Asset Allocation in Smidges and Dollops

How important is it to precisely nail your asset allocation in retirement? You may be spending a lot more time than you need to fretting about investing 35% of your portfolio in equities instead of 40%.

Asset allocation affects a number of retirement plan factors including your portfolio’s exposure to a market crash, your long term expected portfolio return and volatility, and your sustainable withdrawal rate (and sequence of return risk). In this post, I'm primarily referring to your equity and bond allocations, which is the first allocation decision we make.

In his earlier books, The Intelligent Asset Allocator and The Four Pillars of Investing, William Bernstein suggested that the first step in choosing your asset allocation should be answering the question, “What is the biggest annual portfolio loss I am willing to tolerate in order to get the highest returns?"

Bernstein provided a table of asset allocations based on the answer to this question. I have included this table below alongside losses for the 2007 to 2009 market crash according to IFA.com. As you can see, Bernstein's recommendations were reasonable but were more optimistic than actual losses during that crash.

(This is a demonstration of the weakness inherent in using historical data to predict future market risk and returns. The Intelligent Asset Allocator was published in 2001 and a new low-water mark was set in 2009.)

Your individual risk tolerance – at least the risk tolerance you think you have – and your risk capacity are factors that will combine to suggest an appropriate asset allocation, according to Bernstein, and you will note that a 10% change in your portfolio’s equity exposure resulted in about a 6% change in the maximum loss you might have incurred during the 2007-09 crash.

(To clarify, a 5% increase in equity allocation here means increasing stocks from 30% of the portfolio to 35%, and not to 5% more of the original allocation, which would increase equities to 31.5%.)

How precisely you need to nail your asset allocation from the perspective of maximum loss in a market downturn depends, then, on how precisely you feel you need to limit those losses. If a 15% maximum loss versus a 20% loss feels significant to you, then a 10% change in equity exposure is important. If 20% and 30% maximum losses feel about equally acceptable, your equity allocation can vary by as much as 20%.

Asset allocation also affects the long term expected return and volatility of your portfolio. During a market crash, most asset classes tend to fall. This is referred to as “systematic risk" in modern portfolio theory (MPT) and it cannot be diversified away. Over the long term, however, asset diversification is a powerful tool.

Based on index portfolios from IFA.com, using data from 1964 to present, we can see the impact of increases in equity allocation at the conservative end (a 30% equity portfolio with the remainder in bonds and cash) and the more aggressive 70%-equity end of the spectrum.

You can see, for example, in the second row of data that increasing the equity allocation from 30% to 40% would increase the expected portfolio return from 8.01% to 8.9% and the risk from 7.13% to 9.2%.

How do you choose between a portfolio with an 11.15% expected return and a standard deviation of 15.67% and a portfolio with an 11.8% expected return and a 17.9% standard deviation? These are the parameters that would change for an investor contemplating an increase in her equity allocation from 70% to 80% (the fourth row of data in the table above). Although the expected return seems to increase significantly, so does the risk and there is actually very little difference between the two portfolios.

Using a tool provided by MD Anderson called Inequality Calculator, I compared probability density functions for the log-normal distributions of both portfolios. As the diagram below shows, even after increasing equity allocation from 70% to 80%, the probability of improving annual returns of your portfolio is only about 51%.

In other words, there isn't a lot of difference between the two portfolios. You haven't turned a low-risk portfolio into a high-risk one by increasing the equity allocation from 70% to 80%.

A small increase in returns can have a significant impact on terminal wealth after 30 years. Following is another graph from IFA.com showing the growth of $1,000 in their various index portfolios from 1984 through 2013, thirty years.

At the conservative end, an increase in equities from 30% to 35% resulted in a portfolio about 12% larger after 30 years. Increasing the asset allocation from 70% to 75%, on the other hand, increased the portfolio 9.7%. Those returns, however, are not guaranteed. The odds that your portfolio will end up larger with an 80% equity allocation than with a 70% allocation is still just a tad over 50/50.

A third factor influenced by your portfolio’s asset allocation, for those implementing a sustainable withdrawal rate (SWR) spending strategy, is the sustainable withdrawal rate itself. For a demonstration of the impact, let’s look at the original studies published in William Bengen’s Conserving Client Portfolios During Retirement. 

As his charts for both taxable and tax-deferred portfolios show with 30-year life expectancies, the SWR is essentially flat from about 30% to 80% equity allocations. Unless your portfolio has a very low equity allocation or a very high one, changing your equity allocation won’t have much affect on your sustainable withdrawal rate.

