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This is part of our ongoing series on investing. Part 1: Index Investing, Part 2: How To Build a Portfolio
Disclaimer: Since we’re not licensed financial advisors, we aren’t legally allowed to recommend individual assets. We are simply describing the investing strategies that got us here. Please consult a professional before implementing any of these strategies.
So we’ve discussed why Index Investing is the only reliable strategy for investing in the stock market, and we’ve also covered why Modern Portfolio Theory is the best way to control your risk by trading off long term returns for lower volatility (or as I like to call it, “spikiness”).
So how do we put this together?
This is a process called Asset Allocation, or as I like to call it, Slicing the Pie.
Here’s how it works: You start with your portfolio, modelled as the most delicious of all mathematical models, the pie.
Then, you slice that pie into two segments, Bonds and Equities. Remember that the relationship between them is that the more bonds you have, the lower the volatility. The more equities you have, the higher the long term return.
How you decide to do that is based on two things: your Investment Horizon and your Risk Tolerance.
Investment Horizon is simply when you need the money. If you need it in a year to buy a house (PROTIP: DON’T), then you shouldn’t have ANY money in the stock market, because the Index could crash and it may not recover in time for your big purchase. But if you’re investing for retirement, you don’t actually need your money for 15-20 years. In which case, almost all of it should be in equities. This is backed up by hard data, because if you bought the S&P500 at any point in its existence and sat on it for 15 years, you would have a 0% chance of losing money. In fact, you’d have a median return of 12.2%! It makes no sense to buy anything else!
That’s why Larry Swedroe wrote in his excellent book The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments
| 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% |
That is based on mathematical truth. If you don’t need the money for 15 years or more, dump it into the Index and let it ride. You stand a 0% chance of losing money. However, by that logic anyone under 40 should be 100% equity, and we intuitively know that’s a bad idea. Why is that?
Because actually being 100% equity is super volatile. We’re talking crashes that took 50% off the index in 2008! And when most people experience that, they freak out and bail. So another way of determining your asset allocation is based on your Loss Tolerance. Which is defined by the maximum short-term downside you’re willing to tolerate before panicking. Larry Swedroe summarizes it thusly.
| 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% |
Here’s the thing: Larry’s analysis of risk tolerance effectively sums up why investing is so difficult for most people. Rarely is the “correct” answer clear, and most often it’s a tug of war between two opposing forces: Greed and Fear. Logic and Emotion. On paper, everyone under 40 should be 100% equity, but what 20-year-old who’s just starting out in their career can stomach a gut wrenching loss like the one we experienced in 2008?
Investment Horizon is basically set in stone. If you’re 20 or 30, your retirement is decades away, so statistics say you should go all in. But your Loss Tolerance (i.e. the maximum loss you can stomach before jumping off the roof) is the part most people have trouble with. Most people think they’re the stock market equivalent of Clint Eastwood. Until it actually crashes and all your money goes down in flames.
Here’s the truth: Not panicking when markets are plummeting is not easy. It’s similar to an E.R. doc’s ability think on his feet when the his first patient goes into cardiac arrest, or a soldiers’ ability to fight when the first shots start firing. Nobody has any idea how they’ll perform when the pressure’s on.
And some find out they can’t hack it. And that’s fine. No shame in that. But the ones that pull it off usually attribute their survival to two things: their Training and their Experience.
Training. What do I mean by that? Well, no clueless undergrad just walks into their local E.R. and starts dispensing drugs, and no soldier enters a battlefield without going through boot camp. They spend years learning how to do their jobs, and when the shit hits the fan, their training gets them through it.
Fortunately, investing isn’t nearly as difficult as being a doctor, or a soldier. My training involved reading a bunch of books I borrowed from the library, and not buying into the insanity of the housing market. It’s knowledge that anyone can learn, and in fact, that’s the entire point of this blog: To show you that investing really isn’t that hard.
Experience, however, is more difficult to obtain. There’s no real substitute for that first time a trauma surgeon has to resuscitate a dying patient. And no matter how many drills a soldier does, nothing compares them for the first time a rocket gets fired at them. Our skill was forged in 2008. In fact, I remember vividly the moment where everything was on fire, we all thought the world was ending, and my finger was vibrating nervously over the sell button.
