Following up on last week’s question about when to change your asset allocation, a reader asks a logical follow-up:
For the average investor who is looking to do a mix of stocks/bonds, should they use some simple heuristic for bond allocation, such as bond% = 10 x interest rate, up to a max of 50%?
If not, how would they know when to shift that relative allocation?
Not too long after I started this blog I received an email from an older retired gentleman named John.
John enjoyed helping young people and those who were behind on their retirement savings. Each month he sent out articles and blog posts to an email list and asked if he could include some of my blog posts.
I loved the idea.
From there we developed a correspondence over the years. John shared his investment and retirement withdrawal strategy with me to see what I thought. He called it the 4 year rule and it looked like this:
1. Five years before retiring start to accumulate a cash reserve (money market funds, CDs) within your retirement plan if possible (to defer taxes on interest). Your goal should be to accumulate four years of living expenses, net of any pension and Social Security income you will receive, by your retirement date.
2. When you retire, your portfolio should consist of your four year cash reserve plus stock mutual funds allocated appropriately. Then, if the stock market is up (at or relatively close to its historical high level) take your withdrawals for living expenses only from your stock mutual funds, and continue to do so as long as the market remains relatively steady or continues to rise. Do not react to short-term minor fluctuations up or down. (As you do this, be sure to keep your allocation percentages more or less at your desired levels by drawing down different stock mutual funds from time to time.) On the other hand, if the market is down significantly from its historical high levels or has been and still is falling fast when you retire, take your withdrawals for living expenses from your four years of living expenses cash reserve.
3. In the event you are taking withdrawals from your four year cash reserve due to being in a severe, long-term falling market, when the market turns up again, continue taking your withdrawals from the cash reserve for an additional 18 months to two years to allow the market to rise significantly (the market almost always rises fast during the first two years of an up market period) before switching back to taking withdrawals from your stock mutual funds. Then return to living off of your stock mutual funds and also start to ratably replenish (over a period of 18 months to two years) your now significantly drawn down cash reserve in order to bring it back up to its required level. Once the cash reserve is fully replenished you are ready for the next severe market downturn when it inevitably occurs.
The thing I liked most about John’s strategy is he inverted the problem. He started with his end goal in mind — spending — and worked backward from there.
I’m sure 4 years’ worth of spending might be too conservative for some people and too aggressive for others. But the point is he had a plan, it made sense for his risk profile and time horizon and he stuck with that plan.
Sadly, John’s wife informed me last week that he recently that he passed away from an incurable disease. He was easily one of the nicest people I’ve had the pleasure of interacting with because of this blog and he will be missed.
Back to our original question — I’ve never actually heard of the rule of thumb where you multiply the rate of interest by 10.
I guess it makes some sense but the problem is interest rates are extremely volatile.
If we were basing this off 10-year treasury yields, your bond allocation would have gone from 10% at the beginning of the year to 40% now. What if interest rates fall to 2% or rise to 6% — do you then immediately go to a 20% or 60% bond allocation?
That’s a huge shift that seems more tied to valuations than your own personal risk profile and time horizon.
John Bogle’s asset allocation rule of thumb was to put your age in bonds.
So at 25 years old you would have 75% in stocks and 25% in bonds.
By 65 you would have 35% in stocks and 65% in bonds.
A lot of investors find this rule of thumb to be on the conservative side of the risk spectrum so I’ve seen people adjust the number by subtracting either 10 or 20 from your age to be more aggressive.
The first thing to understand here is there is no perfect asset allocation.
It’s more art than science that involves some combination of where you are in your investor lifecycle, your tolerance for risk, your ability to handle losses (both psychologically and financially) and your spending needs.
In your 20s and 30s that’s the accumulation phase where you have the ability to take loads of risk in your retirement accounts for the simple fact that you have many decades ahead of you to save and invest.
At this stage of life developing good saving habits is more important than what you put into your portfolio but this is the time in life when you should have the ability to take lots of equity risk.
The mid-life transition to your 40s and 50s is more about balance. I’m entering this phase and it’s a weird one.
I still have many years ahead of me to save and invest but I also have some meaningful financial assets, unlike in my 20s when I was just starting out.
The good news is most people at this stage of life start making more money, thus allowing them to save more. That’s why this bear market is a good thing for both young and middle-aged savers.
The mid-life point of the investor lifecycle is when you start to realize the importance of retirement planning because there is now a flicker of light at the end of the tunnel. It’s also the time when experimentation should take a back seat to a more structured investment plan.
This is when you begin thinking about having some more balance in your portfolio and figuring out how that glide path to retirement is going to look.
Your 60s and up are your retirement years.
This is when you need to think more like a pension where you’re trying to match assets with liabilities. This is what my friend John did with his portfolio.
And those liabilities are not debts but current and future spending needs as your portfolio goes from accumulation to withdrawals.
I don’t have the right answer for every investor because there is no such thing as the perfect portfolio.
The right asset allocation is the one that offers you a high probability of achieving your goals while balancing out the potential emotional strain of gains and losses or unexpected life events.
Plus, there is the most subjective factor of all — behavior. There are things that will happen in the world or your personal life that will impact your behavior in ways you cannot possibly predict ahead of time.
The right asset allocation for most people is the one they can stick with come hell or high water.
The good strategy you can stick with is decidedly better than the perfect strategy you can’t stick with.
We talked about this question on the latest edition of Portfolio Rescue:
Bill Sweet joined me on the show yet again to answer questions about helping your parents with their investments, using losses in individual stocks to tax purposes, when to sell your individual holdings and which company should buy Peloton.
Here’s the podcast version of today’s show: