What Is Asset Allocation? How Should You Diversify? Here Are Some Tips…

It’s one of the most frequent questions subscribers ask, and unfortunately, we can’t answer it.

“How do I allocate my portfolio as I approach retirement?”

Many of you have asked this question in different ways countless times over the years. We can’t give you an answer because there is no one right answer. It all depends on you.

Even if every reader had the same amount of assets and needed the same retirement income, the way you should allocate your resources would still be different.

Effective asset allocation is an exercise in introspection. You need to answer questions like:

– If you think the market will drop 20% in the next six months, do you still choose to keep your money in it?

– How knowledgeable are you about investing?

– Did your grandmother live to 97, and does longevity run in your family?

– Are you comfortable consuming all your assets before you pass away, or do you want to leave a legacy to your children?

Asset Allocation is Key

A ground-breaking study by Gary Brinson, Randolph Hood, and Gilbert Beebower found that asset allocation is responsible for more than 90% of the volatility of your portfolio returns. While that statistic may be based on selective data, there is no doubt every investor should consider this concept with the utmost seriousness.

In his classic book, The Four Pillars of Investing, William Bernstein contrasted the performance of stock/bond portfolio mixes in the 1973-1974 bear market.

An investor solely invested in stocks came through this period down 41.4%. An investor who had allocated 25% to stocks and 75% to bonds lost less than 1% of the assets.

The results were similar during the 2000-2002 high-tech crash/bear market, according to The Boglehead’s Guide to Investing by Bogle, Lindauer, LeBoeuf, and Larimore. A portfolio of 80% stocks and 20% bonds lost 25.8%. In contrast, a portfolio of 20% stocks and 80% bonds actually gained 16.5%.

Do these statistics suggest you should heavily skew your portfolio to bonds? , even if you’re not near retirement? Of course not.

When we’re not in strong bear markets, stocks handily outperform bonds as investors are compensated for taking on the additional risk. However, if you’re approaching retirement, or are already retired, or just can’t handle the gut-wrenching volatility of sharp market declines without selling into panic, a portfolio weighted toward bonds may be right for you.

What Is Asset Allocation?

A simple synonym for asset allocation is “diversification.” An even simpler way to phrase asset allocation is “Don’t put all your eggs in one basket.”

You may want to keep three goals in mind when planning your allocation strategy.

1) You want the income from your investments to supplement any pensions and old-age income.

2) You want to protect your savings from inflation.

3) If necessary, you want to have enough capital to withdraw an average of 4% annually for the rest of your (and your spouse’s) life. (The 4% withdrawal rate is considered safe, based on an average 7% portfolio growth rate, less an average 3% inflation rate.)

You may not think inflation is much of a factor. But a 3% inflation rate compounded annually over 20 years will reduce your purchasing power by 46%.

How Should You Diversify?

Asset allocation strategies can help you achieve these goals. A key is to balance risk and reward by finding the right mix between stocks and bonds.

Fixed income is generally more secure, but equities have delivered higher returns over the long term. As a rough rule of thumb, you can expect nominal (before inflation) average annual returns of 10% from equities, 5% from fixed income, and 3% from cash or equivalents over the long term.

This handy 10-5-3 rule was developed by James O’Donnell in The Shortest Investment Book Ever: Wall Street Secrets for Making Every Dollar Count. It came from William Bernstein’s seminal research in Four Pillars of Investing. Bernstein found that annual average returns before inflation were roughly 10% from stocks, 5% from bonds, and 4% from Treasury bills.

So, the first step in whipping your nest egg into shape is deciding how much you allocate to lower risk/return fixed income (bonds, preferred stock) and higher risk/return equities.

The conventional answer is 100 minus your age in stocks. By this guideline, if you are 60, you would keep your portfolio 60% in bonds and 40% in stocks.

The rationale is that you invest as if you were to live to 100 to not outlive your assets. Also, as you age, you hold an increasing portion of low-risk fixed income since your capital will have fewer years to recover from a bear market than a younger person’s.

With people living longer and needing to make their retirement nest egg last longer, that guideline has morphed. Jack Bogle, founder of Vanguard funds, suggested the number should now be 110 minus your age. So, a 60-year-old would allocate 50/50 to stocks and bonds.

Whatever you decide depends on how safe you want to play it.

50/50 or 60/40 Is Just a Starting Point

Let’s say you allocate 50% of your portfolio to bonds. Your job is far from complete. You still need to make “intra-asset” class choices.

What’s your division between Treasuries and corporates? Between higher-yielding long-term maturities and lower-yielding but safer short-term maturities? Between taxable bonds and tax-exempt munis? How much will you allocate to investment grade, emerging market, and high-yield bonds?

The answer depends on your risk tolerance, tax bracket, income needs, and market outlook, among other factors.

For example, you could put the bulk of your fixed income allocation, say 70%, into a diversified bond option such as the Fidelity Total Bond fund (NYSE: FBND).

You could also try the Eaton Vance Muni Income (NYSE: EVN) for tax-free income. Preferred shares like Global Ship Lease “B” (NYSE: GSL-B) are also a good choice when you can pick them up below par. And if you’re seeking inflation protection, try Treasury Inflation Protected Securities (TIPS).

You could then spice your income-earning potential by putting the remaining bond allocation into a high-yield fund such as the SPDR Bloomberg High Yield Bond ETF (NYSE: JNK), which pays 6.6% right now.

The same exercise could be undertaken for equities. Here, you would make targeted choices by market capitalization (small/large), industry (defensive/cyclical), investment styles (value/growth), or region (domestic/foreign).

Closing Thoughts

Asset allocation can be a daunting task. But hopefully, this will give you some ideas to get started.

Of course, you can also simplify the process by adding a ready-made conservative or moderate allocation fund to the mix. There are hundreds of these funds, each with slightly different allocation strategies.

Remember, the suggestions we’ve made here are not a panacea. There is always risk inherent in both the stock and bond markets. But a properly allocated portfolio as you approach retirement can provide both diversification and yield – not to mention peace of mind.

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