wouldn’t it make sense to wait a few months to see if the stocks come back?”

I get lots of emails like this. People realize that their portfolio is a mess and that it has performed very poorly. Sometimes they even know exactly what they’d like to switch their portfolio to, but they are still reluctant to make the switch because they don’t want to “sell low.” They don’t want to “lock in” their losses.

Look Forward, Not Backward

The problem with this line of thinking is that, tax considerations aside, it’s irrelevant how your portfolio has performed in the past. The only thing that matters is how to make it perform as well as possible in the future.

It can be helpful to look at the situation this way: If your entire portfolio was in cash right now, how would you invest it?

However you answer that question is (in most cases) how you should invest your portfolio.

In other words, either:

1. You have a good reason to think that your current holdings will outperform a lower-cost, more diversified portfolio in the future, or
2. You do not.

If you have such a reason, why switch your portfolio at all? And if you don’t have such a reason, why wait to make the switch?

And remember, the mere fact that a stock has declined in the recent past (or that a mutual fund has had sub-par performance) is not a reason to think it’s going to have better-than-average performance in the future.

Possible Exceptions

There’s a potential exception for investors who are currently invested in funds that have contingent deferred sales charges. These charges are commissions on certain share classes of certain mutual funds that are charged if you sell the fund within the first several years. Because they decrease (and eventually disappear) over time, it sometimes makes sense to wait before selling the fund.

Alternatively, if the investments in question are in a taxable account, it can sometimes make sense to stick with your current holdings in order to avoid paying taxes on large capital gains,  even if those holdings are not something you’d buy if you were just getting started today. However, if your current holdings have unrealized capital losses, “selling low” would provide some tax savings — giving you all the more reason to make the switch now.

When interest rates rise, bond prices fall. Because today’s interest rates are extremely low, some investors worry that interest rates could rise sharply in the future, thereby causing bond prices to fall sharply.

One method of protecting yourself from such an event is to shift your bond allocation from longer-term bonds to shorter-term bonds.

The reason this would offer you some protection is that when market interest rates rise, a bond’s price (or bond fund’s price) will fall by an amount approximately equal to its duration, multiplied by the increase in interest rates. For example, if a bond fund has an average duration of 3 years, and interest rates rise by 1%, the fund’s price will fall by approximately 3%.

Therefore, if you shift from one bond fund to a shorter-term bond fund of similar credit quality, the amount of protection you’d gain is approximately equal to the difference in the funds’ respective durations, multiplied by the increase in interest rates that eventually occurs.

For example, if all interest rates rose by 2% tomorrow:

• Vanguard Total Bond Market Index Fund (average duration = 5.2 years) would fall by approximately 10.4% (5.2 x 2%), while
• Vanguard Short-Term Bond Index Fund (average duration = 2.6 years) would only fall by approximately 5.2% (2.6 x 2%).

On the other hand, because shorter-term bonds have lower yields than longer-term bonds, you’ll be earning less interest in the interim. To continue our example, according to Vanguard’s site, the difference in yield for the two funds above is currently 1.67%. So if rates go nowhere, the cost of shifting to the shorter-term fund would be approximately 1.67% per year in forgone interest.

My Experiment with Shifting Maturities

When I first created my index fund portfolio, it looked like this:

• 40% Vanguard Total Stock Market Index Fund,
• 40% Vanguard FTSE All-World Ex-US Index Fund,*
• 10% Vanguard REIT Index Fund, and
• 10% Vanguard Intermediate-Term Treasury Fund.

In November 2010 though — while making an IRA contribution and rebalancing our portfolio — I moved from the Intermediate-Term Treasury fund to Vanguard’s Short-Term Treasury Fund in order to pursue the strategy described above. Interest rates were very low, and it seemed clear to me that they’d be increasing at some point.

