Most commentators advise people to reduce the percentage of stocks in their portfolios as they age. Some popular rules of thumb are to make the stock percentage 100 minus your age or 120 minus your age.
Larry Swedroe in his excellent book “Rational Investing in Irrational Times” offers his own advice. Swedroe expresses his advice in terms of how long until you need the money (time horizon) rather than age. (Canadian Capitalist also posted on this subject last month.)
Here is Swedroe’s table of time horizon vs. percentage in stocks:
0-3 years: 0%
4 years: 10%
5 years: 20%
6 years: 30%
7 years: 40%
8 years: 50%
9 years: 60%
10 years: 70%
11-14 years: 80%
15-19 years: 90%
20 years or longer: 100%
How do we test this advice?
Unlike almost everything else in his book, Swedroe offers this table with no analysis of where the numbers came from. I decided to try to come up with my own answer to this question.
It is surprisingly difficult to come up criteria for optimizing a portfolio for some end time. The best I have come up with so far is to optimize a portfolio for a particular target dollar amount. This is similar, but admittedly not exactly the same thing.
So, given a particular dollar amount you are trying to save up, what portfolio mix should you use to minimize the expected time before reaching this goal? Of course, the goal amount should grow with inflation so that you will end up with some fixed amount of purchasing power regardless of how long it takes.
I assumed you start with an initial investment without adding any more money along the way. I also assumed that you were limited to stocks, bonds, and risk-free short-term government debt with returns and volatility as compiled by John Norstad in this paper.
Before letting my computer run for a couple of days to get the answer, I guessed that when you were far from your goal, the portfolio would be heavy with stocks and would start shifting money to bonds and risk-free investments as the goal came nearer.
When the results came in, my guess was more or less correct, but not in the way I expected. The optimal portfolio mix is 100% stocks until you get to 93% of the goal portfolio value. From 93% to 99.8% of the goal, stocks are smoothly shifted into risk-free investments. From 99.8% of the goal onwards, the portfolio is entirely risk-free investments.
At a few points the optimal portfolio had 5% bonds, but for the most part, bonds were completely absent.
Expressed in terms of time, the portfolio mix is 100% stocks until 18 months from the goal. Then stocks are sold steadily until the goal is two months away, and after that everything is in risk-free investments.
What does this mean?
Obviously the answer I came up with is radically different from Swedroe’s table. My table would look something like this:
0-2 months: 0%
6 months: 25%
10 months: 50%
14 months: 75%
18 months or longer: 100%
I don’t recommend using this table. I don’t think you should have any money you will need within 3 years in stocks. A retired person should have at least 3 years worth of living expenses in fixed income investments. This gives you time for planning and adjusting to big upward or downward swings in the stock market.
However, I think it is likely that Swedroe’s table is too conservative. I would like to have seen how he came up with it.