But I drew my strength from my faith in the fundamental truth of Index Investing (i.e. it can never go to zero). So I didn’t hit that button. And as a result, we didn’t lose any money in the Great Financial Crisis of 2008.
However, not everyone can do that. And, as a matter of fact, many did sell, and as a result turned paper losses into real losses.
This is where a Financial Advisor really comes in handy. Most people think that the primary job of a Financial Advisor is to pick stocks. To beat the market. But it’s not true. The primary job of a Financial Advisor is to act as a stupidity filter.
Because while we were able to withstand the market crashing, many couldn’t. And they rushed to their eTrade accounts to panic-sell. And those investors got killed.
A Financial Advisor’s primary job isn’t to hit you a home run. A Financial Advisor’s primary job is to stop you from doing anything stupid. Like selling into a storm when everything’s on fire and the Index is dropping by 10% a day.
Here’s the challenge though: Financial Advisors are a dime-a-dozen. But good Financial Advisors are one-in-a-million. And admittedly, that figure is exaggerated for literary purposes, but it’s not exaggerated by much. When we were searching for a Financial Advisor, we interviewed over a dozen people, and almost all of them were just stupid, smarmy salesmen whose advice couldn’t pass a basic Google search.
Whoever you choose to safeguard your money has to be someone who understands and believes in Index Investing. Someone who understands and believes in Early Retirement. And someone who has a proven track record of helping their clients become Millionaires.
I’ll be honest. It’s a tall order. It could take some time.
Next post: “Rebalancing: How to Buy Low Sell High”
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I probably read too fast, but did you share your AA? I’m always interested in seeing how other people balance.
FWIW, we use Bernstein’s Simpleton’s portfolio, which calls for 25% of each of the following:
1) Large US Stocks (so, for us, S&P500, VFAIX)
2) Small US Stocks (Vanguard Small Cap Index, VSMAX)
3) International Stocks (Vanguard Total International Index, VTIAX)
4) Short Term US Bonds (Vanguard Short Term Bond Index, VBIRX)
I should give the big caveat that we are not financial advisors, aren’t giving investing advice, and no one should follow our advice, ever. Seriously.
Ooh 75% equity! You’re more cowboy than us! We’re only at 60% equity.
Though to be honest, I’m finding my loss tolerance to be increasing the more downturns we survive. We’ve now survived 2008, the US debt ceiling crisis, Grexit 1, Grexit 2, and the oil price crash without losing any money by simply rebalancing. I find the stock market downright boring now, and I think I’m going to gradually increase my equity exposure to 70% or maybe 80%.
How has the Bernstein portfolio worked out for you?
We like it. It’s simple, as the name implies, as all four categories should simply be equal “slices of the pie”. We rebalance quarterly, though there are good arguments for annually, too. Hard to know what’s optimal unless you can predict the future. 🙂
The bonds are short term, in part, I think, to account for the fact that the portfolio is slightly more aggressive than other static AAs. So, they’re the most boring type of bonds in that they’re less subject to interest rate risk, but also have lower returns than, say, buying the total bond index at Vanguard. Does that make up for the fact that they’re only 25% of the overall portfolio? Who knows.
Given your age, how & why did you decide on a 60/40 allocation?
It’s interesting to hear that you’re considering being more aggressive rather than less with no new income coming in, that would seem counterintuitive to me.
“Given your age, how & why did you decide on a 60/40 allocation?”
Because it wasn’t based on age. It was based on retirement date. We wanted less risk because we were going to stop working.
“It’s interesting to hear that you’re considering being more aggressive rather than less with no new income coming in, that would seem counterintuitive to me.”
It does sound counter intuitive. When we first retired a year ago, we were nervous so we picked 60/40 to be more conservative. However, now that we’re out, we realized that once you stop working, your costs actually go down (no more transportation, eating out, etc), so we can live under the yield of the portfolio without touching the principal. By doing this, we can increase our risk, and get a high return over the long term.
Would you be able to share your current asset alocation, and how you rebalance? Or is this Garth’s proprietary information? 🙂
We can share it in broad strokes (60% equity, 40% fixed income), with preferred shares, REITs, Real Return Bonds and High Yield Bonds mixed in. I also have an article about the importance of rebalancing coming up.
