Is Asset Allocation the answer?
When both Don and I were working full time, our basic path toward financial independence looked like this: “Put money in the 401Ks, put money in other investments, keep some money in savings and checking.” It was pretty straightforward. Based on our perceived time-frame of “years from now”, the asset allocation of our assets in the 401Ks and other investments were mostly in stock funds. A bit in bond funds. Stocks go up, stocks go down. Stocks go down faster than they go up but they have always gone up even more. Stick with it; we’ll be fine.
That approach worked for us in upturns and downturns. To be clear, we had really great luck in the middle of the downturns, as well. We both always had jobs and didn’t have to stray from our strategy or dig into any of our retirement funds to live through any of those downturns.
Two years ago, the whole idea of “years from now” moved into focus as, “We can walk away from full-time corporate jobs really soon if we want to.” At that point, I became much more interested in the idea of asset allocation rather than just “always go toward the more aggressive end of the scale.” We would actually be taking money out rather than always contributing a percentage of our income. For life-long savers, the thought was nearly terrifying. A new thing to get my head wrapped around.
Why this is on my mind NOW!!! Short term concerns.
I have been particularly on edge as of late; expecting that there will be a correction, or a big dip or something coming up. While I have been thrilled at what the rising market does for my overall balances, I am always feeling like I’m waiting for the other shoe to drop. Are we positioned okay if it happens?
Asset allocation strategy decisions, at the most basic level, are all about coming to terms with how comfortable you are with in different types of investments with all different levels of risk. It’s easy to think about asset allocation in terms of Cash and Bonds – more stable and very much less at risk of raising and falling based on the market (fixed) versus Stocks – investments that are more volatile and because there is greater risk, may offer greater reward (equities).
I have long been a fan of taking asset allocation quizzes on-line and on paper and in about every form possible. I guess I just love to take small quizzes in which I am always the winner (for example, the Wizard of Oz test, I score 100%!!!!). Those asset allocation questionnaires ring my bell in a couple of ways. First, they stroke my ego. They come back with messages of a kind “you are probably more in tune with goings-on and can sleep at night even with more in the stock market than the average bear.” Second, I get a pretty pie chart in many instances with a “Percentage of Equities vs Percentage of Fixed”. I do love pie charts.
Unfortunately, most of the asset allocation quizzes and answers are worthless when it comes to an actual objective approach to the most basic of information I’m after. I get it….I’m more comfortable with risk than some and less than others. I get it, I’m in a certain age group. First tell me, though, how many of my dollars should be in each major category – cash, fixed and equities? The models are full of subjective questions like “are you likely to pull your assets out of stock funds if the market plunges by 50% next week?” Of course I say no – you are supposed to say no – but would I? I am in a way different place in my life now than when I didn’t think I would be touching most of my investments for 15 to 20 years.
And then there are long term concerns….
Another thing to think about, I am in my mid-fifties and hoping to fund this lifestyle for many, many years. Don and I are in this transition – moving from acquisition of assets into preservation of our assets but I am skeptical of any approach that doesn’t continue to look for growth. According to the Social Security administration, the life expectancy of a woman born 55 years ago is a little over 85 years. That is 30 more years for us to live on our assets. (Your actual results may vary.)
By the way, it’s kind of fun to check out your life expectancy. Go here: Social Security Online, Retirement & Survivors Benefits.
Many of the traditional asset allocation models are too conservative for people working on financial independence with a 30-plus-year time horizon. Some of the older axioms say things like “you should only have as much in stock as a percentage of 100 minus your age.” For me, that would be 55% fixed, 45% equities. What is the motive behind that madness? That seems way too conservative for my planning. Other folks think so, too. I think it’s time that we ditch that way of thinking. I’m not the only one who is skeptical – Forbes, and Money/USNews have recent articles suggesting the same thing.
The market always goes up. There will be dips, corrections and downright dumps but then it goes up. Although never as quickly as it went down! The chart below shows the last hundred years for the Dow Jones – go to the source website for more information on the S&P, a look at inflation-adjusted returns, etc.
Remember – past performance does not guarantee future results. I am not guaranteed that the market will always recover after each drop or that it won’t take longer than it has in the past. I am also not guaranteed that I will live to 85, or that I won’t live to 95. Another thing to get used to – ambiguity. Here’s the cool thing; we are able to react, adjust, and make decisions all along the way.
Getting ready to jump? Living on the assets?
Back to my quest for an objective answer. If you seek, great things can happen! I met Jim Collins, author of The Simple Path to Wealth at the Financial Independence Chautauqua we attended in October, 2017. He gave me a way to think about cash, bonds, and stocks that helped me solidify the first step in thinking about our investments. Here’s the wisdom that Jim shared for those of us who are happy that the market has been performing so well and are also kind of terrified by the roller coaster we may be riding in the future.
Number one priority: Remember, with stocks we want to buy low and sell high. Makes sense, doesn’t it? And yet, during those years around 2008 and in other declines, sometimes people either reacted emotionally and sold really, really low or they didn’t have a lot of choice since they had lost jobs, didn’t have income in other sources, or didn’t have resources available in investments that hadn’t lost value.