Even below 30% equities, the impact on SWR is on the order of a quarter- to a half-percent and it becomes less as retirement progresses. Of the three impacts we are considering, SWR is the least sensitive to asset allocation.

To summarize, you won't change your portfolio's volatility much by changing your equity allocation a 5% or 10% step up or down. You will improve the expected portfolio return, but the probability of improving your actual return or terminal wealth is roughly a coin toss. It won't have an impact on your sustainable withdrawal rate unless you move below about 30% equity or above about 80%.

The factor most sensitive to asset allocation seems to be maximum loss in a bear market. I personally pay the most attention to this dimension of risk because I am just finishing the first decade of retirement and sequence of return risk is front and center of my attention. Bernstein refers to this as "deep risk", a risk from which one might not recover, as opposed to long-term portfolio volatility risk. Antti Ilmanen refers to it as "bad returns in bad times".

Of course, the "best" equity allocation depends on what future market returns turn out to be, which is, of course, unpredictable. If 2007 found you woefully below the equity allocation most experts would recommend, you would've enjoyed the next three years much more than they did. We're trying to find a bet that will work more often than others, not the "best" bet.

Bernstein recommends portfolio allocations in "smidges of natural resources" and "dollops of Treasuries", which tells you what he thinks about our ability to make precise bets. In his words, "Once you’ve arrived at a prudent asset allocation, tweaking it in one direction or the other makes relatively little difference to your long-term results."

Risk and the Life Cycle

I think most retirees probably have a moment not long after calling it quits when the risk of their new endeavour fully dawns on them. I think mine occurred about twenty minutes after I left the building.

Most retirees seem to intuitively sense that they have entered a stage of life with increased risk, but probably few can articulate the issue as clearly as William Bernstein.

In his latest e-book, Rational Expectations, Bernstein compares a young person who has just begun to save for retirement, a 45-year old executive who has already saved enough for retirement, and a retired person all at the beginning of the 1929 market crash.

The 45-year old in Bernstein's example saw his portfolio fall 74% by the end of June 1932, recover a bit by 1937 and fall another 48% by March 1938. Fifteen years later at age 60, he had permanently regained his 1929 purchasing power. He would ultimately have been fine, assuming he had the courage to stick with stocks through that storm. Most didn't.

The Great Depression is ultimately a boon for the young worker because he will be able to buy stocks cheap and their value would have increased dramatically over his working career. Bernstein has long pointed out that volatility and even market crashes early in life are ultimately a huge advantage for the young stock accumulator.

The retired investor, however, found himself in the worst position of the three. Without the ability to work longer, delay spending from savings, or accumulate stocks cheaply, the typical retiree would never have recovered. He would have needed a 3.6% spending rate to nurse his portfolio along for 30 years. In Bernstein's words,

"The overarching lesson of these three men, then, is that the older you are, and the fewer working years you have ahead of you (or, to use a four-bit term, the less human capital you have), the riskier stocks are. For the young saver, stocks are not that risky. For those in the middle phase of their financial life, they are quite risky. For the retiree, they are as toxic as Three Mile Island."

The important difference among these investors of different ages is human capital, or one's ability to earn wealth in the labor market. The young worker has tons of human capital and little else. The mid-career worker has human capital remaining but the retiree has almost none.

The following chart, from a Wade Pfau column in Advisor Perspective, shows the trends of human capital and financial capital over a typical lifetime. Financial capital includes your portfolio and all other financial assets. Human capital actually has a complex definition and several dimensions, but think of it here simply as the present value of all the income you will earn in the future.

The mid-career worker can use remaining but limited human capital to postpone retirement, delay spending her retirement savings, rebuild her savings over time and reduce the number of retirement years she will need to support. Her primary loss will have been not being able to retire as young as she had hoped.

The retired investor has little or no remaining human capital and must continue to spend retirement savings to live after a crash. He will continue to spend down his stock portfolio by selling when equity prices are at their lowest. He will have no cash to buy cheap equities. If retirement has a three-edged sword, surely this is it.

It is sometimes argued — incorrectly — that stocks become less risky the longer you hold them. Actually, stocks are risky no matter how long you hold them.

Stocks generally do become riskier, however, the older you get. Until well into retirement, at least. Their volatility isn't affected by your age, of course, but the financial damage that volatility can create is helpful when you are young, troubling by mid-career, and "toxic" after retirement.

That sense of fear one gets after packing his or her photos and awards into a cardboard box and carrying it to the parking lot for the last time isn't just fear of the unknown.

The trepidation isn't uncommon and certainly isn't unwarranted.

There are real sharks in that water.

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