[Editor’s Note: This article first appeared as part of our series on Advanced Asset Allocation Strategies. To read the rest of this series, check out: Asset Allocation Part 1: What It Is and Why You Need It, Asset Allocation Part 2: Constructing an Efficient Portfolio, and Asset Allocation Part 3: Your Stock and Bond Portfolio Mix]

For the precursors to my final article on asset allocation, see Part 1, Part 2, and Part 3.

It’s time to wrap up this topic with some concrete model portfolios. As I said in Part 3, each person’s situation is different and requires an individualized financial plan, but providing four general guidelines may at least steer you clear of making a really big mistake.

Guideline #1: High Stock Allocation When Young, With Gradual Reduction

Over the long term stocks have historically outperformed virtually every other asset class. Consequently, you must own a core stock allocation early in your investing life (i.e., in your 20s and 30s) when you actually have a long timeframe. Furthermore, you should hold these stocks for the long term in order to take advantage of their likely long-term outperformance. A rule of thumb says that your stock allocation percentage should be 120 minus your age. So, if you’re 20 years old, stocks should be 100% of your portfolio, 95% at age 25, 90% at age 30, etc. Similarly, Vanguard founder Jack Bogle’s rule is to have your bond allocation equal your age.

A more simplistic model can be found on the American Funds website, which provides typical asset allocation plans for various stages in your life, with stocks gradually decreasing as you get older:

Asset Class	20 Years or More to Retirement	5 to 20 Years to Retirement	5 Years or Less to Retirement	First 10 Years of Retirement
Growth Stocks	40%	20%	15%	0%
Dividend-Paying Stocks	35%	35%	30%	20%
Balanced Funds (60% Stock, 40% Bond)	20%	20%	20%	30%
Bonds	5%	25%	35%	50%

Keep in mind that American Funds is primarily a growth shop, so their allocations may be biased towards growth. I’d use the chart simply as a dividing line between stocks and bonds.

Leverage Up!

Two Yale Economics Professors go even further and advocate owning a 200% weighting in stocks early in your investing life by leveraging your equity 2-to-1 with margin debt. Early leveraging allows you to reduce your stock exposure more quickly as you age and accumulate more assets, thus reducing your overall lifetime risk of running out of money. As Professor Barry Nalebuff puts it:

Most people, when they have lots of stocks, don’t have the long run, and when they have the long run, don’t have lots of stocks. People seriously underinvest in the market for the first 25 years of their working life.

The increased market exposure when young allows you to have less exposure later on. And while the total market exposure is the same, it’s better spread out. Therefore, it has less risk.

Returns across time are even less correlated than returns across stocks.

A 100% stock allocation at age 20 isn’t as risky as it sounds because most 20-year-olds don’t own much money. So even if all their stocks were to go to zero, it wouldn’t be very damaging in dollar terms. This strategy is something to consider if you can tolerate margin calls.

By the time you have reached your late 40s and 50s, however, years of earnings often result in a decent-sized amount of savings/investments. Consequently, maintaining a 100% stock allocation into your 50s is not wise even though you may still have a 30- or 40-year life expectancy remaining. The dollar risk of losing a significant chunk of your portfolio is simply too great.

Guideline #2: Overweight Value and Small-Cap Stocks Within The Stock Allocation

In his book Predicting the Markets of Tomorrow, money manager James O’Shaughnessy advocates a stock portfolio composed of the following allocation:

Equity Style	Proposed Allocation	Specific ETFs Recommended	Generic Market Weight
Large-Cap Value	50%	iShares Russell 1000 Value (NYSE: IWD)	22.5%
Large-Cap Growth	15%	Vanguard Growth (NYSE: VUG)	52.5%
Small-Cap	35%	iShares Russell 2000 (NYSE: IWM)	25%

This proposed allocation significantly overweights value and small-cap stocks. What is the justification for this overweighting? O’Shaughnessy says that large-cap growth stocks had their best 20-year performance relative to large-cap value stocks ever between 1980 and 2000. Historically, whenever growth stocks have performed so well, they have performed relatively poorly in the following 20-year period (i.e., 2001-2020).

