Intro to Asset Allocation
Stocks, bonds, real estate, commodities, and cash, what should your investment portfolio consist of?
Asset allocation is a question every investor asks themselves, whether it is upon starting out, as you develop into a confirmed investor, or when you’re looking to add a spice of diversity to your portfolio. In this article we’ll look at stocks and bonds, two indispensable pillars of any portfolio.
The rule of thumb - 100 minus your age
The general rule is that your stocks to bonds allocation should be 100 minus your age. For example a 30 year old investor would hold 70% in stocks and 30% in bonds and, as an investor grows older, we progressively invest more in bonds. This can add stability to our portfolio and paves a smooth road to retirement. While this rule of thumb offers conventional wisdom, the main who coined it, John Bogle (creator of the index fund and founder of the non-profit Vanguard) admits that it was not meant to be taken literally.
Your asset allocation should not depend on your age, but on your goals. Once you have defined what you are trying to achieve through investing you can plan accordingly (e.g. financial independence, complement your pension, buy your dream house, or travel the world for two years). For me the goal is financial independence, i.e. the ability to live comfortably without having to work if I do not want to. To do so I need to keep investing and give my money time to grow. As I do not anticipate any large expenses and have a job which provides me with a source of income, I can afford to dedicate a large portion of my net-worth to equities for long term growth.
That said, I do keep about 24,000€ in bonds which acts as both my 6-month emergency fund and the cash set aside to take a 6 month vacation next year. I have kept the money in bonds as I want it to be available when I need it. While I can always sell some stocks to finance my vacation, I know myself well and, if the stock market crashes next year, I will not find the courage to sell my stocks at a discount so I can go on vacation (it is also the opposite of what you should do!). Storing cash in the form of bonds allows me to take this dream vacation no matter the market’s mood. But enough about me, let’s talk business!
Equity Allocation
Stocks should be the pillar of your portfolio; stocks massively outperform any other asset class over the long term. A small 250 euro monthly investment in a low-cost index fund will make you a millionaire in 40 years. Upon starting out, strive to have at least 70% of your portfolio in stocks to ensure your fair share of market gains (I’m at 85% and rising). If you already have an emergency fund, have a stable job for the foreseeable future, and do not anticipate any large expenses, you can even allocate 100% to stocks.
Should you reduce your stock allocation as you get older?
Not necessarily. Retirement shouldn’t be the end of your investment horizon.
Let’s say you retire at 60 while the life expectancy in your country is 83, that’s 23 more years in the market! Stocks will likely outperform bonds over such a long stretch.
If you retire earlier (which is easy if you start investing early), stocks become even more important. If you join the FIRE movement (Financial Independence Retire Early) and intend to retire at, let’s say, 40, heavy stock allocation is a must (provided that you have some liquidity set aside that you can dig into should the market crash (remember, never sell your stock during a stock market crash!)).
If you are nearing retirement: keep enough in bonds and/or cash to cover basic expenses for a few years and invest the rest in equities. This will allow you to retire at the time of your choosing and sleep soundly when the market crashes.
Equity allocation should depend on your stock portfolio
There are thousands of stocks out there, all of which have a size, nationality, growth and risk profile and this must be considered. For example a portfolio composed of 70% stocks can be either extremely risky or deceptively safe, depending on whether you bought the next hot tech stock or a conservatively financed giant in consumer staples.
Here are some tips on optimal asset allocation based on various investment profiles:
If you focus on growth stocks (which entails high volatility and high returns (e.g. new technology or Biotech)), you may consider lower equity allocation. Such an aggressive stock portfolio is likely to experience several sizable (but temporary) declines of 30 to 50% over the long-term. You should never be placed in a situation where you are forced to sell some socks in the middle of a stock market crash to cover living expenses.
If you are a defensive investor and own stocks in a reliable sector such as food, consumer staples, or energy, you can afford to have higher equity allocation. A defensive portfolio may be less volatile and, as such, you could sell stocks during a bear market without bearing significant losses. As a result, you do not need as much liquidity (in this case, bonds) to cover your expenses. (Beware: defensive stocks will not grow as fast as the market average!)
If you are a dividend investor and have built a diversified portfolio of dividend paying stocks that have a history of increasing dividends every year, you can afford a higher equity allocation. Dividend aristocrats (companies that have increased dividends consistently over the past 25 years) tend to be large established companies that are likely to weather any storm. If your portfolio is large enough that dividend payments cover your living expenses, you only need enough liquidity to cover expenses for about a year. The risk here is that, due to market uncertainty, some dividend aristocrats may halt their dividends for a quarter (or year), and you do not want to be left with no income!
If you are an index fund investor (which I recommend) and invested in low cost index funds to guarantee greater returns over the long term, you may expect lower volatility as you do not own individual stocks. Nevertheless index funds are not immune to a market-wide crash (even the MSCI world), so keep enough in bonds to cover at least a year of living expenses.
Bond Allocation
What is a bond? If a company needs money and goes into debt, it can do so either through a loan or a bond. When you purchase a bond, you simply lend money to a company and they promise to pay you back by a certain date with interest (also known as a coupon).
What are bonds good for? Many investors appreciate bonds as they provide a reliable source of income and are considered safer than stocks. However bonds underperform: After adjusting for inflation, European bonds provided a mere 1.2% average yearly return over the last 100 years. Today, with negative interest rates, you’ll be lucky if your bond return will match inflation. Sure, some companies pay great interests, but these companies tend to be in financial distress and as such may entail a much greater risk of default (these are also known as junk bonds).
Bonds will add stability, but will drag down your performance, as such, are they really useful for the young investor? No financial advisor in their right mind would recommend bonds for a young investor, yet they can still be useful.
