I write a handful of columns a year for ACEP NOW. This recent article originally ran here and is an answer to a complex question I frequently get.
Q. What Should the Mix of Stocks and Bonds Be in My Retirement Portfolio?
Unfortunately, explaining that sentence is going to take the rest of this article. The process of deciding how much of your portfolio to invest in what type of security, such as stocks, bonds, and real estate, is called asset allocation. It turns out that, in the long run, asset allocation (ie, determining the mix of risky assets such as stocks to less risky assets such as bonds) matters far more than individual security selection or your ability to time the market, so it is a great place to spend your limited financial planning time and effort.
The mix of assets determines both your long-term return as well as the volatility of the portfolio. Now, upward volatility rarely bothers investors—it’s the pesky downward volatility that represents losing the money you invested for retirement instead of spending it on a kitchen remodel. Let’s just focus on that. Vanguard, the only mutual fund company owned by its investors, put together a nice study of asset allocation models using data from 1926 to 2015 that gives an idea of the return and worst annual period (but not necessarily worst peak to trough) you could expect in the past with a given stock-to-bond ratio. I summarize its data in Table 1.
Table 1: Historical Return and Maximum Drawdown from Stock-Bond Ratios. Source: Vanguard; personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations.
There Are a Few Things That Can Be Learned From Table 1
1) There is a general correlation between risk and return. If you were willing to tolerate the possibility of bigger losses, you experienced higher returns. The difference between earning a 10 percent return and an 8 percent return is not insignificant. Over 30 years, investing the same amount every year, a 10 percent return results in your nest egg, your retirement income, being 48 percent larger than what you would have with an 8 percent return.
3) Stocks are risky. While the worst year for a 100 percent stock portfolio was a 43.1 percent loss, that understates the way a loss feels. That figure comes from the loss from Jan. 1 to Dec. 31, not the peak-to-trough, which is the percentage decline from the fund’s highest net asset value (peak) to the lowest net asset value (trough) after the peak. For example, in 2008, the US stock market lost 37.1 percent. However, the peak-to-trough loss was -48.4 percent. It was even worse if you extend the period to the bear market bottom in March 2009 (-52.9 percent). Basically, in a nasty bear market, you should expect to lose about 50 percent of the value of whatever portion of your portfolio you invested in risky assets such as stocks.
The Psyche of Losing 40-50% of Your Money
If you have not lost real money in a bear market before, it is a bit difficult to understand how it feels. It is not a matter of logically looking at a 40 percent to 50 percent loss and saying, “I’ll tolerate that because I want those 10 percent returns.” It is more of a visceral feeling of loss. While intellectually you may be able to tolerate that sort of loss, emotionally you may not be able to withstand the very real pressure from your partner, family members, co-workers, media, and your own psyche. Experienced physician investors compare it to the sleepless nights associated with being named in a medical malpractice lawsuit.
Staying With Your Plan in a Bad Bear Market
No turning back now. She's got to stick with the plan.
To make matters worse, if you succumb to that pressure and abandon your plan in the depths of a bad bear market, the results will be far worse than if you had just invested a little less aggressively in the first place. Thus, to get the highest possible returns, you generally want the highest stock-to-bond ratio that you can tolerate without selling out at a market bottom. Unfortunately, most people don’t know what they can tolerate until they have invested through a nasty bear market, such as 2008–2009. There are many attending physicians in the workforce who have never done that. My advice is to pick an asset allocation that is less aggressive than what you think you can tolerate, at least until you pass through your first bear and prove your risk tolerance to yourself. Don’t overestimate your ability to sleep well while hemorrhaging money.
Hedging Against the Risk of a Permanent Decline in Stock Value
There is another factor to consider. The data in Table 1 comes from the past. Physicians in the evidence-based medicine era are all quite familiar with the limitations of retrospective data. The future does not necessarily have to resemble the past. The real risk of stocks is not that they will decline in value temporarily, but that they will decline in value permanently. While that risk is likely fairly low, it’s not zero. Owning some less risky assets in the portfolio is a good way to hedge against that unlikely possibility.
In addition, many investment authorities expect future returns, at least for the next decade, to be lower than the historical averages due to low interest rates and high stock valuations. While my crystal ball is cloudy about what the future holds for stock market returns or interest rates, it’s important to realize that if your retirement plan relies on your achieving historical rates of return to succeed, it may not be as robust of a plan as you think. You may need to save more, work longer, or even take more risk with your investments than you would like, knowing that the risk of running out of money in old age may be worse than the risk of losing money in the markets.
