Investment Workshop 2: Deciding Your Equity Allocation

Wanderer
Follow Me

Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
Follow Me

mrinvestmentbanner2

To new readers who are just starting out with our Investment Workshop, please start at the beginning before reading further.

Alrighty then, welcome back to our Weekly Update on the Millennial Revolution Investment Workshop!

Hopefully people have gone ahead and created their brokerage accounts and at least started the process of signing up. If you haven’t, or it’s taking a while to process for whatever reason, don’t worry. We’re still a few weeks away from doing our first purchase so you’ve got plenty of time.

Funding Your Account

The next step is to fund the account. As with all things banking, never EVER pay any fees. So in order to transfer money into your trading account without paying any annoying bank fees, the easiest way is to set up a Bill Payment from your normal bank’s checking account. I was able to find “Questrade Inc” under my bank’s online payee list, and after entering my trading account number I was able to transfer money in pretty easily. Test with a small amount first and make sure it shows up.

Americans, it looks like all of y’all (that’s my American accent. I’m very proud of it.) have something similar called “ACH”, or Automated Clearing House transaction. You will need the account number and routing number from your checking account, as shown below.

check

For more information, check out TD Ameritrade’s page for instructions here at their Funding FAQ.

Although there are no account maintenance fees with Questrade or TD Ameritrade, I found that for Questrade if you try to access their “Trading” page with a balance of less than $1000, it will just sit there spinning forever and never load. Apparently $1000 is the magic number you need to have to “enable” the trading features.

Picking Your Equity Allocation

OK so while that’s going on, let’s talk about the first and most important decision you have to make when you’re building your investment portfolio: Your Equity Allocation.

Now, it should be no secret that we’re big fans of Index Investing. If you haven’t read our article about Index Investing, please do that now, but to briefly summarize why we love it and will continue to use it:

  • It Works – The Stock Market always makes money over the long term. In fact, over 15 year time periods, the S&P500 has never lost money, and has had a median return of 12.2%.
  • It’s Cheap – Index Investing costs next to nothing because you don’t need to pay a fancy fund manager to just buy the index, so your MERs tend to be around the 0.1% range rather than the 1-2% range of the average equity mutual fund.
  • You Can’t go to Zero – If the Index goes to zero, all companies will have ceased to exist, and at that point the aliens have invaded so who cares about your portfolio?

 

Now if you’ll recall, an Indexed portfolio contains 2 basic types of assets: Equities (i.e. stocks) and Fixed Income (i.e. bonds). Choosing how much of each you’ll have in your portfolio will be the single biggest determinant of how your portfolio will behave, so let’s first take a look at how that works.

efficient_frontier

 

This is an Efficient Frontier plot for the US Stock Market and the Total Bond Market. It was generated using a tool called Portfolio Visualizer, which was super helpful since it meant I didn’t have to generate these myself anymore. You can click here if you want to fiddle with it.

Along the bottom of the chart is Standard Deviation, which is a way to measure volatility (or “spikiness”). Higher means more volatile. And along the left is Expected Return, which is the average yearly return of each asset class. Higher is better.

So this half-moon crescent thing is basically every portfolio you can construct as a combination of Equity / Fixed Income. On the bottom left is an all-bond portfolio and at the top-right is an all-stock portfolio. An all-bond portfolio will have a lower expected return, but it will also have lower volatility. An all-stock portfolio will have a higher expected return, but with higher volatility. And the blue line connecting them is what happens when your portfolio is a combination of these two asset classes. Economists call this the “Efficient Frontier.”

But how do we actually pick a spot on this line that’s right for you? Well, here’s how:

There are two things you can use to decide your equity allocation, as written by economist Larry Swedroe in his book The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments.

The first is timeframe.

It’s About Time

If you need the money in the next few years, your equity allocation should be lower since you’re less tolerant to sudden market crashes. If you don’t need the money for a while, your equity allocation can be higher since over time markets always trend higher. And if you don’t need the money for 15+ years or more, you may as well be almost entirely in equities since in that time period the S&P500 has NEVER lost money.

Your Investment Horizon (years) Maximum Equity Allocation
0–3 0%
4 10%
5 20%
6 30%
7 40%
8 50%
9 60%
10 70%
11–14 80%
15–19 90%
20+ 100%

Source: The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments.

If you can sit down and figure out based on your income and savings rate how long it will take you to retire, this will give you a starting clue as to what your retirement timeframe is. So for example if you’ve been saving like crazy and are only a few years away from retirement, you don’t need to take on much equity exposure to hit your retirement date. But if you’re 10-15 (or more!) years away, then you may as well load up on the equities since the S&P 500 has never lost money in that timeframe anyway.

The next factor that determines your equity allocation is your risk tolerance.

