Friday, December 28, 2007

Does Typical Asset Allocation Advice Make Sense?

Typical advice on asset allocation is that you should put fixed percentages of your savings into each of stocks, bonds, and cash. Usually, the advice is that the percentage in stocks should go down as you get older. I’ve never understood this rigid approach to investing. It makes no sense to me.

The theory is that this approach will reduce risk, particularly as you get older and closer to needing the money for retirement. I think the use of the work “risk” here is misleading. We are really talking about volatility. The asset allocation advice is designed to reduce the volatility of your year-to-year returns. But, you pay for this lower volatility with lower long-term returns.

To illustrate what I mean, consider the following example. Suppose you win a raffle, and your prize is that you get to grab a fistful of cash out of one of two large buckets with your eyes closed. One bucket has just twenty-dollar bills, and the other has half tens and half hundreds. If we say that you could hold about 100 bills in one hand, then the first bucket will give you a predictable roughly $2000. The second bucket will give you between $1000 and $10,000, a much more uncertain or “risky” choice. It’s not too hard to see that the second bucket is worth the added risk.

Over the long term, stocks have been a much better investment than bonds or cash, and there is every reason to believe that this will continue. Why should I put any money in bonds for the long term if the odds are overwhelming that the stock market will give me a higher return?

My Approach

Here is how I see things. Cash is for short term needs, say for the next 6 months. I keep cash as an emergency fund as well. The size of your emergency fund is a personal choice, but it should be higher if your income is variable or at risk in some way.

Bonds are for known big expenses coming up in the next 3 years (or 5 years if you want to be more conservative). The taxes you owe next April and the down payment on the house you plan to buy in 2 years shouldn’t be in stocks; bonds that are timed to come due when you need the money are a better choice. I prefer to buy actual bonds (or other government debt) rather than paying the MER on a bond fund.

All money I don’t need for at least 3 years goes into stocks. This can be individual stocks if you are skilled at analyzing businesses, or it can be a low cost index fund for those who want to put their stock investments on autopilot.

With this approach, you could be 90% in stocks if you have no big financial obligations coming up. Or you could be 75% in bonds if you are planning to buy the other half of the family cottage from your sister soon. The financial realities of your life dictate the appropriate mix of stocks, bonds, and cash rather than some pronouncement from a supposed financial guru.


  1. I agre with the point you're making here ... one question that I'm nt sure I've seen answered clearly before: why choose bonds over high interest savings accounts? Is it because the bond values themselves can rise enough in the long run if interest rates are falling? Are they seen as a hedge against falling interest rates (not provided by high interest accounts)?

  2. CMR: Usually, even the safest bonds (issued by the federal government) earn a higher interest rate than savings accounts even if interest rates remain constant. You can often get a slightly higher rate at a bank if you are willing to tie up your money for a set period of time (in a CD in the US, and a GIC in Canada). Bonds are more flexible because they can be sold if you need the money early.

    Sometimes a bank may offer a savings account that with a higher interest rate than is available from federal government bonds. There is usually a requirement to keep a large minimum balance, and the account may not pay the high rate on the full balance. If you check into the rules on a savings account and find that it consistantly pays higher interest (on the complete balance) than bonds, and there aren't any rules that prevent you from removing your money when you want it (such as the loss of accrued interest), then it may be the better choice.

  3. I am 100% in stocks, indexes and trusts and use preferred share for the safety element in my portfolio.

    I have (and will) invest in junk bonds (example – GMAC) when the yields are big in the 1 to 2 year range.

    That said, stock returns are a matter of timing and luck.

    It is possible that stocks can hit a correction or worse a bear market and drop by 20%. That 20% could take years to make up.

    Check out the Japanese stock market or the history of our markets to see long periods where stocks have been flat or falling.

    The 60 stocks/40 bonds rule is just a form of insurance against a potential long down turn in stock prices

    Bond investors get fewer returns in the long term but sleep better.

  4. John: For the portion of my savings that I won't need for 3 years, I'm 100% in stocks as well. I suppose that if I were having trouble sleeping at night, I might do something different. But, being in bonds and knowing that the odds are strongly against doing as well as stocks is the sort of thing that would keep me up at night.

  5. I should think that moving a greater portion of your nest egg from stocks to bonds is prudent as one gets older and closer to retirement.

    Think about retirees who rely on their investments to pay their bills. For them, a series of below average returns on stocks could wipe out their savings well before their stock valuations returned to historical levels.

    These folks should be thinking about safe stuff like indexed annuities to at least pay their basic living expenses.

    Btw, I really like your blog - it's very well written and offers some great insight. Thx.

  6. Blitzer68: As a general rule, I agree with you. Retirees have a greater need to draw cash from savings than people who are still collecting paychecks, and so they should have more money invested safely. However, there is still room for people to think for themselves rather than follow some formula.

    To take an extreme example, if Warren Buffett were to retire, he wouldn't have any need to place a significant fraction of his fortune in fixed income. Someone else who plans to use all of his savings to have an expensive operation in a year should be 100% in safe fixed-income investments.

    I would like to see people evaluate their circumstances and make a reasonable determination for themselves. My rule of thumb is that money needed in less than 3 to 5 years should be kept out of the stock market. In your retiree example, this translates into the retiree having bonds set to come due as needed for living expenses for the next 3 to 5 years.

    Thanks for the kind words.

  7. Good points.

    I think where we disagree is on risk tolerance. My risk tolerance is probably lower than yours - but that is a personal choice.

    My view is that given that stocks sometimes under-perform bonds for up to 20 years, I would be comfortable with bonds set to come due as needed for living expenses for the next 15 years or so.

    Given that I'm probably more than 15 years away from retirement, I don't own any fixed income yet. However, I just see myself increasing my bond allocation as I get closer to retirement.