Decide Carefully and Then Stick With Your Chosen Plan
Asset allocation is a personal decision that you should make after careful consideration and in consultation with your advisors and those you care about. While there is little performance difference between a 65-35 portfolio and a 60-40 portfolio, you need to get your asset allocation in the right ballpark and then stick with it through thick and thin to reach your financial goals.
Did you stick with your plan during the last bear market? How did you mentally deal with losing 40-50% of your investment? Did you change your allocation as a result? What asset allocation lets you sleep well at night? Sound off below!
I have a really interesting article coming out on physician on fire at the beginning of March that discusses my asset allocation and the reason behind it. Not to spoil it, but my asset allocation is 100% stocks currently, and will stay that way until my student loan debt is paid off in full. I may keep it that way for a few years after that before going to 90/10 or 80/20.
You really have to wrap your mind around a bear market and what it means. If you KNOW that there are really only two possibilities, then you should be able to tolerate the negative volatility:
1) The market must come back up, and if it does come back up keeping my money in will be the best thing in the long run…must maintain a big picture image. This is an opportunity to buy stocks on sale.
2) IF the market does not come back up and crashes into oblivion, you don’t need more bonds in this situation… you need more rifles, ammunition, and water.
So, if the market has to come back up, always has come back up, and you are putting any money into the market… you have to view a Bear market as an opportunity to buy stocks “on sale” that will come back up in value after the correction/recession ends. A bear market, particularly early in your career, can be a great thing.
I’ve said this before, but I actually hope for a strong bear market over the next three to five years for this exact reason. Let me get all my money in low and watch it come back up. (To be clear, I don’t believe in timing the market… I am just going to keep plugging away regardless of what the market does).
While I agree with your long-term view, this exact viewpoint is why you should keep ‘some’ bonds, even if 90-10. It would allow you to better take advantage of the stocks on sale by being able to rebalance from your bond allocation (which ‘should’ grow as the stocks tank). Given the typically higher cashflow of the audience here, you could argue that doller cost averaging is enough, but you are likely putting yourself on the other side of the efficient frontier trade off of variability vs return. Looking forward to your article!
Completely understand what you are saying and think that is obviously a very reasonable recommendation (90/10). I’ll leave the post to explain my thoughts. Looking forward to seeing what you think!
TPP
Another downside to 100% stocks is the amount of time it takes to recover. It’s much easier if you re-balance in these situations. Additionally, when looking at table 1 above, you sacrifice a return of 0.6% to prevent a loss of 8.2% in one year. You reduce risk more than you gain in returns. This principle is laid out very well in this chapter in Road Map for Investing Success:
https://investingroadmap.wordpress.com/2011/02/25/205/
Point taken.
My position is one of being fresh out of training. So I don’t have a whole lot to lose at the moment and can tolerate the loss should it occurr. I have 60 years to make up any losses.
I do plan to change my asset allocation in about two years, though my situation will be different then.
Thanks for the reference! Interesting thought experiment and numbers.
yep 2008,with relatively meagre assets was hungry for “dry powder”, and didnt care re decline. Not sure if will have the “guts” closer to retirement.
Absolutely right. I definitely will not have the guts closer to Retirement! But that point I’ll likely be 60/40.
Of course, there’s also the middle-ground scenario where the market stays down but the world doesn’t end… your nest egg just grows much slower and you have to work an extra decade or 2 when you’d like to be retired. Also a pretty scary scenario…
Not going to keep this asset allocation for that long. It will serve its purpose for the next two years or so before I go to 90/10 or 80/20.
Two years? That means 10-20% of your portfolio is money you need in 2 years to buy bonds. Sure you want that invested in stocks?
Not sure I understand the question, WCI. I don’t need to move any of my money in two years from stocks to bonds. I can just start investing my new contributions into bonds and would get to 90/10 pretty quick and have a 90/10 split in two (or two and a half) years time.
Yea, that’s probably true.
Spoken very much like someone who has not had a significant amount of money invested during a big market crash. As WCI said, it’s very hard, if not impossible, to imagine what it feels like during one of these crashes.
“Everyone has a plan until they get punched in the mouth”
My favorite Mike Tyson quote, except perhaps, “I’m going to fade into Bolivian” 🙂
Haha I hear ya. The thing is that I am young in my career and didn’t come to enlightenment on financial stuff until about 18 months ago. Now I love it and can’t get enough.