Similarly, large-cap stocks had their best 20-year performance relative to small-cap stocks ever between 1980 and 2000. If history repeats, they should perform poorly in the following 20-year period.

Guideline #3: Diversify Beyond Stocks and Bonds

Common stocks and bonds (governments, corporates, and mortgage) are not the only two asset classes in existence, yet people often limit themselves to these two. As I demonstrated in Part 2, the more asset classes with low correlations included in your portfolio, the better. David Swensen, chief investment officer of the Yale University endowment, recommends the following 70% stock, 30% bond allocation for retail investors:

Asset Class	Proposed Allocation	Relevant ETF
Domestic Stocks	30% (25%)	Vanguard Total Stock Market (NYSE: VTI)
Real Estate Investment Trusts (REITs)	15% (10%)	Vanguard REIT Index (NYSE: VNQ)
U.S. Treasury Bonds	15%	iShares Barclays 7-10 Year Treasury (NYSE: IEF)
U.S. Treasury Inflation-Protected Securities (TIPS)	15%	iShares Barclays TIPS Bond (NYSE: TIP)
Foreign Developed-Market Stock	15%	iShares Barclays EAFE Index (NYSE: EFA)
Emerging Market Stock	10%	Vanguard Emerging Markets (NYSE: VWO)
Commodities	(10%)	ELEMENTS S&P Commodity Trend Index (NYSE: LSC)

There has been some criticism of this allocation. Namely, it didn’t perform very well during the 2008 market meltdown and could have benefitted from an allocation to gold or other commodities. Academic studies support an allocation to commodities, so I would change Swensen’s allocation (see percentages in parentheses for my changes). I also think his mix of bonds is too heavily weighted to U.S. Treasuries given current low inflation and interest rates, so I would put more in TIPS. Economist Zvi Bodie recommends 100% in TIPS.

Ladder Up!

Another way to fix Swensen’s bond allocation would be to keep his U.S. Treasury bond allocation but construct it as a bond ladder. A bond ladder invests equal portions of an allocation in bonds of different maturities. For example, in a five-year ladder, 20% would be invested in a one-year bond, 20% in a two-year bond, etc. When one bond matures and principal is returned, the principal is reinvested in the furthest-out maturity (e.g., a new five-year bond). In a rising interest-rate environment with a steep yield curve (like we have now), this laddering process allows you to periodically reinvest money at higher rates while still enjoying the higher rates of bonds versus cash. Ed Easterling, author of Unexpected Returns, has demonstrated that bond ladders of 10 years or shorter have never lost money, even during the high-inflation 1970s:

Fixed income investors have been paralyzed by the fear of rising interest rates. Many investors have elected to hold cash rather than to reinvest farther out on the yield curve in maturities that offer higher interest rates. Although an immediate rise in interest rates does cause a decline in the value of bonds, the loss of higher yields while waiting for better prices can be significant. As well, this analysis of historical interest rates shows that simple bond ladders, particularly maturities of 10 years and less, did not experience annual losses anytime over the past century. A simple bond ladder may be one of the best approaches for fixed income investing as the potential for rising rates looms.

Bond funds, including ETFs, employ bond ladders to some extent, so I’m not necessarily saying you need to construct these ladders yourself. However, doing it yourself does provide the peace of mind of knowing that ladders are being used to the fullest possible extent.

