What is the best asset allocation for a retirement portfolio, and why?

Question

Based on financial conversations I've had with trusted family members, I believe that asset allocation is one of the more critical things to "get right" during retirement savings.

Based on an aggressive investing portfolio and timeline, where can I find more information about what asset allocation is right for me?

One example article comes from the New York Times, linked here.

Of interest would be:

1. articles to read
2. books to read
3. general investing paradigms.

Specifically, most asset allocation engines (e.g. Vanguard) will recommend a mostly stock-based (not bond based) asset allocation plan with an aggressive time horizon. I'm looking for indexes to invest in, and classifications (small cap, large cap, mid cap, international developed or international developing) stocks.

EDIT: What I'm really looking for here is the following:

1. Why should I invest 20% in domestic large cap and 10% in developing markets instead of 10% in domestic large cap and 20% in developing markets? Should I invest in REITs? Why or why not?
2. What mutual funds or index funds should I investigate to implement these strategies?
3. Any resources that help to answer questions like this above.

Answer 1

You're right, the asset allocation is one fundamental thing you want to get right in your portfolio. I agree 110%. If you really want to understand asset allocation, I suggest any and all of the following three books, all by the same author, William J. Bernstein.

• The Intelligent Asset Allocator,
• The Four Pillars of Investing,
• The Investor's Manifesto.

They are excellent – and yes I've read each. From a theory perspective, and being about asset allocation specifically, the Intelligent Asset Allocator is a good choice. Whereas, the next two books are more accessible and more complete, covering topics including investor psychology, history, financial products you can use to implement a strategy, etc. Got the time? Read them all.

I finished reading his latest book, The Investor's Manifesto, two weeks ago. Here are some choice quotes from Chapter 3, "The Nature of the Portfolio", that address some of the points you've asked about. All emphasis below is mine.

Page 74:

The good news is [the asset allocation process] is not really that hard: The investor only makes two important decisions:

1. The overall allocations to stocks and bonds.
2. The allocation among stock asset classes.

Page 76:

Rather, younger investors should own a higher portion of stocks because they have the ability to apply their regular savings to the markets at depressed prices. More precisely, young investors possess more "human capital" than financial capital; that is, their total future earnings dwarf their savings and investments. From a financial perspective, human capital looks like a bond whose coupons escalate with inflation.  

Page 78:

The most important asset allocation decision is the overall stock/bind mix; start with age = bond allocation rule of thumb. [i.e. because the younger you are, you already have bond-like income from anticipated employment earnings; the older you get, the less bond-like income you have in your future, so buy more bonds in your portfolio.]

He also mentions adjusting that with respect to one's risk tolerance. If you can't take the ups-and-downs of the market, adjust the stock portion down (up to 20% less); if you can stomach the risk without a problem, adjust the stock portion up (up to 20% more).

Page 86:

[in reference to a specific example where two assets that zig and zag are purchased in a 50/50 split and adjusted back to targets]   This process, called "rebalancing," provides the investor with an automatic buy-low/sell-high bias that over the long run usually – but not always – improves returns.

Page 87:

The essence of portfolio construction is the combination of asset classes that move in different directions at least some of the time.

Finally, this gem on pages 88 and 89:

Is there a way of scientifically picking the very best future allocation, which offers the maximum return for the minimum risk? No, but people still try.   [... continues with description of Markowitz's "mean-variance analysis" technique...]   It took investment professionals quite a while to realize that limitation of mean-variance analysis, and other "black box" techniques for allocating assets.

I could go on quoting relevant pieces ... he even goes into much detail on constructing an asset allocation suitable for a large portfolio containing a variety of different stock asset classes, but I suggest you read the book :-)

Answer 2

Abstract

This turned out be a lot longer than I expected. So, here's the overview.

Despite the presence of asset allocation calculators and what not, this is a subjective matter. Only you know how much risk you are willing to take. You seem to be aware of one rule of thumb, namely that with a longer investing horizon you can stand to take on more risk. However, how much risk you should take is subject to your own risk aversion. Honestly, the best way to answer your questions is to educate yourself about the individual topics. There are just too many variables to provide neat, concise answers to such a broad question. There are no easy ways around this. You should not blindly rely on the opinions of others, but rather use your own judgment to asses their advice.

Some of the links I provide in the main text:

S&P 500: Total and Inflation-Adjusted Historical Returns

10-year index fund returns

The Motley Fool

Risk aversion

Disclaimer: These are the opinions of an enthusiastic amateur.

