Once again, the old saying that “personal finance is personal” rings true with asset allocation. Everyone’s situation is unique and there is no one size fits all. For sure, there are standard portfolio models to follow that can determine how aggressive or conservative you want to be. But they are only models and don’t provide the “tells” that fit your unique situation.
This article will cover some general ground that won’t likely be rewritten in future articles. In fact, future articles on my specific asset allocation will likely point back to this article to understand general components of asset allocation. Today, we’ll cover:
- Asset classes – Most of these will make up the pieces of your asset allocation
- Model Portfolio Allocations – Courtesy of Vanguard, we’ll let their expertise shine through on this topic
- Sequence of Returns Risk – We need to address this topic but it will be done briefly. There are entire blogs written on this subject by people way smarter than me so let “Google be your friend” in finding this material.
- Bucket Strategy – This is just a brief review of how I’m using the bucket strategy and why it’s important to my personal asset allocation
- My Asset Allocation – Because I’ll be using a bucket strategy, I’ll review my three allocation considerations:
- Total Asset Allocation – Includes all investment assets
- Taxable Allocation (Buckets 1 & 2) – Includes only those assets that I’ll use in retirement
- Tax Advantage Allocation (Bucket 3) – Tax-deffered IRA, Roth IRA, Tax-deferred 401k, Roth 401k, all of which shouldn’t be needed in my retirement
There’s a lot to consider and we’ll try to undercover much of it today. With so many components to think about, I’d propose that asset allocation is both art and science. Everyone’s situation is so different that it really pains me to see someone in an allocation because their “friend” or relative is in the same allocation.
Asset Allocation
With asset allocation, you divide your investments among different asset classes. The relative proportion of each depends on your time horizon—how long before you need the money—and risk tolerance—or how well you can tolerate the idea of losing money in the short term for the prospect of greater gains over the long term.
Asset allocation spreads your dollars across different asset classes based on your goals, age, risk tolerance, and unique circumstances in life. Anytime you put assets more heavily into one asset class versus spreading them around you create a different risk profile. The heavier you lean toward stocks the more risky your portfolio becomes. But the same can also be said when having a heavier weighting in bonds. Both of those scenarios are considered risky but for different reasons and different risks.
With time horizon and tolerance for risk as considerations, asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash.
Even 100% stock portfolios can have different risks. For example, somebody might have 100% of their investment in small cap growth stocks while another might have 100% invested in large cap value stocks. And even though both are 100% invested in stocks, they will each have their own portfolio risks.
Same is true for bonds. If you are 100% invested in short-term U.S. government bonds while your friend is invested in 100% in long-term corporate bonds then you’ll have different risk profiles.
The goal then with asset allocation then is two-fold:
- Create a risk profile using general asset class allocation (e.g. stocks, bonds, real estate, etc…)
- Create a refined risk profile using assets within each general asset class allocations (e.g. growth vs value stocks, government versus corporate versus international bonds, vacant land versus apartment rentals versus single family home rentals, etc…) – This sub-allocation is much more specific and determines the specific make-up of your assets within the general asset classes
We describe the asset classes below but here’s a few things to consider before you choose. Since 1926, total returns are:
- Small Cap Stocks = 11.8%
- Large Cap Stocks = 10%
- Long-Term Gov’t Bonds = 5.5%
- Intermediate-Term Gov’t Bonds = 5.1%
- **U.S. Real Estate = 4.5%
** U.S. Real Estate varies widely based on many factors. For example, single family homes, apartment rentals, commercial property, city and region differences all produce different returns so the 4.5% could be better or worse based on many factors. 4.5% is all real estate in all parts of the U.S.
Asset Classes
It’s kind of hard to write about asset allocation without first talking about some of the asset classes. I’m going to stick to what I consider the tradition assets: cash, bonds, stocks, and real estate. I’m not a fan of commodities (e.g. gold) as an asset class because they don’t normally pay while you wait. And I’m not well versed enough to talk about owning a business since I’ve never done so.
Business ownership is certainly one way that many have made millions of dollars but there are also the majority that either fail or just barely scrape enough income to live. In other words, business ownership is very high risk but high reward too.
