Conventional investing wisdom states that, as a person ages, his or her asset allocation should shift away from stocks and into bonds. Thankfully, conventional wisdom is (mostly) correct in this case. As a person gets older, the expected holding period for his investments becomes shorter, thereby increasing the risk involved in owning stocks.
What I don’t think gets enough attention, though, is the question of when a person should begin adjusting his asset allocation. As far as I can tell, there are 3 main approaches to this topic:
The “Gradual Adjustment” Method
The “have your age in bonds” rule of thumb (and other similar rules) suggest that an investor should shift his equity allocation downward each year.
The advantage to this method is that it’s perfectly easy to understand, and it provides clear instructions for investors at each point in life.
What I don’t like about this method, however, is that it begins the shift toward bonds too early. For example, why should a 37-year old investor have a significantly higher bond allocation than a 24-year old investor?
In each case, the investor has a long enough time horizon remaining that we can reasonably expect stocks to outperform bonds. In other words, the primary reason to include bonds at age 24 or at age 37 is a psychological one, and I don’t see why that need would be greater at age 37 than at age 24.
The “Life Stages” Method
Other financial writers/advisors recommend that you divide your life into distinct stages, shifting between asset allocations as you move from one stage to another. For example:
- Early working years (up to age 40) 80% stocks, 20% bonds
- High earning years (age 41-55) 60% stocks, 40% bonds
- Pre-retirement & early retirement (age 56-75) 40% stocks, 60% bonds
- Advanced retirement (age 76+) 20% stocks, 80% bonds
What I like about this method is that it appropriately recognizes that an investor doesn’t need to start shifting toward bonds while retirement is still 3 decades away.
My biggest complaint with this strategy is that making a dramatic shift in your asset allocation all at once can have unfortunate results if you get unlucky as to timing.
Hybrid method: Adjust each year, but not until age X
My favorite strategy of all is the one followed by Vanguard’s target retirement funds. These funds keep an investor’s allocation unchanged until she is less than 25 years from retirement, at which point they begin to adjust the bond allocation upward each year.
As you’ve surely noticed, this strategy perfectly resolves both of the complaints I have against either of the other methods.
My only issue with the asset allocation in Vanguard’s target retirement funds is that they’re too aggressive for many investors. Thankfully, this problem is easily resolved by holding, say, 10% of your portfolio in a bond fund and the remaining 90% in the appropriately-dated target retirement fund.
What’s your approach?
At what point in your life did you begin shifting away from stocks and into bonds? (Or, if you haven’t yet, when do you plan to?) Did you do it all at once, or was it a gradual process?
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{ 17 comments… read them below or add one }
A good look at asset allocation. Another thing you can try is the 10-5-3 rule, which — when used in conjunction with the rule of 72 — can help you figure out what allocation you need to reach your goals in a set number of years. It gets kind of messy, though, for those who don’t like to work a whole lot with numbers. It’s not difficult, just requires a calculator.
As you know from my blog I recently reallocated my 403(b) to reduce the number of funds I was invested in. Though my investments are 100% equities right now, my actual portfolio is separated into my passive 403(b) and my personal stock portfolio that I follow more closely. Though my stocks are still “buy and hold” ( no day trading for me) I do plan to sell some off and add shares of Bond ETF’s when the market starts reaching towards a bull market again.
I’d like to follow Benjamin Graham’s advice about adjusting my equity vs. bond ratio based on the price multiple of the market.
I think a good consideration is to look at allocation from what your expectations are for the longevity of the money and not the investor. I could make the case that an 80 year old might have a longer investment horizon than a 20 year old.
The 80 year old might want the money to go to her grandchildren and the 20 year old might need the money next week. That being the case, the 80 year old would be more aggressive with her money than the 20 year old.
I don’t like rules of thumb….as a rule of thumb.