Because of this, I don’t have a tremendous amount in the market. Two years from now it’ll probably be around $200k.
I also have a firm grasp on bear markets, the opportunity to buy on sale, and not selling low.
I guess we will have to wait and see! If I don’t sell or change during the next big down turn you owe me a beer! If I do, the beer is on me!
Happy Philosopher, I like your blog BTW. In regards to 1) “the market must come back up”…. so were saying the Japanese in 1991. And look where the Nikkei has been for the last 26 yrs, an entire lifetime of investing for some.
At that time there was an expansionary monetary policy over there. And guess what has been happening here for a while?
I get it about being young in career and having not a lot of money invested, I am in the same boat. But I would not count on the market coming back up. I am 80/20 with even less percentage dedicated to stocks if I count real estate crowdfunding on the side. I agree 100% stocks is reasonable if you can stomach the pain, as long as nobody takes for granted that the Dow will rebound … like it has done “forever”.
Sorry for the bit of hyperbole. I am invested globally as well, not just in American stocks, for the exact reason you are mentioning. Completely agree with everything you said, though. Sage advice, truly.
Thanks for visiting my website, too! Much appreciated.
Those aren’t the only two possibilities. The third possibility is that the market crashes and then does recover in the “long term” but you are dead by then. Just ask the Japanese. Their market will eventually get to the 1989 high but even folks who were 30 years old then will be dead by then.
Many in this thread, and it seems to happen everywhere dont think about the overall goal, path, and amounts when discussing these things. Is this really a riskier portfolio than 50/50? Maybe, maybe not.
If you’re just starting out a 20-30 year career your first years contribution will end up being around 1% of your portfolio or something ridiculously similar. Your contributions will make up the great majority of gains until at least 10 y out, and even likely to 15 years. Is it really risky to be 100% stocks during the initial 5-10 years? You have a smaller account balance that is usually overcome with your contributions, and your spreading your total equity risk exposure over a longer time frame.
I would argue its actually less risky in the long run, the amounts are smaller and you’ve a ton of human capital still. This allows you to better control your glide path and increase your bond allocation towards the tail end of your career when SORR are higher and equities are indeed riskier.
This type of front loading and focus on the overall account at retirement can allow you to harvest and increase in upside account value while getting the same overall risk.
I dont care if I lose 99.9% of a 10 dollar portfolio, its meaningless. People with large account balances lost/gained six figures a day this week, more than years of contributions. Everything has to be put in perspective.
I happen to agree with you Philosopher Physician, I myself am planning to go with an active investment of real estate for rental as a “tangible” asset, and for my brokerage accounts and 401(k) plans I fully intend to use a Warren Buffet portfolio of 90% US Equities and 10% Bonds.
Should the market fall I will take money out of bonds if I need it, and during my re-balance buy the stocks on sale, thus my bond purchases are in a bond fund mostly, so that I can re-balance. This gives my account the ability to shift money into low price bond funds during bull markets for stocks, maintaining the 90/10 portfolio, and allowing me to have the bond fund appreciate when stocks tank, when i strategically re-balance my portfolio the next year.
Should the stock market tank totally I don’t expect the government or its bonds will be solvent, and for that eventuality I have canned food and secure shelter, and don’t anticipate any of my investments to be very valuable except in my own personal health and safety.
Should the market go back up then the stocks recapture their value, including the extra I moved out of bonds into those stocks. In short the bonds really have four purposes:
1 They add some diversification
2 They provide a semi-liquid store of wealth in an investment account not tied to stocks directly that money can be strategically moved into or out of.
3. The bonds can be leaned upon in retirement should stocks be at a low price, at least until stock prices perk back up giving me a good chance to re-allocate back into bonds and use the stocks at their higher value
4. Municipal bonds are an option for low taxation investment
I happen to agree with you Philosopher Physician, I myself am investing in real estate for rental as a “tangible” asset, and for my brokerage accounts and 401(k) plans I am using a Warren Buffet portfolio of 90% Equities and 10% Bonds. I am considering having 20% in foreign equities as well.
If stocks crash and don’t come up then the government and its money and bonds are likely worthless as well. Ten percent in bonds allows me to re-balance, and acts as a buffer to provide money while I wait on prices to perk back up. My plan for government collapse is mostly survival based rather than worrying about legal “assets”.