Something else to consider is that I’m not considering my house as an investment asset. Sure, it’s part of my net worth but I don’t consider it an asset. It has grown in value over the 20+ years we’ve owned it and the mortgage was paid off in 2021. Even though we could do a reverse mortgage, downsize, or sell it and start renting we just consider it as the place we live.
Cash – Worst Wealth Building Asset
Cash is designed to erode in value. Every year, inflation destroys the purchasing power of your cash. This means that every $1 today will only buy $0.90 to $0.98 worth of goods next year. The destruction in value really depends on the amount of inflation.
“Cash is designed to erode in value.”
So, in theory, it would make sense that you don’t want to hold very much cash because it’s designed to erode in value. But not so fast … cash has its benefits:
- Cash serves to prevent forced selling of assets at the wrong time. Emergency funds, both short and long-term, are useful tools for job loss and other major emergencies.
- Cash reserves lets you become a buyer when others are selling during tough economic times. Warren Buffett has been known to keep well over $100+ billion in cash reserves if he can’t find a useful place to have it working. Buffett is famous for being a heavy buyer in tough times because he always keeps cash at the ready. But remember, your cash is eroding in value so whatever you buy must be purchased at a deep enough value to make up for the erosion.
- Finally, your cash position is uniquely yours and it’s specific to your situation. For me, as you’ll read later, I’m sitting a lots of cash for a couple of reasons that are important to me:
- Sequence of returns risk, since I’m less than 3 years away from retirement
- My savings rate is the most important force to me being able to retire in 3-years. A bad market will do me more harm than a good market could. The risk is not worth it given our current economic situation and I must protect the funds I’m currently contributing.
Personally, I think the amount of cash to hold is heavily dependent on our unique situation and there are few rules that can guide you. Just remember, holding too much cash (whatever that means) for too long will eventually weigh down your returns and be destroyed by inflation.
Bonds & Fixed Income – Low Wealth Building Asset
Holding debt during low interest rates does more harm than good. Why? The risk of rates going up and providing negative returns outweighs any benefit achieved by holding bonds. For me, bonds have one main purpose and that is to lower the volatility of my portfolio.
“Bonds have one main purpose, which is to lower portfolio volatility.”
If rates are too low, you might as well hold cash. If rates are rising then either hold cash or keep your bonds very short-term. I’ve been maximizing my purchase of I-Bonds the past few years to benefit from the increase in inflation and rising rate environment. I’m also using these I-Bonds as my cash substitute into retirement so you’ll probably very little actual cash held as an emergency reserve (probably $40,000 emergency reserve?).
If rates 5 or 10-year government rates were to rise to 5% or higher, I might consider a bond ladder. And if taxes go higher, I might turn stock dividends into a tax-free municipal bond ladder. It really just depends on my needs, age, taxes, expenses, and cashflow. When I get past 70 and social security is paying out, I might use our annual taxable stock dividends to fund a bond ladder. Again, that will be a wait and see situation. If I were a retiree and if interest rates get into the 7-9% range on the 10-year government bond, then I might get overweight on my bond portfolio.
Real Estate – Moderate (to High) Wealth Building Asset
When it comes to building wealth, real estate is always one of the main asset classes that people use (along with stocks and business ownership). Nowadays, we are lucky enough to have multiple ways to invest in real estate: (1) individual property ownership, (2) publicly traded REITs, and (3) crowdfunding. I’ve been tempted to own individual properties but I don’t want to invest the time or energy, which is why passive investments are my focus.
“Crowdfunding has become my path to real estate ownership.”
Publicly traded REITs are too volatile and have come to act more like stocks than real estate. Plus, these investments pay non-qualified dividends which are taxed as regular income. These are best held in an IRA.
Crowdfunding has become my path to real estate ownership. I love the diversity of real estate crowdfunding compared to the rest of my investment portfolio. And I like that I can have others do all the work (for a small fee) if I choose to buy into individual properties. I suspect that real estate crowdfunding will eventually become up to 10% of my portfolio within the next 5-10 years.
Stocks – Highest Wealth Building Asset
Whether you own individual companies or mutual funds, stocks give the “average” person a chance to become wealthy just by saving and investing. We seen it over and over where a person mades an average income over 30-40 years and because they saved and invested in stocks they became wealthy.
