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Asset Allocation
(Updated 6/14/08)
Introduction J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to the sleeping point.” Asset allocation is the process to set the risk/reward parameters that will make an investor comfortable. An allocation too aggressive (heavy in stocks), and you might sell in a panic when the market takes a dive. An allocation too conservative (light on stocks), and your portfolio will grow at a very slow pace. So how does one balance the need for growth, yet temper downward swings? That is what will be explored in this article. I will also show that the considerations for an investor accumulating a nest egg (The Accumulation Phase) may differ from a retiree withdrawing from a nest egg (The Distribution Phase). The Accumulation Phase No approach is perfect. But I have devised a simple formula to start the process for how an investor in the accumulation phase might want to split their allocation between stocks and fixed income (the equity-fixed split). First, I looked at the prior nine bear markets since 1950. The declines in the S&P 500 ranged from 20% to 49%.
 Sources: AllFinancialMatters.com Fortune Magazine So I will use 50% as my theoretical downside. Note that for this discussion, I will keep the equity-fixed split simple. Furthermore, it will only include stocks, as represented by the S&P 500 index fund, and cash, represented by a money market fund. At one extreme, an investor might say, “Since I won’t be retiring for another 30 years, I have a very long time horizon. So, I’m going to put everything in stocks and not look at my portfolio until then. If it declines 50% in the meantime, I don’t care. I know that at the end of 30 years, the market growth will be there for me.” Obviously, this investor doesn’t need asset allocation to help him sleep at night. However, most of us cannot bear the thought of a 50% decline to our portfolio. How far does your portfolio have to decline before you get very nervous? 30%? 20%? 10%? Here’s my simple formula: S = D/.5 Where:
S = Percent allocation in stocks Using the above formula, the following table shows some possible asset allocations based on different portfolio decline parameters:
So what does this table say? Let’s say, for example, you cannot bear the thought of your portfolio declining more than 30%. Then you should put no more than 60% in stocks . Let’s assume you had a portfolio of $100,000; you might put $60,000 in stocks and $40,000 in cash. And if you had this portfolio at the start of a 50% bear market, your $60,000 in stocks could decline to $30,000. This would leave you with $30,000 in stocks, $40,000 in cash, and a total portfolio of $70,000 at the market bottom.
The drop from $100,000 (what you had at the top of the market) to $70,000 (what you have at the market bottom) is $30,000 -- a 30% drop. Keep in mind that this was a theoretical example. In practice, an investor will want to rebalance when their equity-fixed split drifts too far from their initial allocation. For example, at the market bottom shown above, the portfolio has $30,000 in stocks and $40,000 in cash. This translates to an asset allocation of 43% stocks and 57% cash -- quite far from the original 60% stocks and 40% cash at the market top. To see how asset allocation worked in practice, we can go back and look at a mutual fund that maintained a 60/40 equity-fixed split during the 2000-2002 bear market. Below is a chart showing Vanguard’s Balanced Index fund (it holds 60% stocks and 40% bonds).
Source: Vanguard.com Remember, the above discussion is meant to be used only as a guide -- more art than science. While the past can inform us as to how stocks have performed, the future is unknowable and may turn out worse than we expect.
In the next section, I will discuss the considerations for an investor in the distribution phase (withdrawing from their nest egg). The considerations for a investor in the distribution phase may be somewhat different than an investor in the accumulation phase. The Distribution Phase Withdrawing from a nest egg poses a different challenge than accumulating a nest egg. Once an investor is ready to pull money out of their nest egg, one impulse would be to keep the money safe by putting all or most of the money into relatively stable investments like high quality bonds, CDs or money market. This reaction is understandable for two reasons. First, retirees are no longer adding to their retirement kitty. And second, a bear market in the early years of retirement can pose a significant risk to portfolio survival. However just as being too conservative while accumulating a nest egg can limit portfolio growth, so too, being too conservative while withdrawing from a nest egg has disadvantages. Consider a 65-year old retiree planning a 30-year retirement. Over time, inflation will erode purchasing power.
In other words, a dollar that buys a dollars worth of goods and services today may have only half the purchasing power after 24 years (if we assume an average inflation rate of 3%). Therefore, a portfolio light on stocks may not be able to sustain a decent level of income. To illustrate, the following chart shows the maximum withdrawal rates obtained from different stock allocations (stocks as represented by the S&P 500) and maintains inflation-adjusted income. The maximum withdrawal rate is one in which the portfolio survived with at least $1 left after 30 years.
Data obtained from my Maximum Withdrawal Rate Spreadsheet (xls) So according to the historical data, a portfolio containing a stock allocation below 35% may not generate an optimal amount of inflation-adjusted income. This is one trade-off retirees should keep in mind if they choose that kind of conservative stock allocation. Conclusion Investing in stocks involves taking risk. Asset allocation is a strategy to manage that risk. By carefully considering the amount of risk one is comfortable taking, an investor will more likely be able to stick with their asset allocation strategy during both good markets and bad. Taken together -- your consideration for risk along with the discipline to stay the course -- and you have the key to reaping the higher returns that stocks have delivered over the long haul. An investor entering the distribution phase has additional issues to consider besides asset allocation. For a more comprehensive discussion, the reader may review my article on Preparing for Retirement. |
