The Better Way To Think About Portfolio Allocation
Here’s a bit of trivia… Did you know there are at least 79 different shoe sizes?
There is even an International Organization for Standardization publication for footwear sizing explaining the conversion of sizing systems and how manufacturers should size their products.
Shoes are obviously important, and that level of detail is certainly necessary. And, thanks to detailed formulas included in the standard, we can all be certain to find shoes that fit.
I wish there was a similar publication explaining how to allocate positions in an investment portfolio. But, there’s not.
There are some general guidelines. One is the 60/40 approach. This is when you allocate 60% of your portfolio to stocks and 40% to bonds. Another approach is to use your age. To determine the allocation using this method, subtract your age from 100 to determine the percentage of your portfolio that should be in stocks. So, a 20-year old would have 80% in stocks under this formula while an 80-year old would place just 20% of their portfolio in stocks.
These guidelines are fine, but they don’t tell us very much. Among the things the formulas don’t tell us is how to generate income when interest rates fall to 5,000-year lows or how to incorporate alternative assets into a portfolio.
I want to dig into those questions today.
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How Should I Allocate My Portfolio?
There is no right answer to this question. I believe the standard formulas such as a 60/40 allocation or using 100 minus your age can work well if you have a large account.
For example, if you have $1 million, that would be $400,000 in fixed income investments. Even at 3%, that would provide income of $1,000 a month. But, with a $1 million account you would withdraw 3% or 4% a year from the account in addition to collecting income.
But a lot of us don’t have $1 million accounts and probably need to find a different approach.
Now, I am not providing specific advice. I am simply considering different scenarios that could provide a framework for thinking about this question.
Many investors believe a 60/40 allocation protects principal. Even if stocks lose 20% of their value, the portfolio would drop just 12% and the bond portion could even deliver a small gain.
It’s Time To Rethink Risk
There’s a serious flaw with this model. You can spot that flaw in the chart below. Bonds have been in a bull market since the early 1980s.
The 60/40 model has performed well over time because interest rates have been dropping for the past 36 years. It’s unlikely that will be the case for the next 36 years. This fact significantly changes the risks of the 60/40 portfolio.
In the future, bonds could carry greater risks than stocks.
With the risk of losses from bonds, investors might want to rethink the idea of income investing altogether.
Dividend stocks could be an alternative, but stocks could also suffer large losses. In fact, stocks could also go nowhere for decades. That’s happened in Japan, where the Nikkei Index is at the same level it was at in 1988. That means buy-and-hold investors saw no gains in 30 years.
A bond bear market and a 30-year bear market in stocks could sound like a worst-case scenario. But it is possible and must be considered by prudent investors.
It’s Time To Rethink Income
Now, we know that there’s a dangerous flaw built into the 60/40 portfolio — the 40% cannot be counted on for income. This leads to the question of how to generate income in a portfolio.
Dividend stocks are one answer. In the long run, however, a diversified portfolio of dividend stocks might be riskier than you realize. The iShares Select Dividend ETF (NYSE: DVY), for example, lost more than 60% of its value in the 2008/2009 bear market.
That could be the most important point to consider related to dividend stocks. A dividend yield of 4% is not much consolation when prices drop 20% or more.
All of these risks indicate that it could be useful to think about income in the short term. By using short-term strategies, the risk of large losses is minimized.
It could also pay to think beyond traditional stocks and bonds. That’s where options come in.
Forget Bonds, Options Are Better
Contrary to what most investors think when they hear the term “options,” there are a couple ways to conservatively generate income for a portfolio. In fact, given the risk factors I’ve outlined, I think they’re the best way to consistently produce income.
Put selling is one strategy that could be beneficial. I will assume you understand the basic idea of selling puts so will not review that information here. (If not, you can read this.) I will simply look at how this strategy could fit into a portfolio.
#-ad_banner-#Put selling could replace part of the fixed income allocation in a traditional 60/40 strategy. If you are considering a strict asset allocation strategy, you should consider options selling within the fixed income portion. The risk profile of options selling will be similar to the risks of a portfolio of high yield bonds.
That insight provides one way of thinking about how much to allocate to selling options. The strategy could be a substitute for corporate bonds without the long-term risks that bonds carry.
Once you decide how much to allocate to the strategy, you need to decide on the tactics of trading. Here, an example could help.
Say you have decided to allocate $15,000 to this strategy. If you use margin, your broker will allow you to increase your income significantly. With $15,000, you could sell options on stocks worth more than $75,000.
With that much capital, you could consistently have three positions open at any given time with two contracts for each position. Each position will be open less than 90 days, and sometimes less than 30 days. But, to be conservative, let’s estimate that you have three positions open at all times and are able to generate income 12 times a year.
Now, let’s be conservative and estimate each contract generates $40 in income. That would be $80 per trade since there are two contracts in each trade, or $960 a year in income. (Again, this very achievable.)
On a $15,000 account, these small trades would provide an annual yield of 6.4%. And that’s being conservative. You could easily enjoy double-digit income since most trades are open for about six weeks. If three positions are opened every six weeks, the yield jumps to 28% on a $15,000 account.
Again, this is just a baseline. Your actual income could be significantly more or less than that. But, given the factors I’ve outlined, it’s clear to me that income-oriented investors are going to need new strategies at their disposal.
I am confident that the total returns of bonds will almost always be less than the income from a put selling strategy. Another strategy that allows you to make more with less risk is my colleague Jim Fink’s “310F” trade.
This is a proprietary method he developed that consistently beats Wall Street at its own game. And it works in markets that are going up, down or sideways. You can use it twice a week, every week, like clockwork – just like Jim and his followers have for the past three years.