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The "essay" itself

Why should I invest 20% in domestic large cap and 10% in developing markets instead of 10% in domestic large cap and 20% in developing markets? Should I invest in REITs? Why or why not?

Simply put, developing markets are very risky. Even if you have a long investment horizon, you should pace yourself and not take on too much risk. How much is "too much" is ultimately subjective. Specific to why 10% in developing vs 20% in large cap, it is probably because 10% seems like a reasonable amount of your total portfolio to gamble. Another way to look at this is to consider that 10% as gone, because it is invested in very risky markets. So, if you're willing to take a 20% haircut, then by all means do that. However, realize that you may be throwing 1/5 of your money out the window.

Meanwhile, REITs can be quite risky as investing in the real estate market itself can be quite risky. One reason is that the assets are very much fixed in place and thus can not be liquidated in the same way as other assets. Thus, you are subject to the vicissitudes of a relatively small market. Another issue is the large capital outlays required for most commercial building projects, thus typically requiring quite a bit of credit and risk. Another way to put it: Donald Trump made his name in real estate, but it was (and still is) a very bumpy ride. Yet another way to put it: you have to build it before they will come and there is no guarantee that they will like what you built.

What mutual funds or index funds should I investigate to implement these strategies?

I would generally avoid actively managed mutual funds, due to the expenses. They can seriously eat into the returns. There is a reason that the most mutual funds compare themselves to the Lipper average instead of something like the S&P 500. All of those costs involved in managing a mutual fund (teams of people and trading costs) tend to weigh down on them quite heavily. As the Motley Fool expounded on years ago, if you can not do better than the S&P 500, you should save yourself the headaches and simply invest in an S&P 500 index fund.

That said, depending on your skill (and luck) picking stocks (or even funds), you may very well have been able to beat the S&P 500 over the past 10 years. Of course, you may have also done a whole lot worse. This article discusses the performance of the S&P 500 over the past 60 years. As you can see, the past 10 years have been a very bumpy ride yielding in a negative return. Again, keep in mind that you could have done much worse with other investments.

That site, Simple Stock Investing may be a good place to start educating yourself. I am not familiar with the site, so do not take this as an endorsement. A quick once-over of the material on the site leads me to believe that it may provide a good bit of information in readily digestible forms. The Motley Fool was a favorite site of mine in the past for the individual investor. However, they seem to have turned to the dark side, charging for much of their advice. That said, it may still be a good place to get started. You may also decide that it is worth paying for their advice.

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This blog post, though dated, compares some Vanguard index funds and is a light introduction into the contrarian view of investing. Simply put, this view holds that one should not be a lemming following the crowd, rather one should do the opposite of what everyone else is doing. One strong argument in favor of this view is the fact that as more people pile onto an investing strategy or into a particular market, the yields thin out and the risk of a correction (i.e. a downturn) increases.

In the worst case, this leads to a bubble, which corrects itself suddenly (or "pops" thus the term "bubble") leading to quite a bit of pain for the unprepared participants. An unprepared participant is one who is not hedged properly. Basically, this means they were not invested in other markets/strategies that would increase in yield as a result of the event that caused the bubble to pop.

Note that the recent housing bubble and resulting credit crunch beat quite heavily on the both the stock and bond markets. So, the easy hedge for stocks being bonds did not necessarily work out so well. This makes sense, as the housing bubble burst due to concerns over easy credit.

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Unfortunately, I don't have any good resources on hand that may provide starting points or discuss the various investing strategies. I must admit that I am turning my interests back to investing after a hiatus.

As I stated, I used to really like the Motley Fool, but now I am somewhat suspicious of them. The main reason is the fact that as they were exploring alternatives to advertising driven revenue for their site, they promised to always have free resources available for those unwilling to pay for their advice. A cursory review of their site does show a decent amount of general investing information, so take these words with a grain of salt. (Another reason I am suspicious of them is the fact that they "spammed" me with lots of enticements to pay for their advice which seemed just like the type of advice they spoke against.)

Anyway, time to put the soapbox away. As I do that though, I should explain the reason for this soapboxing. Simply put, investing is a risky endeavor, any way you slice it. You can never eliminate risk, you can only hope to reduce it to an acceptable level. What is acceptable is subject to your situation and to the magnitude of your risk aversion. Ultimately, it is rather subjective and you should not blindly follow someone else's opinion (professional or otherwise). Point being, use your judgment to evaluate anything you read about investing.