OI,
Whats your opinion on reallocating when things get a little out of whack (I think that is a technical term). Using moi as an example – 401(k) is up 17% this year (down 30%ish 1year) – in gaining that 17% YTD some funds are higher than their original allocation %s. When do I readjust?
Wealth Pilgrim: Absolutely. It definitely has more to do with the goal in question that it does with the investor’s age. Essentially, this is me being lazy again and assuming we’re talking about retirement. Oops!
But the same question is equally important (and interesting, IMO) when applied to any goal: How many years before the expected cash outlay do you begin to adjust asset allocation away from stocks and into bonds? And how quickly or gradually do you do so?
My Journey: I just rebalance annually no matter how out of whack things get. That said, I do adjust my contributions so that they bring me more in line with my ideal allocation. Is this the ideal solution? Honest truth: probably not. Though I’ve been assured by people far more knowledgeable than myself that there’s no way to know ahead of time whether annual rebalancing, quarterly rebalancing, or [anything else] is likely to earn the greatest return over any given period in the future.
Mike,
Well said. The allocation question still remains.
I do this monthly but I’m OCD.
The historical data indicates that what matters is not age, but valuations.
Someone in retirement is fine with a high stock allocation so long as valuations are not high.
Someone who is a young investor is in danger with a high stock allocation when valuations are high.
It’s not retirement that makes stocks risky. It’s ignoring valuations that makes stocks risky.
Rob
I have a pretty conservative asset allocation which I have basically left alone for a while now. I only adjust my allocation when there are large relative movements among my investment choices. If an allocation gets out of whack I adjust. Otherwise I leave it alone.
@Dave C.: “I’d like to follow Benjamin Graham’s advice about adjusting my equity vs. bond ratio based on the price multiple of the market.”
Sounds sensible. Did Ben Graham suggest a rule of thumb? I think we can be safe in assuming that “normal” p/e ratios should not change markedly – there’s no such thing as a “paradigm shift” in the financial markets.
Sounds sensible. Did Ben Graham suggest a rule of thumb? I think we can be safe in assuming that “normal” p/e ratios should not change markedly – there’s no such thing as a “paradigm shift” in the financial markets.
I don’t have the words in front of me but my recollection is that Greham suggested that stock investors might want to go with a stock allocation of 75 percent at times of low valuations, 50 percent at times of moderate valuations and 25 percent at times of high valuations.
Graham is the person who came up with the P/E10 concept that is now used by Robert Shiller and John Walter Russell and others well informed about the effect of valuations on long-term returns. P/E10 is different from P/E1 (the most commonly cited valuation metric) in that it smooths out the earnings numbers (P/E10 is the price of the index over the average of the last 10 years of earnings). One of the reasons why there is so much confusion on valuation topics is that too many people test the effect of valuation using P/E1 and P/E1 is unreliable. The problem with P/E1 is that the earnings number is overstated during economic good times and understated during economic bad times. You want a smoothed-out number that reflects the overall economic reality that will be applying in the future.
The fair-value P/E10 number is 14. 7 is extremely low. 21 is dangerous. 25 is insane. We were at 25 or above for pretty much the entire time-period from 1996 through 2008. We are today at 16, which is fine. The long-term (10 years out) value proposition for stocks is today strong.
Rob
Rob says, “Someone in retirement is fine with a high stock allocation so long as valuations are not high.”
Not necessarily. As nfs, a poster at the Retire Early Home Page pointed out ;
“In July 1911, PE10 was 15.08, a moderate valuation level according to everything you have ever written.
The real value of the S&P 500 price was 206.45. Ten years later in July 1921, the real value of the S&P 500 price was 69.98, a 66% decrease in real terms.”
It would seem that the retiree might be well advised to consider some rendition of the old rule-of-thumb regarding age in bonds. And others as well with little tolerance for the inherent volatility of equities.
Ten years later in July 1921, the real value of the S&P 500 price was 69.98, a 66% decrease in real terms.”
That’s accurate.
But looks at the returns from July 1921 through 1929. They’re fantastic. They make it worth having gone with a high stock allocation.