Paycheck after paycheck, you can put work dollars into buying an asset (stocks) that will work even when you don’t. That is the trick. If you only rely on work income they will you die working. And I was not put on this great earth to work until I die. The exchange of work dollars converted into passive assets is the only way to eventually end the need to work for income. And the best way to do this is to invest in stocks.
Model Portfolio Allocations
Before we close this article, let’s set some standards by using Vanguard’s Model Portfolio Allocation. The model you choose today will likely change over time. Historically, younger people that are far away from retirement have a more aggressive allocation versus someone closer to or in retirement. These allocation models can help you understand different goals-based investment strategies. There’s no right or wrong model, so it’s important to tune in to what you feel best fits your goals and risk tolerance.
What you won’t see in these portfolios are real estate, commodities, or other defined asset classes. For every 5% of my portfolio that is in real estate, I’ll reduce my stock percentage down. For example, if I want an allocation of 60% stock/40% bond plus I want 10% in real estate then my portfolio might look like:
- 50% stocks
- 35% bonds
- 10% real estate
- 5% cash
NOTE: Returns listed below are from 1926-2021.
INCOME
An income portfolio consists primarily of dividend-paying stocks and coupon-yielding bonds. If you’re comfortable with minimal risk and have a short- to midrange investment time horizon, this approach may suit your needs. Keep in mind, depending on the account, dividends and returns can be taxable.
- 100% Bonds
- Average annual return: 6.3%
- Best year (1982): 45.5%
- Worst year (1969): -8.1%
- Years with a loss: 20 of 96
- 20% stocks / 80% bonds
- Average annual return: 7.5%
- Best year (1982): 40.7%
- Worst year (1931): –10.1%
- Years with a loss: 16 of 96
- 30% stocks / 70% bonds
- Average annual return: 8.1%
- Best year (1982): 38.3%
- Worst year (1931): –14.2%
- Years with a loss: 18 of 96
One could call the people that invest for mainly income as those that have already won the asset accumulation game or they are just really conservative. Of course, the big concern for this group (mainly if they are just being conservative) is the impact that inflation has on their portfolio. The concern would be that they are to conservative and will run out of money in retirement.
Sequence of returns risk might have someone at 30% stocks/70% bonds and cash just before retirement and then they will glide path their way to a more aggressive portfolio once they are 5-10 years into retirement. This is the approach I’m using as I head into retire given that I’m about 30% equity at the moment with less than 3 years remaining until I retire.
BALANCED
A balanced portfolio invests in both stocks and bonds to reduce potential volatility. An investor seeking a balanced portfolio is comfortable tolerating short-term price fluctuations, is willing to tolerate moderate growth, and has a mid- to long-range investment time horizon.
- 40% stocks / 60% bonds
- Average annual return: 8.7%
- Best year (1982): 35.9%
- Worst year (1931): –18.4%
- Years with a loss: 19 of 96
- 50% stocks / 50% bonds
- Average annual return: 9.3%
- Best year (1982): 33.5%
- Worst year (1931): –22.5%
- Years with a loss: 20 of 96
- 60% stocks / 40% bonds
- Average annual return: 9.9%
- Best year (1933): 36.7%
- Worst year (1931): –26.6%
- Years with a loss: 22 of 96
I’ve always been a believer that a good 50/50 mix of stocks and bonds is an excellent way to not outlive your money. Of course, this depends on when I retire too. If I was retiring after a long-term bull market and there was a potential of poor market returns for several years then I might sit on a 50/50 for a few years and then move it to 60/40 if conditions seemed right. Is that timing the market? Perhaps but we do that in nearly every decision we make anyway.
GROWTH
A growth portfolio consists of mostly stocks expected to appreciate, taking into account long-term potential and potentially large short-term price fluctuations. An investor seeking this portfolio has a high risk tolerance and a long-term investment time horizon. Generating current income isn’t a primary goal.