3 reasons why bonds should be part of your portfolio
Liquidity – Bonds can be bought and sold over an exchange in an instant and, while bonds do fluctuate in prices, they tend to remain relatively stable. This makes bonds an excellent source of liquidity. Do you anticipate a large purchase and need cash quickly? Sell some of your bonds!
Rebalancing – Not only will bonds make your portfolio more stable, but they can help you achieve better returns. Consider the following example of a 60% – 40% stocks to bonds allocation: in 2018 the stock market fell by about 8%, as such your asset allocation would have dropped to 58-42. Under a rebalancing strategy, at the end of the year you would have rebalanced your portfolio by selling bonds to buy stocks and return to a 60-40 allocation (hence you would have bought stocks when they were low (i.e. cheap)). In 2019, the market increased by 28%, hence your asset allocation would have moved to 66-34, upon rebalancing you would sell stocks and buy bonds to return to a 60-40 allocation (hence you would have sold high). The simple trick of rebalancing allows you to buy low and sell high (a trader’s dream!)
Human psychology – Benjamin Graham (successful asset manager and mentor of Warren Buffet) recommends in his 1949 book The Intelligent Investor to maintain at least 25% of your portfolio in bonds. Graham explains that 25% in bonds allows you to survive whatever the market throws at you and ensure that you will never be wiped out. If an extraordinary crash does happen, you would be one of the few investors left standing and would be able to dig into your remaining 25% to buy stocks at dirt-cheap price.
My recommendation is that you hold bonds in the form of a bond ETF (e.g. Vanguard Total World Bond ETF) to achieve the greatest stability and simplicity. You can then progressively buy or sell into the ETF when you need to without having to search for the right corporate or government bond.
Asset Allocation in retirement planning
The 4% rule is the golden rule of retirement planning. It implies that you can safely withdraw 4% of your portfolio every year and have a 95% chance to never run out of money under a simple allocation of 60% stocks and 40% bonds. Numerous studies have been performed on the efficacy of this method. Experts have back-tested the 4% rule on every time period possible and demonstrated that the portfolio would either remain stable or actually grow for each period. Maintaining a 60-40 allocation allows you to periodically withdraw cash without any worries.
To calculate how much money you would need to retire with a portfolio of 60% stocks and 40% bonds, here is how much gross monthly income you should expect utilising the 4% rule:
Monthly Income | Portfolio size |
1000 euro | 300,000 euro |
1500 euro | 450,000 euro |
2000 euro | 600,000 euro |
2500 euro | 750,000 euro |
3000 euro | 900,000 euro |
Summary
To conclude, here are my recommendations on asset allocation based on three period:
Wealth building phase
Invest in the MSCI World index fund and a world bond ETF. Use the stability of the world bond ETF to your advantage and use it as an additional emergency fund. As you near a mini-retirement (e.g. a year-long vacation), shore-up your bond allocation to ensure you will have plenty of cash available should it be needed.
As long as you have a steady stream of income, your bond allocation should have enough to cover at least one year of living expenses, this should be plenty of time to allow the stock market to recover and you will never be forced to sell during a stock market crash!
Wealth consolidation phase
As you near financial independence remember not to get too excited, yes the market may have made you rich, but the market is known for its mood. Secure your future millionaire status by progressively adding more into bonds. This way, if the market crashes and you are out of a job, it won’t be an issue! Not only will you have plenty in bonds to survive for a few years, but you may also consider buying into the stock market to profit off the crash. it’s a win-win!
Financial independence phase
First off, congratulations on reaching financial freedom! This is an extraordinary feat which took a lot of patience and discipline. The bulk of the work and effort is behind you, you may now enjoy the fruits of your labour and live life the way you to. You may now allocate 60% of your portfolio to equity and 40% to bonds. Then, simply withdraw up to 4% of your portfolio every year. This strategy has been thoroughly back-tested and it works! If you would still prefer to play it safe, aim to reduce your withdrawals to 3.5% instead.
Recap
Both. Stocks will bring-in the gains and should be the larger sum. Bonds are less volatile and will serve as an emergency fund for a few years, ensuring that you always have cash to achieve your dreams.
Only to an extent. You should strive to have at least 60% in stocks at all times. Lowering your stock allocation is riskier than it sounds, you could run out of money!
Absolutely.
Dividends are not guaranteed and even dividend legends can fall. This year, Royal Dutch Shell, one of the major oil companies, has cut its dividend for the first time in 75 years. Always have some bonds on-hand ready to be sold, this will serve as your second emergency funds.
Further, even if dividends keep on coming, they may stop growing or grow at such a small pace that inflation may catch up to you! The dividends you receive today may simply not be sufficient in 10 years if the cost of living has increased. Protect yourself and keep a few year of living expenses as bonds to weather any sustained market storm.
It depends.
If you do not anticipate any large expenses (e.g. a down payment on a house), and you already have an emergency fund, feel free to invest everything you can in stocks (especially if its via index funds (they don’t fall as hard!))
If you have a large expense coming up within the next 12 months, place that amount in bonds. Bonds are less volatile and, even in times of a financial crisis, you should be able to recuperate most of your money if you invested in a bond ETF. This will ensure you will be able to finance your project no matter what!
If your planned expense is more than a year away, it becomes a little bit more complicated. On the one hand you do not want to place too much cash in bonds as they under-perform stocks in the long term. On the other hand, if the stock market crashes at the same time that you need the cash, it may be difficult to find the courage to sell your stocks at a loss. My recommendation would be to keep about half of the planned expense in bonds and invest the rest in stocks. Then, a few months before the purchase date, simply invest more of your salary in bonds and less in stocks. This will ensure you have the cash when you need it, all the while maximizing your investment income.