But as you’ll see below, it’s one of those parts of investing that you simply can’t ignore – largely because it can have a MAJOR effect on your finances and how long they ultimately last.
The reason I wanted to bring this up is because of the roller-coaster of market activity lately. In case you haven’t checked your stocks or 401k balance in a while, there have been some pretty big up’s and down’s to the stock market. Sometimes the Dow index has been down as much as 300 points – that’s almost a 2% down in one day!
How does your stomach feel after seeing a 2% drop in one day?
Or more importantly if you look at the Dow over the first 3 months since 2015 started, all the gains we’ve accumulated so far have been erased (notice how the chart starts and finishes pretty much right at the 17,800 line).
Again – how does your stomach feel after hearing that news?
It’s okay to answer “NOT GOOD!” We’re humans, and humans base a lot of our decisions on emotion. Try as hard as we do to separate emotion from logic when it comes to investing, it’s still admittedly very difficult not to admit that you feel a sting when you see something like that.
So what can we do about this? Well … obviously you can’t change what happens in the markets anymore than you can stand out in the middle of the expressway and expect to stop moving cars with your bare hands. So that’s where coming up with the right asset allocation model comes in. Deciding how you want to divide up your money between stocks, bonds, and whatever other types of investments is pretty much your only line of defense when it comes to protecting your fortune.
But I ask the question – how effective is this really?
To answer that, I put together a fun little experiment to see just how all of this would work.
Testing My Asset Allocation Model Against An Index Fund:
Read pretty much any financial blog or book and they will have you believing that the only thing you need to invest in is a stock market index fund.
While an index fund can be a strong part of your portfolio, it’s probably not the only thing you’d want to have in there – especially if you get the jitters when you see the markets take a nose dive.
So I ask this: Can we create an asset allocation model that gives us the best of both worlds? Strong returns BUT ALSO less fluctuation?
I decided to put this experiment to the test by creating a very simple portfolio made up of just three Vanguard Index Funds:
- Vanguard 500 Index Inv (VFINX) – 35%
- Vanguard Intermediate-Term Treasury Investor (VFITX) – 25%
- Vanguard Long-Term Treasury Inv (VUSTX) – 40%
(In other words, if every month I sent in $1,000 to Vanguard, I’d invest $350 in the S&P 500 stock market index, $250 in intermediate-term government bonds and $400 in long-term government bonds.)
It was pretty easy to download all the historical prices from Yahoo Finance, drop it all into Microsoft Excel, and then put together a mock portfolio to see how much money you’d have with a $1,000 investment every month. (My model starts at 1992 because that’s as far back as the Yahoo data went.)
So how does our asset allocation (blue line) stack up 23 years later by January of 2015 against JUST the S&P 500 stock market index fund (red line)?
Interesting! There’s a few things we can learn from this experiment:
- You actually DO make more money with only S&P 500 index fund (or at least during the years used for this data set). You would have ended with $822,017 for the Index fund versus $712,116 for our made-up portfolio. Percentage wise, that’s an annual compounded rate of 8.9% for the benchmark versus 7.8% for our asset allocation model.
- You actually had about the same number of bad years (years where you lost money): 5 for the index fund, 4 for our portfolio. However the amount of loss was much less significant for our portfolio: -8.9% versus -39.4% for the stock market index fund. By the way – both of those losses were during the infamous 2009 Great Recession!
- Similarly to Point No. 2, you actually had about the same number of bad months (months where you lost money): 96 for the index fund, 93 for our asset allocation. Again, the amount of loss was much less significant for our portfolio: -7.3% versus -16.8% for the stock market index fund.
(Note that author Daniel Solin published very similar results in his book The Smartest Retirement Book You’ll Ever Read.)
Hmmm … so what does this experiment say about asset allocation during the accumulation phase of wealth building? So far just proved to ourselves that over the last 23 years:
- We’d have made less money (although the annualized returns were very close)
- We’d have approximately the same number of “bad” years
- We’d have approximately the same number of “bad” months
So then … why bother?