Granted its possible I may not be alive to withdraw it at a great price if the market stays down for a few decades, but I should essentially be fine because of my direct real estate investments, my pension, my social security, and other assets. I would also consider leaving my unused retirement stock and bond allocation in a trust for my heirs.
I really think rental real estate passive income is a good backbone for those who are both working and in retirement. Beyond this I really think partial retirement is preferable to full retirement to avoid a work gap should an unintended shortfall in funds occur. Consultant jobs and part time medical jobs are pretty easy as a partial retirement solution to “ease” into retirement.
Vanguard makes a wonderful 11 question asset allocation questionnaire. Most docs get to a 70 percent stock allocation plus or minus 5 percent. The questionnaire helps sort out this issue very quickly. I would like to make the argument that you don’t “lose” money in a bear market. Specifically, I do not agree with this statement: it’s the pesky downward volatility that represents losing the money you invested for retirement instead of spending it on a kitchen remodel.” First, just because we are in a bear market does not mean you have lost the money. You only lose the money when you SELL in a bear market. Historically at least, bear markets represent a temporary incorrect quote on the value of your securities. Ben Graham, Warren Buffett’s mentor, calls this a “temporary vagary of finance.” Additionally, if you want to remodel your kitchen, that money should not be in the stock market. The stock market is for money that you won’t be using for 7 plus years. Bear markets will force investors to buy low because their allocation to stocks will have declined. The true long term investor roots for a bear market and does not like a bull market. I subscribe to Jeremy Siegel’s argument that over long periods of time being in cash is risky, and stocks are safe. That is, you are close to guaranteed to lose your purchasing power of real goods over time in a “safe” cash investment at a FDIC insured bank. A car 15 years ago does not cost what a car costs today. Hence, the “risk averse” investor lost purchasing power over time and cannot purchase a car like the “risky” stock market investor can. All that said, a possible permanent decline in the stock value is an important one. Although theoretical, the clever author of the article does make a valid point that it is not a zero probability event and a “black swan” is possible. Clear as mud, eh?
Randy-
That simply isn’t true. Thinking about it that way may help you stay the course with your plan, which matters far more than whether you actually lost money or not, but asserting “you didn’t really lose money because you didn’t sell” is simply false. The money is gone. Will a wise investment probably increase in value in the future? Sure. But that doesn’t mean it isn’t gone for now. Every day you lose and gain money on your house, you just don’t realize it because it isn’t marked to market daily. But when it goes down in value, you really did lose money. Likewise, when your stocks or Bitcoin or whatever else goes down in value, you really did lose money.
I agree, it’s akin to people saying they are “playing with the house’s money” when they have gains. It’s never the house’s money, it’s always your money.
Exactly. It’s all psychological tricks to help you stay the course. Fine if that helps you, but let’s not kid ourselves here.
In mark to market accounting, yes, I agree it IS a loss. There is no doubt about that, by formal definition. If I had a bill that day (March 2009) and sold the stock to pay the bill, then yes, it IS a loss. However, on your IRS federal taxes, it did not count as a loss, just like this year I don’t have a capital gain on my Vanguard Total Stock Index Fund. I am referring to the practice of stock market investing as it applies to philosophy and general attitudes toward stock market fluctuations. I suppose we are arguing about accounting definitions more than anything. My argument is that most investors do not, and should not, mark their portfolios to market every day. For example, I don’t think your audience is going to log on at 4pm today and tally their losses or gains. This number is not meaningful as you have written previously because it is money you won’t be using for decades.
I agree with everything but your last sentence. It is meaningful because it is where you stand right now. If you’re not going to use that number to determine where you stand, what number are you going to use? There is no better number. You’re arguing that the number doesn’t matter, not that this isn’t the number to use.
WCI responses to this thread are correct if you subscribe fully to the efficient market hypothesis. They are not correct if you don’t.
It doesn’t need to be completely efficient for acting as if it is to be the right move.
Here’s a link to the Vanguard Asset Allocation Questionnaire. A lot of people like this, and I suppose it is better than nothing, but it isn’t nearly as useful as a gauge of your risk tolerance as your actual behavior in a bear market.
https://personal.vanguard.com/us/FundsInvQuestionnaire
It recommends 100% stocks for me and I assure you that was not the right asset allocation for me in 2008. So take it with a grain of salt and err on the conservative side until you go through your first bear market.