Goal – set up your allocations so that you don’t have a large risk of having to cash in stock and stock funds in the decline.
Here are the tactical steps that support the goal:
- Set aside a year’s worth of your expenses available in cash and near-cash types of savings. Examples – a high-interest savings account, checking account, short-term CDs, or some combination of those. This is money that you will not pay a penalty on if you need access during the year.
- Keep about three to six years worth to cover your must-have expenses (plus a little) in fixed investments. Jim likes the Vanguard Total Bond ETF. If you have additional sources of income, like a pension or a monthly annuity payment that won’t be impacted by swings in the market, adjust your number accordingly. For example, if your expenses are $5,000 a month and you are receiving $1,500 a month in a part time job or pension, your monthly exposure is $3,500/month. You don’t want to have to sell your stocks after the drop and while the market is still recovering. You are the one that gets to decide how much you want to / need to hold in this bucket.
- Keep the rest in your equity investments or whatever asset allocation in which you are comfortable. Jim likes the Vanguard Total Stock ETF. Over the long run, the most likely scenario is that the market will recover within three to six years and will continue to rise. Sources from CNN, US News – How long from the crash to the recovery?
- Assess your situation at least once a year and adjust as necessary. You may need to keep more in the fixed positions once the market is out of the dumps. Or maybe you’ve taken on a new income source, like a new job, and you don’t think you need as much in fixed investments.
Et voilà! Thanks to your planning, you will most likely be able to ride out a dip or correction or major downturn in the stock market.
Step 1 – Cover the risk of a volatile market with an objective approach
Here’s an example using Chris and Kris. They have been following Jim’s Simple Path to Wealth for years and are on track to jump out of the full-time employment scene. They are putting together their strategy for jumping into that new phase and have that same question – how much in which investments?
Calculate the Basics:
Estimated annual expenses that they expect to cover with their investments: $60,000
Estimated annual expenses, in a pinch, they could live on: $50,000
Chris and Kris have decided that they want to be on the higher-end of the recovery estimate; they want a little less risk so they choose 5 years for their recovery assets.
Cash Accounts: $60,000 (1 year x 1 annual expenses)
Fixed Income Investments: $250,000 (5 years x 1 pinch expenses)
But what about that percentage of total assets? If Kris/Chris’s first priority is trying to lower the risk of having to sell low, it’s not about the percentage, it’s about the actual expense numbers. If they have total assets of $800,000, that means that they will position at least 38.75% of their assets in cash, near cash and fixed accounts. If they have total assets of $1,500,000, the above approach puts cash, near cash and fixed assets at 20.66%.
Notice – if Chris and Kris have $310,000 in investments for retirement, that puts their cash, near cash and fixed accounts at 100%. They need to re-evaluate their expenses, income sources and money available for financial independence for a more creative approach if they expect to have assets available for more than just a few years.
Step 2 – Assess your attitude with the subjective questions for Asset Allocation
Once you have Step 1 in place, then it makes sense to assess your ability to stop looking at the numbers in a stock correction. Now the asset allocation quizzes make sense. They help you put some thought and context into where the additional investments land. Chris and Kris may be the type that really can’t sleep at night when the market is up and down. Perhaps more of their monies should be in bond funds and CDs rather than stock funds or real estate.
Pulling it altogether – an objective measure with a subjective look at the way I think about things – that is my sweet spot. The real value to the questions about your potential behavior and your experience as an investor is really 1) should you even be putting money into equities and equity funds at all and 2) can we start talking about a variety of options like international stock funds and real estate investment trusts? Once you’ve got the volatility risk covered, you can dive deeper into those pieces of asset allocation models.
Objective analysis plus understanding your subjective relationship with risk makes so much more sense to me than just “X% bonds and X% equities”. Working to account for the possible volatility of the market is an approach that gives me a set plan. I love to have a plan.
What about you?
If you are where we are, take a look at your assets. See what you think.
Remember, this may not be the right time in your financial journey for this approach. Only you know your attitudes toward risk, your financial situation, your expectation of your other sources of income and whether or not this rings true for you. Here are a couple of additional key questions:
- First, how comfortable are you with the idea that the stock market goes up and down? If you haven’t yet either confronted or made peace with that fact, you need an approach that is conservative. You have to be able to sleep at night so maybe lowering your expenses is a better option than living with risk.
- Second, how far are you from expecting to live on your retirement investments? If you are early in your savings and investment journey, you have a long time for the market to go up, down, recover and go up again. Your need for accessible assets are more based on emergency funds and additional funds set aside for more immediate financial goals. You aren’t likely to be expecting to cover your life-long expenses at this point.
Remember, also, that there are no guarantees in life. Again, why do I even have to say this? I think it is because it is in our nature, well my nature, to want to be able to control for everything. We can’t. We each do the best we can with the information we have at the time. You get to choose your own adventure.
JL Collins – The Simple Path to Wealth
Future State Renee: Calculating Your Monthly Expenses – Knowing your expenses is key to this process.
New Retirement – Best Asset Allocation Strategy for Retirement