Wild Swings, You Make my Heart Sing

Risk Tolerance is one of these terms that gets thrown around a lot but isn’t understood very well. The reason for this is that it’s really hard to measure.

Let’s take a look at our sample portfolio again. Here are 3 portfolios I created in that tool: 100% equity, 75% equity/25% fixed income, and 50% equity/50% fixed income.

workshop_portfolio_allocation

Now lets see how these portfolios performed over the last 35 years, from 1980 to 2015.

workshop_portfolio_backtest

We can clearly see here what the Efficient Frontier was also telling us: Higher Equity Allocation means higher portfolio returns over the long term, but also higher volatility which you can also see based on how much “spikier” Portfolio 1 is vs Portfolio 3. So far so good.

Now, look at that table over the chart under the column “Worst Year.” This is where we should be looking at to determine our risk tolerance, because this is biggest one-year drop each portfolio will experience during a market crash. Not surprisingly the worst year in all these portfolios was the Great Financial Crisis of 2008/2009 (an experience I remember not so fondly). At a 100% equity weighting, the portfolio plummeted by -37%, and at 50%, the worst year was less than half that, at -16%.

So the question that you need to ask is: How big of a temporary drop are you OK with stomaching before you’re going to panic and sell everything? The same author in that same book proposes the following table to take that and determine your equity allocation.

Maximum Loss You’ll Tolerate Maximum Equity Allocation
5% 20%
10% 30%
15% 40%
20% 50%
25% 60%
30% 70%
35% 80%
40% 90%
50% 100%

Source: The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments.

Two Answers?

So now we have two methods of determining your equity allocation: Investment Timeframe and Risk Tolerance. The first is relatively simple to calculate while the second is, unfortunately, subjective and personal to you. If you’re a cowboy like some of our fellow FI-ers like Justin from RootofGood or Jeremy from GoCurryCracker.com, you may conclude that you have the brass balls to NEVER get scared and sell, and therefore 100% equity is for you.

Us? We’re somewhat more cautious than they are. So here’s how we picked our Asset Allocation when we were starting out.

  1. Based on our savings rate of 70-80% when we were working, we were projecting a working timeframe, and therefore investment timeframe, of about 10 years. This gave us a 70% equity weighting.
  2. Based on our investment knowledge and experience, we figured we could take a 25% hit and be OK, so that gave us an equity weighting of 60%.
  3. So with two different estimations giving us 60% and 70%, we took the slightly more conservative number and went with 60%.

And as it turns out, our estimations turned out to be pretty accurate. We managed to successfully ride out a 25-30% correction in 2008/2009 without selling (something most of Wall Street couldn’t do themselves), and we managed to retire in 9 years after starting full time work.

Of course, the trick with many of you is that likely your timeframe is quite long while your perceived risk tolerance is quite low, giving you a really big spread between the two equity weighting numbers. In cases like this, a few tips to help you choose:

  • Remember, the “worst year” numbers are temporary. TEMPORARY. An Indexed portfolio can never go to zero and will always march higher given enough time.

and

  • Your equity allocation isn’t set in stone. It’s OK to pick a more conservative allocation and adjust upwards as you get more experienced. Obviously, it’s better to pick it right the first time, but investing more conservatively than you need is better than not investing at all.

So that’s it! For the purposes of this Workshop, we will be going again with a 60% equity/40% fixed income allocation, since that continues to be our risk tolerance, but feel free to increase or decrease depending on your own personal situation. If you’re planning on mirroring our purchases, you’ll be able to see in real-time how your choice effects your overall return/volatility performance vs ours, so that should be fun.

What is your equity allocation going to be and how did you came up with that number? We will try help out if we can if you have any questions in the comments section below.

Liked this article? Join the Millennial Revolution and help us spread by Sharing or Liking!

31 thoughts on “Investment Workshop 2: Deciding Your Equity Allocation”

  1. I had the Swedroe book on my Amazon wishlist. Thanks for saving me $20. 🙂

    My husband and I have enough to retire now. (We’re mid-40s, no kids, paid off home). Plan to work for another ten years to have an extra cushion for healthcare premiums. The crappiest plans in the U.S. cost us 10k a year and are going up 20 to 30% a year.

    By work we mean our own business that we set up a couple of years ago. Just to meet living costs for the next decade or so.

    1. Awesome! But don’t forget that in retirement your earned income drops to zero and you qualify for Obamacare subsidies that pay for your premiums, so take that into account when you’re calculating how many years extra you have to work.

  2. As for asset allocations, with the bond bubble and interest rate hikes on the horizon, I’m sticking to a 90% stocks, 10% short term Treasuries and CDs – exactly what Buffet said he would leave his wife.