Have you written about balancing one’s risk aversion with their spouse’s? I am much more risk averse than my wife on these questionnaires and in real life. I also know my wife fairly well and she does not tolerate losing money at all even though she answers that she would buy in a down market in these questionnaires (completely false when reality hits).
Thank you for all that you do.
I think I’d go with the more conservative spouse.
“First, just because we are in a bear market does not mean you have lost the money. You only lose the money when you SELL in a bear market.”
I would disagree with this although using that mindset might help people get through a bear market. A portfolio is only worth what it is worth at a given moment. If being in a bear market doesn’t mean you have lost money, then it must also be true that being in a bull market doesn’t mean you have gained money.
Which in my opinion is true. Until you realize the loss or gain..its not a loss or gain. So you’ve supposedly made 100% on that one stock…yeah and you can lose 50% of it tomorrow if you have not realized those gains so until you do that..no gains or losses have been locked in. The goal is not to sell in a down turn and one way of avoiding that is to realize that these losses are not realized. Why do we talk about investing for the longer term if we are on here advocating for recognizing the short term fluctuations as gains or losses which I agree could be substantial in a downturn.
I agree with the original poster.
Agree- sorry didn’t see this before adding my comment below
I feel sort of like it IS true. A house or a stock portfolio is “worth” what you can sell it for today (or soon). In that case my white elephant of a house is worth 50% of the money I have in it, or less. But if I have a year or three to wait on selling it, maybe I could get 200% of the money paid on house and improvements. (And as we tell each other, if we can’t sell it for what we want/ need to move where we wish, we’ll change our mind about moving!
So all knowing my portfolio has lost 40% does is make me anxious? And want to buy more stocks. But I have “bonds” (in my case laddered CDs) to cover a cheap wedding for each of my kids, the car one might need, the Ivy league degree I have agreed to pay for if she’s accepted to such a place. ANything further down the road, well, if I don’t have a convenient decently priced time to sell stocks then I have to reduce how large I’m living or plan to live in retirement. (Having already mostly retired, working longer/ going back to work probably won’t be the answer.) So it really doesn’t matter for a few years until I run through my budgeted ‘bonds’ where the stock market is.
And no use feeling or telling myself I lost 50% or gained 50%- until I lock in those losses or gains.
As you stated the numbers in the table are true, but deceptive. I wouldn’t want people to think the loss is “capped” at that level. I have experienced a 25% loss in one day (1987), the tech crash of 2000, and I don’t even want to talk about 2008! Older investors remember scary times in the 1970’s. In the last GFC my “diversified” portfolio hemorrhaged over 50%. At one mutual fund company, my account went from millionaire to not a millionaire and was still plummeting. My overall fees and the fees for each account shot up due to lower balances. It felt like the end of the U.S. economy. When 100-year-old pillars like Bear Stearns are quaking, anything could happen. It felt like we were heading for another 89% loss like in the great depression. I agree that unless you experience this you won’t know how you will react. So, in summary, if you are investing for 5-10 years or more then you should have mostly stocks. Maybe 100% stocks. But if there is any chance you would freak out and sell at the wrong time, consider adding short-term bonds to “smooth out the ride.”
MY PHILOSOPY IS SIMPLE-if I can tolerate a 50% loss in my equity allocation and have it not affect my lifestyle
obviously in retirement AA is much more critical
Vanguard now thinks 4-6% in equities in the next 5-10yrs but who really knows
REVERSION TO THE MEAN
AA is critical but saving prolifically makes the road to success much faster
When I was practicing my first $$$ monthly went into pension plan
Compounding is the 8th wonder of the world
No need in my mind to be 100% stocks age 30-40 when most physicians start making money
Buffett says be fearful when others are greedy and greedy when others are fearful. Charlie Munger once likened a frothy stock market to a New Year’s Eve party that has gone on long enough. The bubbly is flowing, everyone is enjoying themselves, the clocks have no arms on them. No one has a clue that it is time to leave, nor do they want to. How about just one more drink?
The problem is in knowing how long conditions will persist. The market seemed frothy a year ago, but if you would have been fearful, you would have missed an amazing year of returns. Since I’m not Buffett or Munger, I see the wisdom in the “coffee can” strategy of set and forget. I’ve done the set, now the big challenge will be to forget (and just keep buying) when the bottom falls out.