Geoff Considine vs. David Swensen

Another diversified asset allocation model worthy of note is that of money manager Geoff Considine. He optimizes portfolios of different stock exposures, all the way from 10% stock to 80% stock. For comparison purposes to Swensen’s model, let’s look at Considine’s 70% stock, 30% bond portfolio, which includes commodities:

Asset Class	Proposed Allocation	Specific ETF Recommended
Large-Cap Domestic Stocks	15%	iShares S&P 500 (NYSE: IVV)
Small-Cap Domestic Stocks	5%	iShares Russell 2000 (NYSE: IWM)
Real Estate Investment Trusts (REITs)	15%	iShares Cohen & Steers Realty Majors (NYSE: ICF)
Foreign Developed-Market Stock	5%	iShares Barclays EAFE Index (NYSE: EFA)
Utility Stocks	10%	iShares Dow Jones U.S. Utility Index (NYSE: IDU)
Emerging Market Stock	5%	iShares MSCI Emerging Markets Index (NYSE: EEM)
Taxable Bond	5%	iShares Barclays Aggregate Bond (NYSE: AGG)
U.S. Treasury Inflation-Protected Securities (TIPS)	25%	iShares Barclays TIPS Bond (NYSE: TIP)
Commodities	15%	iPath Dow Jones-AIG Commodity (NYSE: DJP)

Guideline #4: Post Retirement, Understand Product Allocation and Sequence of Returns Risk

Once you have retired and are withdrawing money each year from your retirement nest egg, asset allocation is not enough. You need to supplement asset allocation with product allocation.

Moshe Milevsky, Finance Professor at Toronto’s York University, discusses product allocation in his book Are You a Stock or Bond?, as well as in this interview:

As people transition from accumulating wealth to distributing income and creating an income stream, they are going to have to think more broadly about their investment. Although their asset allocation will not have to change, their product allocation will have to change.

What do I mean by product allocation? Investing in things like annuities, investing in things that have lifetime income, investing in things with downside protection, investing in things that keep up with inflation – product allocation as opposed to asset allocation.

Retirement savings are but one retirement product, albeit the one everyone is familiar with. Milevsky calls it the “Systematic Withdrawal Plan” and it is the product that benefits from asset allocation. He recommends 70% stocks and 30% bonds for a 65-year-old because it offers the highest likelihood of maintaining a sustainable income stream that doesn’t run out. Milevsky, however, considers only generic stocks and bonds as the possible investment universe.

Geoff Considine, in contrast, says that a more conservative 50% stock, 50% bond allocation is optimal for a 65 year old if you diversify into more asset classes:

 

Asset Class	Proposed Allocation	Specific ETF Recommended
Large-Cap Domestic Stocks	15%	iShares S&P 500 (NYSE: IVV)
Small-Cap Domestic Stocks	5%	iShares Russell 2000 (NYSE: IWM)
Real Estate Investment Trusts (REITs)	5%	iShares Cohen & Steers Realty Majors (NYSE: ICF)
Foreign Developed-Market Stock	5%	iShares Barclays EAFE Index (NYSE: EFA)
Utility Stocks	5%	iShares Dow Jones U.S. Utility Index (NYSE: IDU)
Emerging Market Stock	5%	iShares MSCI Emerging Markets Index (NYSE: EEM)
Taxable Bond	10%	iShares Barclays Aggregate Bond (NYSE: AGG)
U.S. Treasury Inflation-Protected Securities (TIPS)	40%	iShares Barclays TIPS Bond (NYSE: TIP)
Commodities	10%	iPath Dow Jones-AIG Commodity (NYSE: DJP)

 

How Much Can You Safely Withdraw From Savings Each Year?

After retirement, you aren’t earning any money, so you must live off of your retirement savings. As far as an optimal annual withdrawal rate, Milevsky says that an initial withdrawal rate of 4.7% (indexed for inflation at 3% per year) is sustainable, but that a higher withdrawal could be preferable if the person has a higher risk tolerance or other income streams. Financial planner Jonathan Guyton believes that a 6.2% annual withdrawal rate is sustainable if a retiree is willing to follow three rules:

1. If your portfolio loses money during the year, you can’t give yourself a raise the following year. In other words, if you add up your portfolio’s year-end value and the money withdrawn during the prior 12 months and this sum is less than your portfolio’s beginning-of-year value, you can’t increase your next year’s withdrawal to compensate for inflation.