    1. Nutrivore, one of the smartest comments I have seen on this blog. Nobody seems to talk about the bond bubble. They show backtests of returns of stocks and bonds for the past 40 years and make you think it will be the same. Interest rates have been dropping this whole time, inflating bond prices. Interest rates can’t go any lower. Bond returns will never be what they were in the past, as bond prices go down once interest rates go up.

      That is why it is so misleading and naïve to assume you will get a similar return to the past when you have bonds. A 60/40 portfolio is not going to yield 8% on average like it has in the past. Probably only 3-5% as bonds won’t get the 8-9% return they have the past 40 years. Stocks will have to do all the heavy lifting.

      I agree with a heavy stock portfolio.

      One other thing: Keep in mind that although it is true that when the market crashes you can rebalance and sell bonds and buy stocks at a lower price, but what is deceiving and left out is that the market goes up 75% of the time. Therefore that 40% in bonds is going to be a huge drag on your returns most of the time and those few times you can buy some cheap stocks won’t counteract the damage done by not letting your portfolio fly in up markets which is what happens most of the time.

      This in addition to the bond bubble spells trouble for those of you holding higher bond allocations. Just a heads up.

  3. If your asset allocation was influenced by how many years away you were from retirement, does this mean you adjusted the allocation to have a higher percentage of bonds every year since you keep getting one year closer to retirement? Or do you still maintain a 60/40 portfolio today? Thanks.

    1. Under a traditional retirement (at 65), yes you would shift your allocation towards fixed income over time, and under normal circumstances we’d probably by 40/60 in retirement. However, with our much longer retirement time frames we need to have a higher equity weighting than “normal” retirees, so we’re sticking with 60/40.

  4. “We’re still a few weeks away from doing our first purchase so you’ve got plenty of time.”
    But I’m ready now! I’ve read all the books, and blogs, did my homework, emailed you, had my portfolio all picked out, I’m ready to dive in. Then you announced this here workshop and I slammed on the brakes because I want to see how my picks stack up against yours.
    Any chance you could drop a hint of what the workshop timeline looks like?

  5. My attitude is a little different, at the bottom of a cycle, I am 80% equity, at the top, I am
    50/50.

    By my calculation, “letting the dogs run’ for no more than 7 years into a cycle (now) and then reblancing on a “dollar cost average” schedule works for me. I use no load MF’s, as the trading costs of a self directed equal to about the same, and ETF’s still have a MER, so you pay to have your money managed no matter what.

    So after 7 years, (remember the big dump in 2012? it was too soon, and therefore no panic… markets returned) and no sooner, you start moving from Equity to Fixed Income in chunks, no more than 5 or 6, until your reach 60/40.

    So where am I now… 60/40, with Fixed income split between short and long and even real cash (in AM dollars) Interesting enough, the bonds and some treasurys, have not lost any money, as the distributions have offset the prices. And Equitys have all gone up.

    Now you have cash ready for the next “Correction” be it small or large.

    So where am I now… 60/40, with Fixed income split between short and long and even real cash (in AM dollars) Interesting enough, the bonds and some treasury’s, have not lost any money, as the distributions have offset the prices. And Equitys have all gone up.

    next step is to move your equitys to less volatile dividend paying companies, like J&J. Reducing risk, but still staying the 60% in equitys.

    Your bang on so far, keep going I want to hear more…

    D.

    1. I’d be curious to know more about a no load mutual fund as I find it hard to imagine they can compete with ETF’s on fees. The management fee on an ETF can be as low as 0.05%, what are no load mutual fund fees like?

      1. The e-series TD mutual funds are no-load funds, and have an MER of about 0.3-0.5%. No-load just means there aren’t any front-end sales commissions or Deferred Sales charges, they still have MERs.

        1. Okay so whilst much better than a regular mutual fund they don’t compete with ETF’s. Pretty much what I had expected. Thanks.

  6. I like to press my luck, so I’ve been going all in with a 100% equity portfolio. Since I don’t anticipate needing this money for quite some time, I figure I’ll let it ride. I was in college during the financial crisis, so I was pretty insulated from its effects (other than the not being able to find a job when I graduated). Hoping that I can keep myself on track when the next downturn happens sometime in the future. Gotta just remember that any downturn can’t last forever.

    1. I just went 100% equity too after reading a few blogs recommending it for someone in my kind of situation. I don’t envisage needing the money in the next 10-20 years, it’s really just being put aside to grow as large as possible over a long-term horizon, with no set goal or intention of using it. 100% equity has performed better than any other allocation over a long-term horizon, so I see no reason to go with anything else. The only reason to not go 100% equity is a) You expect to need that money soon, b) You don’t think you can tolerate seeing your money fall up to 50% without selling and c) You need the security of guaranteed income from your investment to live on, such as dividends. Outside of those situations I don’t see any reason to hold fixed income. With a 60/40 portfolio you might get 6-7% long-term, with a 100% equity portfolio you could be hitting 9-10%, if not more.