Great post Doc… I’m at my highest percentage of stocks that I’ve ever been, mostly because the bull keeps raging and those funds are going nuts. In a good way of course. A big part of me wants to move a decent chunk to my Total Bond Index fund and correct, but the voice in my head say “you can’t time the market dude, don’t pretend you can”. I probably just need to do it and forget it. If I miss out on more raging-bull gains then so be it. I need to set my percentages and stick to them.
You can set a target asset allocation and stick to it. You don’t need to panic sell and take a tax hit. If you’re in the accumulation phase, put more money into the asset where you’re light. If you’re in the retirement phase, draw down more from the asset category where you’re heavy.
You shouldn’t watch your asset allocation veer out of control as if you’re helpless. Take responsibility for correcting back to your desired asset allocation. It forces you to buy the asset class that’s on sale relative to the other.
As another person who like wealthydoc has actually experienced a bad market I cannot emphasize enough that you do not know yourself until you experience some bad times. I had no money in the ’87 crash but my oldest brother did. His money was heavily invested in the company he worked for and it slowly returned (IBM). He learned about diversification the hard way. 2000 dotcom implosion I had lots of individual stocks. I lost a lot of money. I was also very skewed to tech stocks. I gradually sold these positions but not in a panicky way. 2008 for me I had recovered from the dotcom bust and my net worth was higher than in 2000. 2008 was scary because the whole financial system seemed to be on thin ice. If you did not experience this it is hard to explain. I managed to do something right in that I swapped one big mutual fund position to something similar at the same fund family. I had a $300000 tax loss harvest. As the market got on good footing again I was able to realign most of my portfolio into indexes. I also bought a couple of stocks. Citigroup for about $1 and Apple. I still own the Apple. If you feel you must do something look for BIG tax loss harvest opportunities and of course do not panic.
$300,000 loss to tax loss harvest? Egads. Offsetting $3,000 of income for 100 years would be a record I think.
Well, of course she could apply it to capital gains at any future point as well. My 2008 tax loss harvest was more modest and I long ago used it up against income tax.
They often get burned through faster by realized gains and capital gains distributions.
The decision is very personal. I am retired and have no bonds, I have dividend paying stocks instead. If you don’t have that much taxable income you pay no federal income taxes. There is also a difference between your actual cash flow and the value of your investments.
Dividend paying stocks are not a bond substitute. Maybe you don’t need bonds, but don’t pretend any kind of stocks are the same thing. Many stocks cut dividends in 2008 AND lost a lot of value while safe bonds went up in value.
https://www.whitecoatinvestor.com/substituting-dividend-stocks-for-bonds-friday-qa/
Great reminder post to all of us who have been enjoying the ride in one of the longest bull market in history.
What goes up must come down and diversification is the key to asset protection. I started looking at bonds two years ago but decided on a more conservative ETF. Still, bonds are under consideration possibly in the next two years or so as I get a little older. Currently, I am still at 70% equity FYI.
I’ve been 90 / 10 since I really started paying attention to my asset allocation. Before that (maybe 6 or 7 years ago), I was closer to 100% stocks, including through 2008 / 2009.
My plan in retirement is to hold about 5 years’ worth of bonds (i.e. with a budget of $80,000 a year, we’ll have $400,000 in bonds). So we may start out with an allocation of 85 /15, but if the portfolio grows in retirement (which it normally does if we don’t suffer a poor sequence of returns early on), I can see a glidepath where our stock allocation actually grows in retirement as the bond allocation becomes smaller in terms of the percentage.
It also helps to have different income streams (real estate, small business, etc…) that can allow you to be more aggressive if you want to be.
Best,
-PoF
This is an interesting way of looking at allocation. Think about the bond allocation in terms of a margin of years of safety. I like.
Thanks, Kevin. It’s basically a modification of the bucket strategy with a “cash cushion.” But research shows that the opportunity cost of the cash drag you’ll see in most years is stronger than the benefit you’ll get from spending down the cash cushion in the occasional nasty bear market.
Bonds are obviously not a perfect substitute for cash, but they’re not likely to tank to the extent that stocks will in a bear market, and should provide some returns over the long haul, keeping up with inflation, and perhaps performing a bit better, depending on the type of bond holdings and relative risk. I simply hold the Total Bond Index. TIPS would be another option.
Best,
-PoF
100% stocks through ’87, ’00, and ’08–didn’t flinch a bit. I don’t worry about the 50% haircut just around the corner, because as Buffet says, my investing timeline is forever. If you can stomach the investment risk when you are young and able to ride out the bears with sacrifice, earned income, and continued investing; then the presumably overall higher returns will give you a big enough portfolio that will allow you to ride out the bears when you are old–without needing to take your foot off the gas pedal. If you are end of career/retired and have a portfolio that barely allows you to retire, that’s when you need to be careful.