If it sounds too good to be true, it probably is. If someone purports to have some strategy for guaranteed (steady) returns, be very suspicious of it. (Read up on the Bernard Madoff scandal.) If someone is putting on a heavy sales pitch, be weary.

Be especially suspicious of anyone asking you to pay for their advice before giving you any solid understanding of their strategy. Sure, many people want to get paid for their advice in some way (in fact, I am getting "paid" with reputation on this site). However, if they take the sketchy approach of a slimy salesmen, they are likely making more money from selling their strategy, than they are from the advice itself. Most likely, if they were getting outsized returns from their strategy they would keep quiet about it and continue using it themselves. As stated before, the more people pile onto a strategy, the smaller the returns. The typical model for selling is to make money from the sale. When the item being sold is an intangible good, your risk as a buyer increases.

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You may wonder why I have written at length without much discussion of asset allocation. One reason is that I am still a relative neophyte and have a mostly high level understanding of the various strategies. While I feel confident enough in my understanding for my own purposes, I do not necessarily feel confident creating an asset allocation strategy for someone else. The more important reason is that this is a subjective matter with a lot of variables to consider. If you want a quick and simple answer, I am afraid you will be disappointed. The best approach is to educate yourself and make these decisions for yourself. Hence, my attempt to educate you as best as I can at this point in time.

Personally, I suggest you do what I did. Start reading the Wall Street Journal every day. (An acceptable substitute may be the business section of the New York Times.) At first you will be overwhelmed with information, but in the long run it will pay off. Another good piece of advice is to be patient and not rush into investing.

If you are in a hurry to determine how you should invest in a 401(k) or other such investment vehicle due to a desire to take advantage of an employer's matching funds, then I would place my money in an S&P 500 index fund. I would also explore placing some of that money into broad index funds from other regions of the globe. The reason for broad index funds is to provide some protection from the normal fluctuations and to reduce the risk of a sudden downturn causing you a lot pain while you determine the best approach for yourself. In this scenario, think more about capital preservation and hedging against inflation then about "beating" the market.

Answer 3

Aggressiveness in a retirement portfolio is usually a function of your age and your risk tolerance.

Your portfolio is usually a mix of the following asset classes:

• Stocks = Historically the highest return, but also very volatile
• Foreign/Developing Countries = Potentially a high return, but it's more of a gamble. (What if China's economy doesn't boom like we expect?)
• Bonds = Lower return, less volatile (varies depending on the specific type of bond)
• Money Market = Most Conservative, pretty much zero risk

You can break down these asset classes further, but each one is a topic unto itself.

If you are young, you want to invest in things that have a higher return, but are more volatile, because market fluctuations (like the current financial meltdown) will be long gone before you reach retirement age. This means that at a younger age, you should be investing more in stocks and foreign/developing countries.

If you are older, you need to be into more conservative investments (bonds, money market, etc). If you were in your 50s-60s and still heavily invested in stock, something like the current financial crisis could have ruined your retirement plans. (A lot of baby boomers learned this the hard way.)

For most of your life, you will probably be somewhere in between these two. Start aggressive, and gradually get more conservative as you get older. You will probably need to re-check your asset allocation once every 5 years or so.

As for how much of each investment class, there are no hard and fast rules. The idea is to maximize return while accepting a certain amount of risk. There are two big unknowns in there: (1) how much return do you expect from the various investments, and (2) how much risk are you willing to accept. #1 is a big guess, and #2 is personal opinion.

A general portfolio guideline is "100 minus your age". This means if you are 20, you should have 80% of your retirement portfolio in stocks. If you are 60, your retirement portfolio should be 40% stock. Over the years, the "100" number has varied. Some financial advisor types have suggested "150" or "200". Unfortunately, that's why a lot of baby boomers can't retire now.

Above all, re-balance your portfolio regularly. At least once a year, perhaps quarterly if the market is going wild. Make sure you are still in-line with your desired asset allocation. If the stock market tanks and you are under-invested in stocks, buy more stock, selling off other funds if necessary. (I've read interviews with fund managers who say failure to rebalance in a down stock market is one of the big mistakes people make when managing a retirement portfolio.)

As for specific mutual fund suggestions, I'm not going to do that, because it depends on what your 401k or IRA has available as investment options. I do suggest that your focus on selecting a "passive" index fund, not an actively managed fund with a high expense ratio.

Personally, I like "total market" funds to give you the broadest allocation of small and big companies. (This makes your question about large/small cap stocks moot.) The next best choice would be an S&P 500 index fund.