- 70% stocks / 30% bonds
- Average annual return: 10.5%
- Best year (1933): 41.1%
- Worst year (1931): –30.7%
- Years with a loss: 23 of 96
- 80% stocks / 20% bonds
- Average annual return: 11.1%
- Best year (1933): 45.4%
- Worst year (1931): –34.9%
- Years with a loss: 24 of 96
- 100% stocks
- Average annual return: 12.3%
- Best year (1933): 54.2%
- Worst year (1931): –43.1%
- Years with a loss: 25 of 96
This growth allocation is likely best suited to younger people with over 10 years until retirement. However, it’s very likely I’ll have a portfolio that is tilted toward the growth allocation because of my large corporate pension (~$77,000) and good social security ($66,000 annually with wife and I). Additionally, I’m using a bucket strategy and my 3rd bucket, which is focused on kids inheritance, will be most stocks. Overall, it’s likely my portfolio in retirement will look close to this:
- 60% stock
- 30% bond/cash
- 10% real estate
I’ve not finalized my target asset allocations by age range (e.g. 60-70, 70-80, 80-death). If I’m comfortable with our cashflow and I’m still in my right mind then I want to still play the game. That would mean I’d still be actively managing my funds with an eye toward simplicity as I age.
Bucket Strategy Review
It’s important to understand how I’m going to use the Bucket Strategy in retirement as it relates to asset allocation. Yes, all assets combined will have an allocation percentage. It’s also important to know that each buckets will have their own important function and their own allocation.
- Bucket 1 & 2 – These buckets will be taxable assets and will fund my retirement. The buckets will have cash, dividend stocks, bonds, and real estate. Some assets will produce income, some will focus on growth, and some will be tax deferred until they are withdrawn (and then they’ll be taxed.
- Bucket 3 – This bucket will consist of my 401k, which will eventually become my Roth IRA. If all goes according to design, we should not need to use this bucket for our retirement. Its main purpose is our last resort funds and our kids inheritance. Because of this purpose, it will be focused on growth once I’m in retirement.
How I allocate Bucket 3, which we should not have to use in retirement, will be entirely different than Buckets 1 & 2. I’m more focused on how the buckets that will fund my retirement are allocated because they will need to last 30 years.
Sequence of Returns Risk
There are some real experts available to better educate people on sequence of returns risk (SRR) so I’m just going to mention it briefly here. In a nutshell, SRR is the the risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio.
If you are taking withdrawals from your portfolio, the order or the sequence of investment returns can significantly impact your portfolios overall value. For example, if during the first 10-years of your retirement your portfolio averages 10% per year you might think all is well. But, if you are drawing from your portfolio and the first few years of retirement the portfolio returns are -5%, -8%, and -2% then your portfolio might be at risk of not lasting through retirement.
Essentially, you will have a sequence that negatively impacts your portfolio and retirement. But if those 3-years of negative returns (-5%, -8%, and -2%) occur in year 10, 11, and 12 of retirement then you will have avoided the bad sequence. The most import part to avoid is about 5-years before retirement and 5-10 years after retirement. That 10-15 year period is the most dangerous from an SRR perspective.
For this article, we aren’t going into all the ways to handle this potentially bad SSR. But one major way to mitigate or minimize the risk is via your asset allocation. As you’ll see, my asset allocation has kept stocks on the lower of of my allocation (about 30%) but that will rise once I get into retirement. Since I’ve got good pension, I’m probably being overly conservative heading into retirement but that will resolve in year 1-5 of retirement as I move my 401k into a heavier stock portfolio. I’ll explain that in the next sections.
ASSET ALLOCATION – All My Investments
Regardless of how you might slice and dice your portfolio, it’s always good to get a look at the big picture. Though you will likely be managing various portfolio buckets that all have different purposes, it’s always important to remember that everything comes together into one big portfolio.
The most important thing to consider here is I’m entering retirement in less than 3-years so I’m in a de-risking mode. It’s probably a little conservative given my nice pension but it’s being done with intention.
Basically, my main assets currently sit in certain accounts:
- Stocks are mainly in my taxable account (Bucket 2). Eventually, they be both taxable and Roth IRA upon my retirement.
- Bond placement is a little tricky for me at the moment. The majority sit in a tax-differed account at work but will be paid out over 5-years the minute I retire (which is why I’ve got them listed in Bucket 2). I’ve got I-bonds in a taxable account and some in my 401k too.
- Cash is nearly all in my 401k (Bucket 3). I’m contributing the max to that account and just trying to conserve what’s there because I loose more than I gain by having it heavily in stocks. Once I retire, I’ll move those funds into stocks over time.