But with the help of some members of the Bogleheads forum, I eventually realized my plan was poorly conceived:

• I intended to move back to the Intermediate-Term fund at some point, but I had no specific plan for when to do so. I was just making it up as I went along;
• I had absolutely no idea how long it would take before interest rates would rise; and
• As somebody who makes a conscious effort to ignore economic news (hence the name of this blog), it’s likely that I wouldn’t even notice when interest rates eventually did reach a more historically-normal level.

After mulling it over for a couple months, I finally moved back to the Intermediate-Term Treasury Fund. This time I plan to stay put.

Why am I telling you this?

Admittedly, in my particular case, this mistake was rather trivial. It was only 10% of my portfolio, and it was a shift from one type of bond to a mostly-similar, lower-risk type of bond.

Still, it was a poorly reasoned decision, and hopefully we can draw a lesson from it.

That lesson: It’s easy to make observations about current market conditions (e.g., “by historical standards, interest rates are unusually high/low” or “by historical standards, stocks are expensive/cheap”). But interest rates can stay low (or high) and stocks can stay cheap (or expensive) for a very long time. And unless we can predict when things will change, it’s difficult to draw much benefit from such observations.

*This has since been replaced with Vanguard Total International Stock Index Fund. At the time I created my portfolio, the Total International fund had a higher expense ratio, but that’s no longer the case.

Mainstream investing advice is packed with rules of thumb. Some are helpful, albeit imperfect: “Don’t withdraw more than 4% of your portfolio per year at the beginning of retirement.” Some are, to put it plainly, garbage: “In retirement you’ll need to replace 80% of your pre-retirement income.”

One rule of thumb that I do find helpful is related to asset allocation:

Set your stock allocation equal to your maximum tolerable loss, times two.

Or, said differently, assume that your stocks can lose 50% of their value at any time.

Asset Allocation for Accumulation Stage

The tricky part of implementing this rule of thumb is determining what, exactly, your maximum tolerable loss is. For investors a long way from retirement, it’s a purely emotional question: How much loss can you stomach without losing sleep or feeling terribly stressed?

Naturally, this isn’t something you can calculate, per se. All you can do is consider how you’ve responded to portfolio declines in the past and try to imagine how you’d deal with declines of a certain size in the future.

When answering this question, be sure to try to answer it as both a percentage and as a dollar value. Otherwise you may come to inaccurate conclusions. For example, you may remember that at age 30 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 6-times the size that it was at age 30, a 40% loss could be an entirely different experience.

Asset Allocation In and Near Retirement

For those in (or near) retirement, maximum tolerable loss includes the same emotional aspect as well as an obvious financial aspect: Declines in value can be a real, tangible problem when you’re selling off your portfolio bit by bit to pay the bills.

Takeaway: The closer you’re cutting it with regard to using an unsafely-high withdrawal rate, the more of your portfolio you should think about putting into low-risk things like TIPS and fixed lifetime annuities.

Important Caveats

As with any rule of thumb, this one has some important caveats.

First, I’d encourage highly risk tolerant investors to put an upper limit on their equity allocation. Even if the formula says 100% stocks would be appropriate, I think it’s usually wise to go no higher than 90%. The additional expected return from putting that last 10% in stocks isn’t terribly significant, while the reduction in volatility that comes from having at least a little bit in bonds is significant.

Second, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

Third, this rule of thumb only deals with your ability to take risk. It says nothing about the other aspect of risk tolerance: your need to take risk. If you have little need for risk in your portfolio, then you may want to adjust your stock allocation downward from what this rule would suggest.

In short, “stock allocation = maximum tolerable loss x 2″ can be helpful in that it gives you a starting point for analysis when determining what asset allocation you want to use. Just remember that that’s all it is: a starting point.

One mistake I see repeatedly in emails and online discussions is the assumption that holding more funds automatically makes your portfolio more diversified.

For example, in a recent discussion I participated in on the Bogleheads Forum, a new investor was looking for feedback on his proposed portfolio. In addition to a few bond funds and international stock funds, the proposed portfolio included all three of the following U.S. stock index funds (all in the same account):

• Vanguard Total Stock Market Index Fund
• Vanguard 500 Index Fund
• Vanguard Extended Market Index Fund

See the mistake here? The Extended Market Index Fund is basically the Total Stock Market Index Fund, minus the holdings that appear in the 500 Index Fund. In other words, the investor owns multiple U.S. stock funds, but that’s not adding anything meaningful to his underlying holdings. He’s no more diversified than he’d be if he just bought the Total Stock Market fund.