You should also be able to find a low-cost Bond Index Fund that will give you a healthy mix of different bond types.

However, you need to look at expense ratios to make an informed decision. A better-performing fund is pointless if you lose it all to fees!

Also, watch out for overlap between your fund choices. Investing in both a Total Market fund, and an S&P 500 fund undermines the idea of a diversified portfolio.

An aggressive portfolio usually includes some Foreign/Developing Nation investments. There aren't many index fund options here, so you may have to go with an actively-managed fund (with a much higher expense ratio). However, this kind of investment can be worth it to take advantage of the economic growth in places like China.

http://www.getrichslowly.org/blog/2009/04/27/how-to-create-your-own-target-date-mutual-fund/

Answer 4

It's all about risk. These guidelines were all developed based on the risk characteristics of the various asset categories. Bonds are ultra-low-risk, large caps are low-risk (you don't see most big stocks like Coca-Cola going anywhere soon), foreign stocks are medium-risk (subject to additional political risk and currency risk, especially so in developing markets) and small-caps are higher risk (more to gain, but more likely to go out of business).

Moreover, the risks of different asset classes tend to balance each other out some. When stocks fall, bonds typically rise (the recent credit crunch being a notable but temporary exception) as people flock to safety or as the Fed adjusts interest rates. When stocks soar, bonds don't look as attractive, and interest rates may rise (a bummer when you already own the bonds). Is the US economy stumbling with the dollar in the dumps, while the rest of the world passes us by? Your foreign holdings will be worth more in dollar terms.

If you'd like to work alternative asset classes (real estate, gold and other commodities, etc) into your mix, consider their risk characteristics, and what will make them go up and down. A good asset allocation should limit the amount of 'down' that can happen all at once; the more conservative the allocation needs to be, the less 'down' is possible (at the expense of the 'up').

.... As for what risks you are willing to take, that will depend on your position in life, and what risks you are presently are exposed to (including: your job, how stable your company is and whether it could fold or do layoffs in a recession like this one, whether you're married, whether you have kids, where you live). For instance, if you're a realtor by trade, you should probably avoid investing too much in real estate or it'll be a double-whammy if the market crashes. A good financial advisor can discuss these matters with you in detail.

Answer 5

Take the easy approach - as suggested by John Bogle (founder of Vanguard - and a man worthy of tremendous respect). Two portfolios consisting of 1 index fund each. Invest your age% in the Fixed Income index fund. Invest (1-age)% in the stock index fund.

Examples of these funds are the Total Market Index Fund (VTSMX) and the Total Bond Market Index (VBMFX). If you wish to be slightly more adventurous, blend (1-age-10)% as the Total Market Index Fund and a fixed 10% as Total International Stock Index (VGTSX).

You will sleep well at night for most of your life.

Answer 6

The best asset allocation is one that lets you sleep well at night. Can you stomach a loss of 50% and hold on to that asset for 3 years, 5 years, or however long it will take to bounce back while everyone is telling you to sell it at a loss? All these calculations will be thrown out the window at the next market panic. You've probably been in situations where everyone's panicking and the market seems upside down and there are no rules. Most people think they'll stay rational, but unless you've been through a market panic, you don't really know how you'll react.

Answer 7

Retirement portfolios have two phases: an accumulating phase where you are saving money and a consumption phase where you are using up the saved money.

During the accumulating phase you are saving money every month and you are looking for the greatest growth possible. This is achieved by having a stock heavy portfolio with a few or no bonds. Since this portfolio doesn't give you income yet, you can accept it's volatility risk for great growth potential.

During the consumption phase your portfolio provides you income and as such you don't want volatility anymore so you switch to a more conservative portfolio typically it means more bonds than stocks.

When to switch? (based on comments)

It depends on your retirement plan. Most people seems to have a fixed age plan: "I want to retire by age X". If the market is bullish and keeps beating historical records like now, you probably want to switch 5-6 years before that age. As it takes roughly 5 years to recover from a recession. So if a recession hits tomorrow it won't hit you hard at retirement if you switched to bonds before.

Others have different plans. For example I don't have a fixed age in mind, instead I ask the following questions: How much money will I need each month after I retire? How many years do I expect to live? How high real returns should I expect on my portfolio? After I have answers for the first 3 questions I can use an annuity calculator to calculate the money I need. And just keep working and saving until the portfolio hits the mark, and then switch.