Because that’s not where the story ends ….
Protecting Your Fortune During the Distribution Phase:
Suppose we were in retirement (or close to it) in what’s called the distribution phase. That’s when we’re taking money OUT of our nest egg for expenses.
Notice how our model (blue line) had far less “noise” as it climbed upward from left to right along the graph. That’s not true for the stock market index (red line). The fluctuations were far more jagged and more vertically spread.
Let’s come back to emotions: What would that do to your nerves? Remember in 2009 when there was that 39% drop in the stock market? How did you (or your parents) feel about seeing almost half of your 401k disappear? Suppose there was a million dollars in there. Then suddenly it’s only $610,000. Holy cow! It would be time to panic!
That’s where a good asset allocation model can help. It can reduce the severity of market swings to align with your tolerance for risk. In our portfolio we only lost as much as 9% during that same year. While that’s not great, that’s not nearly as scary as a 39% drop. Your million dollars would now only be $910,000 which is much safer than $610,000.
I believe the next scariest loss in our diversified portfolio was 4% followed by 2%. Now those are losses I can live with!
And the best part – it only cost you approximately 1% in overall annualized return to have that stability.
My second point and the crux to this whole discussion: During retirement as you made withdrawals that you will use for living expenses, losses can compound over time and eventually cause you to lose all your money more quickly.
The easiest way to prove this yourself is to use a cool program called FireCalc. Basically what this does is take any stretch of time over the past 100 years and show you how long your portfolio would have lasted (in other words how many periods your money would have lasted as opposed to how many periods you would have ran out of money). Not only is this a great way to test different withdrawal rates, but it also allows you to work with REAL historical market data.
Again – having the right asset allocation can make all the difference in the odds of how long your money will last. You have no idea what the stock market is going to do over the next 10, 20, or 50 years. This is perfectly okay while you’re working and building up your fortune in the accumulation phase. But when you retire and no longer are earning an income, you don’t want that! In the distribution phase you NEED consistency and confidence that your money will not run out before you die. And that’s where a diverse portfolio can really be useful – both for your emotions and your wealth.
Readers – How much do you pay attention to diversifying your investments? Does anyone have a good asset allocation model that they follow and swear by?
Featured Image courtesy of Kenny Cole | Flickr
We know that stocks can be volatile, offering either greater risks or rewards. Cash and income tend to be safer bets. While it’s generally advisable that I take on a more conservative investing approach as I reach retirement, it actually will depend on my own circumstances and tolerance for risk.
How much risk do you think you’d be willing to take on during the retirement years?
I’m comfortable enough with the swings in the market to ride out some down times. Right now our investments are 75% stocks to 25% bonds/income producing assets. Plus we have rental income pouring in so we are diversified that way as well. I know our stock allocation will be reduced as we move into retirement but that won’t be for another 20+ years.
If we had rental income I’m sure the allocation could swing a little higher towards stocks. Good tenants can equal stable income for a long time to come.
Right now it’s 100% stocks as I’m still in the accumulation years (with the exception of my emergency fund in cash). I might add real estate in the future, but no plans of bonds/t-bills, etc. anytime in the near future.
Interesting strategy going with all stocks. Given their volatility, you don’t think that adding in just a few bonds might help reduce your risk more than it adds to your potential gains?
Stock market out performs other asset classes over long periods of time (historically…) and I’m in it for the long haul.
That is true, and if you can stomach the ups and downs, then more power to you! Within the class of stocks, what are your feelings towards Mid and Small cap? I once saw (I believe it was in a book somewhere) that Small caps out-perform all other classes over time BUT have the most volatility of all.
As of right now, I am in the 60% US stocks, 20 International, and 20% bonds allocations. I don’t mind the ups and downs because I don’t need the money anytime soon. I plan to leave all the money in my 401K and Roth’s for decades to come so it can compound. I will fund my preretirement expenses with after tax dividend income and real estate income.