“A big enough portfolio that will allow you to ride out the bears when you are old” – I like that.
that is my philosophy. Will it suck? sure….but if you have 20 million and it goes to 10 million your life will probably not change vs if you have 1 million and it goes to 500K. we never took foot off gas (87, dot.com bust, 2008)…this week we bought three rounds of stocks…who doesn’t love a sale????
For psychology of investing, I cant recommend The Simple Path to Wealth by JL Collins enough. Very entertaining read, and really gives a good perspective on how your attitude to the stock market should ideally be. If you can maintain the course, there is no way to fail. Failure happens when you sell at the bottom.
I agree with that. It’s a real financial catastrophe if you do that in your 50s or 60s.
I have ~20% bonds. Though I think I could survive the volatility of 100% equities, my primary rationale for having a 20% bond allocation was efficiency — a small decrease in expected returns in exchange for a relatively larger decrease in standard deviation. I admit, though, at times over the past few years I have second-guessed the bond allocation, but decided it’s better just to stick with the original plan.
Fantastic article. As another one who has seen 3 bears, your risk tolerance can change as your career and investment portfolio progress through life. In 1987, I was in residency with very little savings so the bear wasn’t relevant to me. In 2000, because I was early in my career and I was in the accumulation mode, it was easy to keep putting money into the market every month. In 2008, I considered myself mid-career but still accumulating. WCI explained it perfectly, when the market craters there is a battle between your intellect and emotions. If your emotions win, and mine did to the tune of selling about a third of my portfolio, use the opportunity to reassess your risk tolerance. If the selling generates tax losses, even better, you can reallocate while minimizing capital gains taxes. Now as I approach the end of my career, I am still a relative aggressive equities investor, but now keep a significant cash/bond position in my taxable account at or above a level to cover at least 3 years of living expenses. It allows me to sleep better at night and hopefully tolerate the next downturn without changing my investing plan. We should all prepare for bear markets and be ready to learn from them.
While stocks and other equities are certainly risky, bonds come with their own form of risk as well. Mainly, interest rate risk. Also, a 5% return from a bond fund is only about a 2% real return after inflation. Not too impressive.
Currently, I’m in the all equities all the time camp. Any money that I don’t feel comfortable risking is in my FDIC insured online savings account, much safer than bonds.
Re: interest rate risk, it’s mainly an concern if the duration of the bond isn’t aligned with the time horizon of the investment. If you’re a long-term bond investor holding a diversified ladder of maturities then you should generally be happy to see interest rates rise.
I disagree that interest rate risk is the main risk with bonds. That’s a relatively minor risk as long as you stick to short and medium term bonds and are investing money you probably won’t need for longer than the duration of the bonds. The main risks are default risk and inflation risk. You can minimize default risk by keeping quality high and you can fight against inflation risk by holding other asset classes and using inflation-indexed bonds like TIPS and I Bonds.
WCI, do you mean buying actual TIPS bonds, or do you mean investing in a TIPS bond fund, or both?
Either is fine. Pluses and minuses each way.
Is table 1 annual declines or peak to trough declines? In one paragraph, it says it’s peak to trough but then a following paragraph suggests it’s annual.
The data is annual. It was my error to describe it as peak to trough. Amazingly, you’re the first to catch that error.
1/3 total stock
1/3 international
1/3 bonds
Will save 50% of gross annually
Will (probably) work 30+ years
That ought to do it
Uhhh…yea. That’ll work just fine. It’ll likely work in about half that time.
I think savings rate matters tremendously and is rarely discussed as a factor. Asset allocation is almost irrelevant for many of the accumulation years as you pile in new assets. When new contributions are a meaningful percentage of your portfolio total, it also eases psychological pain during market corrections. Suffering a 50% dip is easier when you have $20k and even $200k invested, especially if you are saving $50k a year. Bottom line – I think most investors spend way too much time agonizing about and trying to optimize AA. Until you have a portfolio well into the 6 figures, just focus on saving.
I also think the dollar amounts involved can skew the percentage amounts that are reasonable in theory. 100% stocks is fine for many people with $100k or less, but when you have $2m invested, it’s a different thing to see 7 figures disappear overnight. On the other hand, having 50/50 stocks/bonds may seem reasonable in theory to a retiree – but if you have a $10m portfolio it is difficult to see multiple millions of dollars barely returning the inflation rate.