      Hopefully I can ride out a market collapse of up to 50% okay, only time will tell I guess. My biggest fear is an unexpected event immediately after a market crash (like me or my wife needing urgent medical care) in which you have to withdraw money at the worst possible time. You can’t plan for that though and it would be very unlucky if it happened.

  7. Great read. I’m going to go 100% equities on my initial investment since it’s money I can afford to lose.

    Slightly off topic:

    Let’s say that markets take a huge dip following the US election (regardless of who wins). Will you take advantage and go on a buying spree to make quick return once the market inevitably buoys itself?

    1. They’re in it for the long term. The election may be a good entry point but only if Trump wins. Then again much of the volatility is priced in.

    2. Tommy, you should take a look at a stock chart. It is filled with ups and downs, rallies, false breakouts etc.

      You suggested to buy during the dip following the US election and go on a buying spree. Let me ask you Tommy, how do you know that dip is the lowest the market will go? Perhaps the market drops 9% with Trump taking office and you go nuts and buy everything you can, thinking you nailed the dip…then what happens is there is a false rally and the market goes up 5%, you think you are a genius, only to see the following week it drops 15% more. Then rallies and drops another 23%. You blew your whole load on a tiny fluctuation. This is why you don’t try to time the market. You don’t know what a dip is or how far it will go or if it is nothing. Stick with the DCA.

      Its natural to keep thinking you are smarter than the market. “I will just buy the dip and get a higher return.” Trust me Tommy, it doesn’t work that way, you are not the only person to think of it and try it. If you don’t believe me, give it a whirl. Try buying what you think are dips and do that consistently. Then wait for another dip. That dip you are waiting for may never come and you will miss out on a massive gain.

      Good luck buddy, be smart

  8. Hey there!

    I’m looking to fund my account using money I have in a TD Investment Mutual Fund RSP. I’m a bit confused (and admittedly nervous now) about how to go about transferring these funds to this Questrade account without tax penalty. Have I opened the wrong type of Questrade account to have this registered money transferred over?

    I just want to fund my account and get started with everyone else! 🙂

    Thanks!

    1. As far as I know, TD mutual funds can only be held in TD. You’d have to sell it, but because it’s an RRSP, there’s no tax implications as long as you don’t withdraw it. So you need to open a Questrade RRSP account and get it transferred over.

      1. I thought as much. Complete noob question – will I still be able to follow along with this workshop? I see I can still trade stocks, ETFs, bonds, etc. with one?

    2. If you just open an RRSP account in Questrade you can request for the money to be transferred from your mutual fund account to your RRSP account at Questrade directly. I have done this with both a TFSA and RRSP account from mutual funds in a bank.

      All you need to do in Questrade is under “Funding” go to “Transfer From Another Broker” and fill in all the details then send the form to Questrade. They will handle it all by contacting your bank and showing them the form you filled out. You will be asked on the form whether to transfer “in kind”, which means to transfer your account over exactly as is (i.e. you will keep hold of your mutual funds) or you can transfer in cash (i.e. your bank sells your mutual fund at the market rate and then sends the cash over to Questrade).

      Neither method will incur taxes as the money is never leaving your RRSP account. It is going from RRSP to RRSP.

      I will say though, it took several weeks for me to transfer “in cash” from my bank to Questrade, largely because my bank was so damn slow to sell the mutual fund and move it over. I also incurred fees of something like $50 (which you will likely incur however you transfer it). It may be a bit faster to transfer “in kind” as the bank does not have to sell anything to do that. I have never done that though so can’t be sure.

      1. Never mind just saw Wanderer’s message, perhaps “in cash” is your only option if Questrade doesn’t hold the necessary mutual fund to transfer “in kind”.

      2. Thank you so much for the advice. I’ve been reading on whether or not I should do just that, but was a bit anxious to pull the trigger. I’ll take those steps now.

  9. I am 40 and my wife is 38. We’re at 72% U.S Stocks, 18% International Stocks and 10% U.S Intermediate Bonds. I remember the crash of 2008/2009. At the time I wished I had more money to invest. Like she said in this article, bear markets usually last a few years and based on history always bounce back. Index portfolios never land to zero. We have a high risk tolerance. When we retire we’ll probably be 75/25 or 70/30 and stay there. In bear markets you’ll just need to reduce your spending at that time.

    1. Well said. The people who wished they had more money to invest and didn’t panic during the crashes are the ones who come out ahead. Good for you guys.

Leave a Reply

Your email address will not be published. Required fields are marked *

Social Media Auto Publish Powered By : XYZScripts.com