Plug a P/E10 of 15 into The Retirement Risk Evaluator and you get a safe withdrawal rate for an 80 percent portfolio of 5 percent. The SWR is calculated assuming that you will see the worst 30-year returns sequence we have even seen in U.S. history. Assuming the worst, a 5 percent real takeout worked with an 80 percent allocation. That’s not at all bad.
Now try some lower stock allocations. What do you see? The SWR does not go up. There’s nothing wrong with an 80 percent stock allocation for a retiree at that price level.
Now. I think it’s fine to go with a lower stock allocation. At 50 percent stocks, you still have an SWR of 4.8 percent. You are going with less stocks and not giving up much in the way of SWR. That makes sense.
But I think it is fair to say that the big danger to stock investors is overvaluation, not retirement. We are warning people about the chance of getting stung by a jellyfish and doing nothing about protecting them from man-eating sharks.
Rob
Does your Retirement Risk Evaluatior use the same set of fabricated return sequencses as does The Scenario Surfer?
Shortly after retirement four years ago, I initiated two methods of gradually lowering my equity allocation and creating cash flow. First, I redirected all dividends and capital gains from all mutual funds into a money market fund. Second, I started a series of automatic exchanges from primary equity fund to primary bond fund. I aim for a 30% equity allocation by age 70, ten years from now.
-Grandpa
I’m choosing my own equity and bond mutual funds, but also trying to figure out for myself what balance I want to strike at what age regarding equity/bond mutual funds. I’m 32 and I started investing while the stock market was down, with a 10% bonds and 90% equity balance. Now as the stock market is going up, I’m at 93% equity and 7% bonds.
My question is, how long should I wait to re-balance to my 90-10 again? Should I do this every year, say–on my birthday? Or every 3 years? Quarterly? Any advice??
Hi OBL.
Well, you’ve hit right on one of the trickiest questions in personal finance. There isn’t really a “best” answer to it. Over certain periods, history shows us that rebalancing annually would have been best. Over other periods, once every 3 years would have been best.
William Bernstein argues persuasively in his Four Pillars of Investing that rebalancing more than once per year is likely to be detrimental to returns due to the fact that bull and bear markets tend to last greater than one year.
Larry Swedroe argues in favor of doing quarterly checks using a “5%/25% rule.” According to this rule, you rebalance any time an asset class becomes out of whack by more than 5% of your total portfolio value, or by more than 25% of the value initially allocated to that asset class. (So, for example, his rule would suggest that you’re due for a rebalancing due to your bond allocation being more than 2.5% (or 25% of its initial 10%) off target.)
My own method is simply to use each monthly contribution to bring me closer in line to my target allocation, then do one big rebalancing each year.
We use a four screen process in determining asset allocations for our users:
(1) Number of Years to Retirement
(2) Attitude Towards Loss
(3) Market Valuation Measured by P/E10
(4) Ability to Absorb Losses
While this sounds relatively standard, we measure the ability to absorb losses not only in investment terms, but in the analysis of each of our user’s personal financial condition. As an example, someone that does not have an emergency fund is directed to have a sufficient cash allocation to make up the difference. Someone who is 50 might have a 12 month cash reserve requirement versus a 3 month requirement for a 25 year old. This is one of the factors in determining the ‘ability to absorb losses’.
That’s the 50,000 ft. picture, but the most important part of asset allocation is understanding what you can afford to lose or to put it a better way, “What must I absolutely have available if something goes wrong?” Sometimes this is safeguarding against a major market decline, having enough money to carry through during times of unemployment, or having enough money outside of the stock market to not worry about what the market does. This last one is a personal favorite of mine. If you’re retired and have two years’ worth of cash and five years’ worth of bonds, that’s seven years to ride out a downturn in the stock market. When you have this much money outside of equities, are you more or less likely to react to market movements?
You have a solid blog and I’ll be adding an RSS feed into our site in Q1 2010.