- Real estate is in my taxable account (Bucket 2) that is currently growth-focused. At some point in retirement, I’ll move this into more income producing and not focus as much on growth.
Like I said earlier, what ever you do with your allocation do it with intention based on your situation.
Bucket 1 & 2 – ASSET ALLOCATION
Including my pension and social security, it’s these two buckets (1 & 2) that will fund my retirement. Just a 5 years ago, these buckets were only about $75,000 in value. Today they are worth $460,000 and within 3-years (at retirement) it should be worth about $850,000.
This portfolio will be heavily dependent on stock dividend income through my retirement. I’ve got some assets, mainly my restoration fund at work that is considered a bond, that will help bridge me to social security at 70. Once I hit 70, most of these assets shouldn’t be needed for living because my pension and social security should provide for most everything. At least that is the plan.
Each year into retirement, my stock portfolio will naturally increase in allocation because I’ll be pulling from my bonds. These bridge assets helps me eliminate the sequence of returns risk (SRR) because I don’t need to sell any stock during a down year. In fact, for the first 8-years of my retirement (ages 62-70), I could completely eliminate most portfolio spending if needed because of the pension. This flexibility is just another way to minimize SRR.
My allocation of government I-Bonds, work restoration fund (another bond), and cash will drain down until social security begins at 70. Again, my situation is unique to me. Most people won’t have a $75,000-$80,000 pension at retirement. That’s like having about $1.5M extra in the portfolio … it’s really that sweet.
Honestly, I’ve not determined what my allocation will be after 70. I won’t need the funds so I’ll probably have a stock allocation in the 60-70% range in these buckets. Each year, the stock dividends can either be spent or reallocated into a new stock or bond.
Bucket 3 – ASSET ALLOCATION – My Kids Inheritance
This allocation is a little deceiving right now. When I retire, it will likely be 100% stocks. The plan is that we won’t need the funds so we’ll keep it focused on our kids inheritance and our LTC back-up plan.
At retirement, this portfolio will be an all growth portfolio. If money isn’t invested in stocks it will likely be in cash waiting to be invested. If 10-year government bond rates have raise to 6-7% then I’d certainly consider parking some money in bonds until a good stock opportunity comes along.
I suppose there could come a day when this portfolio is modeled into a growth/income or income/growth portfolio but that would likely be when I’m in my 80’s. Only time will tell.
Again, the purpose of this bucket enables it to be focused on stocks. My risk and time horizon combined with not likely needing the funds for retirement make this something unique. If I didn’t have the pension, then I’d imagine these funds would be funding my later years of retirement and I’d manage the allocation accordingly.
This means it would be growth focused for some time until I felt it needed to be focused on producing income. Sequence of returns risk would come into consideration because probably handle the allocation like I would as I near retirement. Meaning, if the funds were needed at 80 then I’d probably start de-risking about 70 to more bonds and continue that bond allocation accordingly. Again, that’s where the art and science converge.
Summary
I’m the first to admit that my asset allocations have historically been poor. I’ve either had too much speculative stock, too much cash, no real estate (minus my house), and little consideration for my corporate pension.
Why do I mention the pension? Because that large $75,000-$80,000 pension allows me to take more risk since I’m likely not needing to sell stocks to cover my basic needs. And let’s not forget one asset I didn’t mention if you don’t have a pension … the annuity! Many recommend taking your bond allocation at retirement and buying a life annuity to raise your income floor. This would give you a chance to take more risk with the remaining assets.
Remember, your asset allocation should never be static, because your needs will likely change over time. You’ll want to review your allocations periodically to ensure that it continues to make sense for your situation. As asset valuations move so will your allocations adjust over time too. For example, if the stock market is doing well, your allocation to stocks will likely grow and become a larger percentage of the portfolio. If this occurs, rebalancing should be considered to bring your portfolio back in line with your ideal allocation.
The easiest way to change allocations might be by redirecting new cash to the area(s) that need changed. For example, if my stock allocation is 50% and I want it to be 55%, then one choice I have is by directing all new money to buying stock. This will change your allocation over time and you won’t need to sell anything. Of course, if you are in a tax-advantaged account (e.g. IRA or 401k) then you won’t have any tax ramifications to worry about.
Thanks for reading!
Mr. TLR