It’s akin to going to your favorite pizza joint, ordering a slice of cheese pizza, paying for it, then ordering and paying for another slice of the same thing–and repeating the process until you’ve purchased 8 slices. It would have been easier (and probably less expensive) to just buy one pizza.

Other Cases of Unnecessary Fund Duplication

The same sort of thing occurs frequently with international stock funds. Vanguard’s Total International Stock Index Fund already includes emerging markets, European markets, and Pacific markets. There’s no need to hold individual funds for each region.

Ditto for bonds. If you own a fund that tracks the Barclays Capital U.S. Aggregate Float Adjusted Bond Index (e.g., Vanguard’s Total Bond Market Index Fund), you already own Treasury bonds, government mortgage-backed bonds, and corporate bonds. So adding category-specific bond funds won’t necessarily make you any more diversified.

“Slicing and Dicing” to Achieve a Specific Allocation

Despite the above, there are cases in which it would make sense to own a fund that invests in a particular sub-category of stocks or bonds. For example, if your 401(k) has access to a low-cost S&P 500 index fund, but no low-cost small-cap or mid-cap funds, it would be perfectly reasonable to hold the S&P 500 fund in your 401(k) and complement it with an extended market index fund in your IRA.

Or, you may have a legitimate reason to overweight a particular industry or style of stocks or bonds relative to its market weighting. For example, many investors choose to overweight small-cap and value stocks because they want the additional expected return that comes with the increased risk.

The key distinction here is that it makes sense to increase the number of funds you own if that’s what it takes to achieve your target asset allocation. But owning more funds does not, in itself, make you more diversified.

Conventional personal finance wisdom says that it’s essential to have a designated emergency fund. The typical suggestion is that your emergency fund should be a checking, savings, or money market account with 3-12 months of living expenses in it.

But is there a point at which there’s no need to keep a separate emergency fund? That is, is there a point at which your retirement portfolio (and other assets) can do double duty as your emergency fund?

I think there is. If your retirement portfolio is large enough, liquid enough, and accessible without adverse tax consequences, you don’t necessarily need a separate emergency fund.

Is Your Portfolio Large Enough?

In order to be able to safely do away with your emergency fund, you have to know that, in the event of an emergency, your portfolio would be large enough to satisfy any immediate, short-term spending needs.

Whether or not it can do that depends on the size of your portfolio, your asset allocation, and the size of any potential unplanned spending needs.

For example, if your stock holdings declined by 50% over the next year, and at the end of that year you got laid off or found out you needed a major home repair, how problematic would it be? The more problematic such a scenario would be, the greater your need for an emergency fund.

Are Your Assets Liquid Enough?

In order to live safely without an emergency fund, you also have to know that you can turn your assets into spendable cash in a short period of time.

For example, if you place a sell order for one of the holdings in your brokerage account, you should be able to have the money in your bank account within just a few business days. For most unexpected spending needs, that should be just fine.

In contrast, if most of your net worth is tied up in something significantly less liquid (real estate or a lifetime annuity, for example), you probably need an emergency fund.

Tax Considerations

Finally, in order for it to make sense to do away with your emergency fund, you need to be able to get to your money without adverse tax consequences. If you’re under age 59½, you would want to make sure you have sufficient Roth IRA contributions (which can be withdrawn free from tax or penalty at any time) or sufficient holdings in taxable accounts (without large unrealized capital gains) to satisfy any unexpected spending needs.

Obvious Exception

As with most personal finance concepts, the above discussion comes with some exceptions. Most importantly, if you know you’re not going to be able to sleep at night without a certain-size pile of cash in your checking account, the question of whether or not you need an emergency fund pretty much settles itself.