I agree. Savings rate matters much more than rate of return during the first half of your career, then vice versa. That is one factor that should be considered when determining your asset allocation.
For those close or just retired and who have sufficient funds to do so, i recently asked myself a question that made it very clear how to adjust my AA to where it should be:
“If the stock market dropped 50 percent would i still retire?”
If the answer is no, adjust stock AA downward until answer is yes.
Does anyone think most retirees are 50% in equities
In retirement living off your ira and taxable acts is a different game
In my experience (I’m a private banker and work with our wealth managers often), most retirees are around 50/50 – more or less aggressive by 10-20% depending on a variety of factors. Having reliable income from a business, RE, or pension makes some folks more aggressive; having truly “won the game” with 8 figures or more makes some people a lot more conservative since they have no need to take risk.
I’m just going to close my eyes, hang on, and keep buying. We put ~5k a month into mostly index funds in addition to 5% of pre-tax income into a govt sponsored pension that the govt contributes 15.34% salary to. I suppose the pension plan is the insurance to a big crash.
I was 90/10 for about 30 years. And the 10 was cash, not bonds. Never worried much about the down times.
I’ve moved to 60/40 over the last few years, since I might retire in a month or year or two.
The feeling of “missing out” on the awesome recent gains ate at me for a while.
But Friday’s drop made me appreciate my new bonds!
A retiree with 50% equities hit with a bad sequence of returns might never r3cover and have his portfolio depleted before his demise
I am 20% and can absorb a 50% equity loss which is not improbable
I know this website and WCI generally has an anti-Dividend investing bend but here is another Asset Allocation strategy people may want to consider: holding a diversified dividend portfolio or dividend etf and live off dividends only in retirement. Augment this with 5x living expenses in short term government bond fund from which you only withdraw if dividends get cut. If you can get 4% yield from your dividend portfolio (possible currently here in Canada but likely not currently in states due to lower payout ratios and higher valuations), you now have a conservative 3.3% withdrawal rate. In your drawdown stage do the following: in years where your dividends grow greater than inflation, put the greater than inflation part in your bond fund, and consume the rest of your dividends. In years where your dividends decline or grow less than inflation, draw the difference from your bond funds. Never worry about sequence of returns because you never sell stocks. Sure probably anything with a 3.3% withdrawal rate will be successful but here you are really acting like a business owner (your stocks) with a reasonable amount of safe savings (your bonds) rather than someone who is beholden to the whims of the market. Even if the market crashes 50% in price (since dividends are less volatile than price let’s assume worst case scenario they drop 40% — your bonds of 5x living expenses can still cover Many many many years of the difference until the dividends recover). Just some food for thought for those looking for an alternative way to think about things than the pure Bernstein/bogleheads approach.
That will probably survive just fine but is also likely to leave a great deal of money on the table.
Also important to keep in mind that dividends get cut. Many stocks cut their dividend in 2008-2009.
I’ve wondered why brokerage firms don’t give you the option to remove the returns being posted and instead report the number of shares you have accumulated.
You’ll always have positive “results”, which will only accelaerate during a downturn. It more accurately reflects the goal of investing… accumulate as many shares as possible before retirement.
If you don’t see the red numbers, you can continue investing without anxiety (if you’re capable of ignoring the news). Red numbers should also be removed from brokerage websites.
I bet you love stock splits.
Once we gave our kid our 10 shares of Hershey right as it split and were confused for a few days that she AND we both had 10 shares. By the time of the second kid we weren’t mucking about with changing ownership on stock certificates. Next gifts mutual fund shares.
Don’t buy stocks.
But psychologically, stock splits are not red events. They keep you in the game.
Once retired, shouldn’t equity/bond ratio include PV of Pensions and Social Security?
Example, my ratio of investments is 70/30 and I’m retired. However, when I include the Present Value of my Pension, and Social Security, my ratio drops to 48/52.
Isn’t the 48/52 a better representation of my ratio? Also, included in my consideration is the amount of investment income used for living expenses is around .5%. As long as this number is low, this methodology is a better representation of the Equity/Bond ratio. Any thoughts on this approach?
No. It’s usually better to just reduce the amount of income you need your portfolio to provide by the amount of the pension and Social Security rather than trying to assign a present value to it.