Top 5 Asset Allocation Strategies
“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett
Probably the single most common incorrect quote in investing is: “Asset allocation determines 94% of your investment returns.” The quote refers to a study1 that is misquoted by both the investment industry to market simple investment strategies and by the index industry to downplay fund manager skill.
“Asset allocation” attempts to balance risk and return by adjusting the mix between equities (stocks), bonds and cash. While the benefits are far less than touted, it is an objective and simple way to help investors understand both the risk level and return potential of their portfolio.
There is a common belief that it is just a matter of deciding whether you are more comfortable with the classic mix of 60% stocks/40% bonds or a more growth-oriented 80%/20% mix. However, there are actually a variety of asset allocation strategies.
Here are 5 possible strategies. All are reasonable and based on studies. The best strategy for you depends on multiple factors, including your risk tolerance, time horizon and your long term goals, especially your retirement goal.
- Fixed allocation: This is the traditional method. It is based on your risk tolerance. After filling out a “risk tolerance questionnaire” and based on the degree of ups and downs you can tolerate in your investments, you choose an allocation, say 70% stocks/30% bonds. You generally maintain the same allocation through your life, unless your risk tolerance changes.
Pros:
– Investments should be suitable to your risk tolerance. Most investors are not very knowledgeable about investing and this allows them to have a constant level of ups and downs that they can get comfortable with.
– Easy for you to understand the risk and return level of your investments.
Cons:
- Risk tolerance for most people changes based on the situation. In great bull markets, most investors become more aggressive, while in scary bear markets most investors become more cautious.
- You may end up with a portfolio that is too conservative when you are young and too aggressive when you are old.
- Many investors end up with a portfolio too conservative to have any chance at all of having the retirement they want because they base their investments only on their risk tolerance, without knowing what return they need to achieve their life goals.
- Target date: This method is based on the “birthday theory” that you should become more cautious as you get older. The formula used is usually something like: 110 – your age = % in stocks. At age 30, you should have 80% in stocks and at age 60 that should have 50%. There are target date mutual funds that do the adjustment for you automatically each year.
Pros:
- Automatically adjusts for the shorter time horizons and more conservative nature that is common as you get older.
- Reduces risk as your portfolio gets larger with time. A 20% decline on a $1 million portfolio at age 60 may be harder to tolerate than a 20% decline on a $50,000 portfolio at age 30.
Cons:
- Many people become comfortable with the ups and downs of their investments, so they may not want more conservative investments every year.
- With more experience, not nearly all investors become more conservative with age.
- You may end up with a portfolio too conservative to have any chance of having the retirement you want.
- Lifecycle investing: Based on an in-depth study by 2 Yale professors2, they proved that retirement risk over your lifetime is lower if you “diversify across time”. Traditional asset allocation does not give you much growth when you are young and have a long time horizon with a relatively small portfolio.
Traditional investing also creates a big “last decade risk” because 80% of your investments over your working life are usually after age 50. If your last decade is a bad decade (like the 2000-09 decade), it probably means your rate of return for your entire working life is low. One bad decade can put you far below your retirement goal.
Lifecycle investing reduces “last decade risk” by diversifying across time. Essentially, you borrow to at least double the size of your investments in your first decade of investing and invest 100% in stocks. If you have $50,000, you borrow another $50,000, so you can invest $100,000 all in stocks. That means you essentially have 200% in stocks.3 Then you slowly pay off the leverage by your early 50s, when you start adding bonds, moving to your desired mix by retirement.
The study (and book) by 2 Yale professors proved lifecycle investing for your entire working life provided a better retirement 99-100% of the time.
Pros:
- Provides a better retirement income than traditional asset allocation 99-100% of the time (based on the study).
- Offers more growth potential when you are young and have a long time horizon.
- Reduces “last decade risk” that one bad decade can mess up your retirement.
Cons:
- Borrowing to invest in your 20s and 30s is a riskier strategy at a time when you may not be experienced.
- Borrowing to invest may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative.
- Stocks for the long run: Investing seems to arbitrarily focus on 1-year returns, even though most investors will be invested for at least 30 years. In the investing bible “Stocks for the Long Run”, Prof. Jeremy Siegel proved that over long periods of time, stocks always produce higher returns and are more consistent than bonds. If your time horizon is more than 30 years, then stocks have historically beaten bonds 100% of the time.
His study shows that for investors with a 30-year time horizon, ultraconservative investors (least risk) should have 71% stocks, moderate investors 116% stocks (by borrowing), and aggressive investors 139% stocks.
One of my mentors, Nick Murray, worded it well – the long term return of stocks has been 10%/year, bonds 6%/year and cash 2%/year. How many 10%s vs. 6%s vs. 2%s do you want in your portfolio?