However, for liability reasons I can’t reveal exact percentages because I’m not a licensed investment advisor. If you want to know exact percentages, you can email Garth and he can tell you because he’s licensed.
Is the fixed income side of your portfolio all Canadian assets or do you own some US & international bonds?
The vast majority of our fixed income is Canadian. Because we rely on preferred shares to get some yield, the dividend tax credit only works with Canadian assets.
We do own significant US assets, denominated in USD though, about 25% I believe. That USD currency exposure saved our butts last year when oil cratered and the loonie took a swan dive (loonie dive?) against the greenback. We came out flat while the TSX was -12%.
Many investors are reaching higher on the bond risk ladder for yield because of the low rate environment we’re in (-ve rates on govt bonds in many countries). Investors & portfolio mgrs whom under “normal” circumstances would never have purchased preferred shares, corp or HY bonds are doing so for additional yield. I worry that this is becoming a crowded trade & that the risk in this segment of the market is in fact greater than risk in the equity market. As a result, I’m 100% US equities & have been for the last 3 years.
Yup. I agree. You and I can argue the merits and disadvantages of fixed income until Bernake yells at us to “cut it out! It’s 2 AM!”
But if you are 100% equities (or 100% ANYTHING), you can’t rebalance. When the next crash happens, you’re just stuck with a falling asset and your choice is limited to sell or hold. With an allocation of at least some fixed income (or cash, that works too!) you have a third choice: buy into the storm.
You don’t recover from a crash by holding. You recover by buying into the storm. That’s why we didn’t lose money in 2008.
Good point. I did the same in 2008-9. I’m not retired yet and continue to buy “the dips”. 2008 was a big dip. ??
Bonds have traditionally used, as you said, as a hedge against a falling equity market. One can rebalance during an equity market correction. However, what if the next correction or bear market is in bonds & not equities. Something few are considering.
Bull and Bear markets are defined by equities not bonds. The only way that bonds can crash is if interest rates shoot up, which is INSANELY unlikely, given that the Fed is humming hawing over a 25bp increase. The Feds would have to want to crush their own bond holders, as well as increase their own cost of borrowing for no reason.
Not necessarily. Negative interest rates in many countries globally signifies an extreme in the bond market (18% interest rates in 1982 was the opposite end of that extreme). No bonds won’t crash like the stock market in 2008 but they are currently pricing in very low (or negative) returns for a very long time. Government bonds could be a terrible investment for the next 10 or more years.
I agree. Held in isolation, bonds suck ass. However, they provide something that Modern Portfolio Theory requires: uncorrelated/anti-correlated assets relative to the equity market.
I think of fixed income as a disciplined way to keep dry powder ready to fire when the rest of the portfolio’s under attack.
Thanks for the post guys!
Thanks for the support, derkavich! You rock! 🙂
Thank you for our blog. It’s has much good information and I appreciate your perspective.
With your array of investment types, broadly speaking, which ones do you hold in your registered accounts, RRSPs and TFSAs, mainly for taxation purposes?
I would imagine that your Canadian common and preferred shares are in your non-registered accounts because of the dividend tax credit. Bond interest is taxed as income and foreign dividends don’t get the same tax treatment.
I imagine with low expenses and thus a low income to support those expenses, taxes matter less than they did when you were working.
Thanks in advance for your answer.
“I would imagine that your Canadian common and preferred shares are in your non-registered accounts because of the dividend tax credit. Bond interest is taxed as income and foreign dividends don’t get the same tax treatment.”
– Correct. Our US equities, bonds, and REITS are in RRSPs, CAD equities are in TFSAs, and preferred shares are in non-reg.
“I imagine with low expenses and thus a low income to support those expenses, taxes matter less than they did when you were working.”
– Correct again. After you retire, your investment income is tax more favourably than earned income, so you hardly pay any taxes.
Hi, according to the asset allocation table, you should be 0% equities, right?
Why are you still 60/40 or maybe higher?
Thanks!
3 reasons:
1) The current interest rate environment is too low to be 0% equities.