2. No matter how high inflation gets, your maximum annual increase is 6%.

3. You have to avoid selling hard-hit stock funds. Instead, each year, start by lightening up on winning stock funds.

Having a stock portfolio (i.e., Milevsky’s Systematic Withdrawal Plan) is the retirement product needed to protect against inflation risk and erosion of purchasing power.

Two Retirement Risks That Asset Allocation Can’t Solve

But there are two other types of risk in retirement that a stock portfolio does not protect against: (1) longevity risk; and (2) sequence of returns risk. Other retirement products are needed to combat these risks.

Who Thought Living Too Long Could Be a Problem?

For longevity risk (i.e., the risk of outliving your assets), an insurance product known as an immediate lifetime annuity does the trick. With an annuity, you are guaranteed a fixed annual payout for life, regardless of how long you live. The advantage of an annuity is that you never run out of money; the disadvantage is that you lose ownership of the up-front payment you make to the insurance company, so that if you die early your heirs are screwed. There is an insurance rider you can purchase that guarantees a minimum payout equal to your initial investment, which is useful for your heirs if you die early, but this can substantially reduce your annual payout while you are living.

An Ibbotson Associates study found that investing 50% of your retirement savings at age 65 into a lifetime annuity and investing the remaining 50% in a 60% stock, 40% bond portfolio increases the odds that you will not run out of money by age 100 to 58%. In contrast, investing 100% of your savings in the 60/40 portfolio at age 65 provides you with only a 42% chance of still having money at age 100.

Insurance companies are willing to offer lifetime annuities and assume the risk that you live a long time because they pool longevity risk among thousands of people, many of whom won’t live a long time. The lump sum payments made by people who die early are called “mortality credits” and they defray the cost of paying annuities to people who live a long time.

The Sequence of Returns Matters in Retirement

Sequence of returns risk is the last risk that a retiree needs to protect against. It comes into play in retirement because of the annual withdrawals made from savings. Without withdrawals, the sequence of returns doesn’t matter. Whether your five-year portfolio returns on $100,000 are -12%, +10%, -8%, +9, and +16%, or the reverse: +16%, +9%, -8%, +10%, and -12%, doesn’t matter. Both sequences provide a total compound return of 12.6% or $112,602 over five years. But things change dramatically when you are withdrawing money every year. For illustrative purposes, I will use a ridiculously high 20% annual withdrawal rate and only a five-year period:

Scenario #1	Annual Return	Withdrawal at Beginning of Year	Year-End Balance
Year 1	16%	$20,000	$92,800
Year 2	9%	$20,000	$79,352
Year 3	-8%	$20,000	$54,604
Year 4	10%	$20,000	$38,064
Year 5	-12%	$20,000	$15,897

 

Scenario #2	Annual Return	Withdrawal at Beginning of Year	Year-End Balance
Year 1	-12%	$20,000	$70,400
Year 2	10%	$20,000	$55,440
Year 3	-8%	$20,000	$32,605
Year 4	9%	$20,000	$13,739
Year 5	16%	$20,000	$0

Getting negative returns to start retirement can have a devastating impact on your retirement and how long you can live without running out of money. Consequently, Milevsky recommends investing in insurance products that provide downside protection during the five years before and after retirement when sequence risk is highest. Product examples are put options and structured products like stock index-linked guaranteed investment contracts (GICs) and principal-protected notes.

That’s All Folks

I hope my four-part series on asset allocation has provided you with an appreciation for its importance in ensuring a happy and prosperous retirement. It takes a lot of thought and preparation, but properly constructing an investment portfolio – and adding insurance products to the allocation mix after retirement – is well worth the time and effort. If you consult with a qualified financial planner and follow the four guidelines outlined above, you should be OK. Good luck.

Editor’s Note: For more information on this topic, check out our FREE special report on Asset Allocation Strategies!