Any plan involving dividends and/or capital gains to fund your retirement income sounds like a solid plan to me. The real estate income won’t be too bad either; just be careful to select really good tenants.
As soon as I read what your portfolio contained, I thought “that’s a pretty low-risk allocation” …so I’m glad to see that it was less volatile for you!
Fun exercise.
That last chart looks like someone went to town with a box of pencil crayons, it’s hard to see much for all the noise!
That last chart was from FIRECalc. If you’ve never tried it before, I highly encourage you to give it a shot. It’s free. It basically takes your retirement estimates and tells you how long your money would have lasted given any period of market activity over the last +100 years. It’s really handy and can give you something of confidence when you’re putting your numbers together.
I was a 100% in stocks up until a few years ago and now have an 80/20 stock bond mix. Ups and downs don’t worry me right now, but it will become much more important as time goes on. I think anything I’d need within 10 years time, I would not put in stocks.
Interesting post. I would have guessed that your portfolio so heavily invested in bonds would have performed worse in terms of returns than it actually did.
I have an asset allocation model set up that has 80% stocks/20% bonds. From there, the 80% stocks is broken down between US large and small and international stocks.
I hope readers take away the impact of allocation when it comes to taking money out of your portfolio.
I must say I was pleasantly surprised by the stock/bond mix as well as I ran the numbers. What this tells me is that if you’re a person who values security over growth, you really don’t have to trade much opportunity to secure your portfolio. And vice versa – bonds are certainly no guarantee that every day in the market is going to be sunny. But there the magnitude of the changes are certainly much less.
This is great advice for anyone taking on a traditional retirement strategy (namely, the Trinity Study’s 4% Withdrawal Rate) or looking to invest in index funds. For myself, though, I invest 100% in stocks. But I invest differently. I’m a dividend growth investor, and dividend income is the end goal. Selling a stock is an event that only occurs in my portfolio if a stock takes a turn for the worst (meaning the fundamentals of the company have eroded and the dividend or even the company itself is at risk). Since the portfolio balance is trivial next to the actual dividend income, seeing a million dollars go down to $610,000 would be perfectly fine for me provided that my dividend income stays stable and growing. Look at Exxon Mobil during the recession; lost 40% of its share price but kept right on paying (and growing) that dividend. In fact, not only would I be perfectly fine with this, depending on my available capital to invest, I might even see it as an opportunity to invest more. That is, like I said, depending on whether I have the money on hand to invest (I am retired and living off that dividend income in this scenario, so I may just not have enough).
It is very important to be able to stomach a large drop. Warren Buffett has stated that if you can’t stomach a 50% drop in the value of your stocks, then you have no business being in the market. Jason Feiber of the blog Dividend Mantra has called stock volatility “opportunity” rather than “risk”. I believe both are 100% right. For me, a plummeting stock market provides me with opportunity. If I am retired and living off my dividends, then I regard a drop in share prices with apathy at the very worst (provided that the drop in prices are just reflections of market movements or macroeconomic factors rather than actual issues that may erode my companies’ profitability over the long term).
Of course, to do this, one must invest CONSERVATIVELY in stocks. That means no “exciting” Silicon Valley startups. Just “boring” blue chips like Coca-Cola and Johnson & Johnson.
Sincerely,
ARB–Angry Retail Banker
Good point with dividends. One of the big draws to dividend investing (when done correctly) is the fact that you can literally rely less on your asset allocation because your focus is more on the payout you will receive. Though I can no longer call myself a 100% dividend investor because I have grown to appreciate the upside of capital gains, dividend return is still a very, very important part of my own stock picking strategy (I own shares of KO and JNJ). In a lot of ways because of their guaranteed income I almost tend to treat conservative dividend bearing stocks like these with the reliability and security of bonds when I think about my own asset allocation mix.