2) You want some equities in the portfolio to hedge for inflation.
3) Equities are taxed far more favourably than fixed income.
The tables are a good guideline, but need to be combined with your risk tolerance and the current interest rate environment.
Thanks FIRECracker!
I suppose that a 25-45% equities in retirement is ok then*.
Thank you for this fabulous blog that has changed my mind about buying a house in Luxembourg, where the flat I’m currently renting has a PER of 31!
*source1: http://www.financialsamurai.com/the-proper-asset-allocation-of-stocks-and-bonds-by-age/
source2: http://www.financialsamurai.com/the-best-asset-allocation-of-stocks-and-bonds-by-age/
Yup. If that falls within your risk tolerance, it makes sense.
And holy geez! I didn’t know the PER ratio is THAT bad in Luxembourg. Makes no sense to buy in that case.
I feel like this blog post was made for me. I have always dreamed of an early retirement so I can spend time with my wife, kids, and family as well as travel with them, but when I tell others about it everyone gets uncomfortable and says it’s not possible. I hate that feeling. I believe it is possible. I want to say thank you for sharing the information of your recommended financial advisor. I am going to look more into his credentials.
You’re welcome! And I find it hilarious when people can’t do math or are too scared of making any changes, throw up their hands and say “it can’t be done”. I’m like “Oh really? Then how come I’m doing it?” Whether you think you can or you think you can’t, you’re right.
Thank you for the inspiration. I subscribed to your blog/newsletter to learn more. I feel there is much to learn here. I’ve made a decision to change things in my life and start investing more heavily. This past week was a good week 🙂
Hey FIRECracker and Wanderer!
Immensely enjoying your blog and your openness and honesty on exactly how you went about doing this. Also the anti-boomer rants, those are good too.
Currently trying to figure out a plan to emulate over here in London but struggling to translate things like tax benefits over. Figure I’m going to need a financial advisor for the ins and outs so I wanted to ask you more about how you found such a good ‘un and whether it was an expensive process?
Hi ,
Love your posts, blog and the pragmatic approach to all! Quick question as I may have missed it when reading here. Do you also keep cash/emergency fund in your portfolio and if so, is that part of the 40% fixed income allocation? I ask because my wife and I have our allocation across retirement and taxable investments at 60-40 without taking into account our cash reserve. Bogleheads seems to be split on counting EF as part of AA or not. Was hoping to get your thoughts. Thanks and keep going with the inspirational posts!
We hold 5% of our 60/40 portfolio in cash. We also keep another 3-5 years of living expenses outside the portfolio, just in case. Generally, if you’re in the accumulation phase and are still working, 5% of the portfolio in cash is more than enough. The extra cash cushion of 3-5 years living expenses is only necessary once you stop working. Just our 2 cents 🙂
thanks !
This came right as I’m rebalancing my 401k portfolio.
My taxable account is 100% dividend stocks with the intent (read: pipe dream) of retiring early. But my 401k was just rebalanced from a 90/10 allocation to an 80/20. I’m about you guys’ age and figured that I needed a little more conservatism, especially when we know a huge drop is on it’s way. I also switched the target date funds in my account for the 401k’s only S&P 500 and bond market index funds. No need to pay some “supernatural” funds manager to NOT best the natural forces of the market.
Heh, I recently considered timing the market by putting all of my 401k money into bonds, waiting for the inevitable crash, and then putting it all back into stocks. But then I remembered what happens to market timers, and how you actually leave more money on the table doing stuff like that than you risk losing. Thankfully cooler heads prevailed, and I just doubled my bond allocation as well.
Great article!
Sincerely,
ARB–Angry Retail Banker
All I read about your strategy sound plausible. And if you raised all that money and retired based on this strategy, it has to work.
A question came to mind when thinking about Larry Swedroe’s table above. If I am looking forward for an investment longer than 20 years, I should go all equity. What would I rebalance then ? I would miss out all the fun of buying low and selling high. This is what I think is the best / profitable part of the strategy.
What about using a robo-advisor such as Betterment or Wealthfront for your IRAs? seems like the tax harvesting and rebalancing is optimized. Any thoughts on this? would it be better to do it by yourself?