When you look at 30-year periods (instead of 1-year periods), the returns of stocks has been more reliable and consistent than bonds. This is because the return on bonds is highly susceptible to inflation. The worst 30-year period ever for the S&P500 since 1871 was a gain of 5.09%/year4, which would more than quadruple your money. After inflation, the worst 30-year period for stocks was +2.6%/year, while for bonds it was a loss of -2.0%/year.5
Many major countries have had their government bonds go to zero (or near zero) in the last century, including Germany, Italy, Japan, Russia and Brazil, but the stock market has always recovered in every country.4
The underlying theory is that stock markets are based on large companies that are able to adjust their businesses to keep raising their profits over time. They have many tools, including raising prices, getting new clients, introducing new products, expanding into new markets, cutting costs or buying competitors. As long as companies continue to increase profits over time, the stock market eventually goes up.
Pros:
- Provides a much better retirement for investors with long time horizons that are able to tolerate the ups and downs.
- Easy to understand and based on research.
- Avoids the most common investing error of switching to more bonds at the bottom of the market.
Cons:
- Most investors think short term, even if their time horizon is long.
- Many investors are not able to tolerate the ups and downs of the stock markets.
- Investing only in stocks may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative. The average investor makes 6-7%/year less than the investments they own because of bad market timing.7
- Rempel Maximum: This is the strategy for people that want to build serious wealth – borrowing to invest for the long term.8 Borrowing to invest magnifies gains and losses, but the stock market has never had a loss for a 15-year period or longer.4 Borrowing to invest is a risky strategy, but the risks are far lower if you invest long term. The interest is normally tax deductible as well.
It is the logical extension of “Stocks for the long run”. Long term, stocks have consistently outperformed both bonds and the cost of borrowing to invest.4 Leverage is the strategy used by nearly all wealthy people, who use “other people’s money” to invest in their business or in the stock market (many businesses), including 87% of the Forbes 400 richest people.9
The amount borrowed to invest can range widely and depends on many factors. Often the intent is to borrow the maximum amount that you can support long term.
Pros:
- Can build significant wealth and the security that comes from having a huge nest egg.
- Provides a much better retirement for investors with long time horizons that are able to tolerate the ups and downs – significantly higher than “stocks for the long run”.
- Avoids the most common investing error of switching to more bonds at the bottom of the market.
- Interest payments are fully tax-deductible every year, while tax on the growth of the investments can be deferred until you sell them far in the future if you have tax-efficient investments.
Cons:
- Too risky of a strategy for most people who may not be able to stomach significant down periods, especially if the investments drop below the value of the amount borrowed.
- Most investors think short term, even if their time horizon is long.
- Borrowing to invest may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative.
The best strategy for you depends on multiple factors, including your risk tolerance, time horizon and your long term goals, especially your retirement goal.
Story of Jim and Jennifer
Jim and Jennifer are 35 and make a good income. They want to retire comfortably a bit early at age 60. They are deciding on their asset allocation. Consider the following:
- Goal: They sat down with us and created a detailed, line-by-line retirement lifestyle that they want. In order to make it given how much they can afford to invest, their investments will need to average 8%/year long term. That means they would have to invest 100% in equities to make their goal.
- Gut feel: They are thinking of investing with a balanced 50%/50% allocation because they are a bit nervous with the difficult markets recently.
- Risk tolerance: A discussion of their risk tolerance and a questionnaire show they can tolerate the level of ups and downs of the stock market.
- Market crash: They said that in a big market crash, they would invest more to buy low.
- Time horizon: Even though they plan to retire in 25 years, their time horizon is closer to 50 years, including after they retire.
Here are possible allocations based on these 5 strategies:
- Fixed allocation: 70% stocks/30% bonds. (They are young and have a relatively high risk tolerance, but are a bit nervous.)
- Target date: 75% stocks/25% bonds. (Formula is 110- age 35 = 75% stocks.)
- Lifecycle investing: 200% stocks/-100% bonds. (Borrow to double their investments at their age. Count the loan as a negative bond holding.)
- Stocks for the Long Run: 100% stocks/0% bonds.
- Rempel Maximum: 400% stocks/-300% bonds. (Just an example using a 3:1 investment loan.)
What strategy should Jim and Jennifer use?
Which asset allocation strategy is best for you?
Ed
1 Brinson, Hood, and Beebower (1986, 1991) The study actual shows that 40% of the difference in return between different balanced funds was explained by the asset allocation.
2 “Lifecycle Investing”, Ian Ayres and Barry Nalebuff
3 If you count the investment loan as a negative bond position, then you are investing 200% stocks/-100% bonds in your first decade.
4 Standard & Poor’s
5 “Stocks for the Long Run”, 4th edition, Jeremy Siegel
6 The only exception I am aware of is Russia when it converted to communism and the government seized many companies. This is a political reason, not an investment reason for a stock market collapse.
7 “Quantitative Analysis of Investor Behavior 2011”, Dalbar
8 Borrowing to invest for the long term is essentially a negative bond allocation.
9 “The Forbes 400 – The richest people in America”
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