Static Asset Allocation vs. Shifting With Age

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wannabe_CPA
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Static Asset Allocation vs. Shifting With Age

Post by wannabe_CPA » Tue Mar 09, 2010 11:44 am

Now I'll ask for your forgiveness as this isn't the most technical post, but it came up a while back and I've been thinking about it a lot.

I'll start by saying I try to focus on big wins in investing. By "Big Wins" I mean things which are simple to understand and implement and will have the most to do with whether or not you're successful in your goals. These are also things you can gain a working understanding of in a short time more often than not.

Saving enough money is a big win. Controlling costs is a big win. Keeping your emotions in check when markets dive or soar is a big win. Diversifying is a big win. You get the idea.

To this end asset allocation is a big win, specifically, to me anyway, specifically in the allocation between equity and fixed income in the portion of my personal holdings which I hope to use to generate cash flows some day (and presently as I reinvest the dividends).

I've followed the notion of age in fixed income for a while now, but I find I don't worry so much about constant rebalancing. As long as it hovers around the mark it's all good. My plan has basically been similar to a targeted date fund, shift to more conservative holdings more and more with age.

After pouring over some of the stuff here, the wiki, and a book or two (The Coffeehouse Investor for one), I've noticed that a lot of savvy people are instead simply saying "Here's the allocation, done." And it never changes whether they're 32 or 89. Some books say shift with age (Random Walk for example), some say nothing, some just lay out a ratio and never deviate from it for anything.

But I also know Mr. Bogle himself seems to follow the age in bonds rule, judging from snippets here and there which allude to his having more bonds as he gets older.

Basically the age in fixed income idea seems to be a very broad stroke attempt at timing. I guess I'm like a lot of people, I assume that the overall price of the stock markets will generally keep heading up as businesses improve on their ability to deliver more value for less if you look at a wide enough window of time. Now it may have some crazy things go on in the middle but I'm assuming since I'm looking at decades it's a safe bet I'll finish with more than I start with, therefore it's more logical to buy more equity now and less later.

But I don't know that's going to be the case either.
It seems a dangerous assumption based on past performance.

Then again for all I know it may be the bond portion of the portfolio that drags and not the equity.

The point is I'm at a crossroads here. Would it be better to keep doing what I'm doing and shift slowly with age to more fixed income, or should I rebalance to a 60/40 or some other split, maybe even 50/50, and just stick to it. It seems like I could be missing out on a Big Win with trying to "time" the market even though it doesn't seem to be such ill conceived timing.

Obviously no one can answer this question for me but me and I'm in no hurry, but this is something I need to pour over for a while. Any thoughts? What would you do?

Rodc
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Post by Rodc » Tue Mar 09, 2010 11:51 am

http://home.comcast.net/~rodec/finance/ ... nBonds.pdf

That link might be of interest. Graph 3 in particular.

Rather than either totally mechanistic method (fixed constant plan, or fixed sliding plan) it is probably best to sit down every few years and assess your needs and refine your plans. If your needs change, if you find you have more (or less) than expected, etc, your plan should change.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

metalman
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Post by metalman » Tue Mar 09, 2010 12:10 pm

Of course you should shift with age, and you don't need fancy models to figure it out. In fact, such models which generally ignore black swans can be hazardous to your financial health, since such events have greater impact as you age.
At retirement you need predictability, i.e., minimal volatility, much more than when you are earning and accumulating.
Try a test at the boundaries: Suppose you are 60/40 both at age 65, with $1M, and at age 21 with $10K . If the stock market plunged 50% over a prolonged period, which would affect your retirement the most: The $300K loss in retirement or the $3K loss at age 21?
The loss is bigger in magnitude and even more important is more difficult, perhaps impossible, to recover from when you are older.
Last edited by metalman on Tue Mar 09, 2010 12:21 pm, edited 1 time in total.

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bob90245
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Re: Static Asset Allocation vs. Shifting With Age

Post by bob90245 » Tue Mar 09, 2010 12:20 pm

wannabe_CPA wrote:What would you do?
Call it Couch Potato or the Nobel Laureate's portfolio.

"My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities."
-- Harry Markowitz
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

gizzsdad
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Post by gizzsdad » Tue Mar 09, 2010 12:33 pm

FWIW, I was at 80/20 until I was 20 years from retirement. At that point I instituted a glide path to bring me to 60/40 at retirement. I'm currently 12 years out, and at 72/28. When I need to rebalance, I'm flexible enough to use my contrarian instinct to round a little high or low based on recent(2-3 year) market activity.

My thought is that, if necessary, we will annuitize enough at retirement to help with fixed expenses, though we live a thrifty enough lifestyle that we will nearly be able to 'get by' on SS alone. We can then use our investments to fund the fun stuff at our leisure.

fishndoc
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Post by fishndoc » Tue Mar 09, 2010 12:47 pm

Basically the age in fixed income idea seems to be a very broad stroke attempt at timing
No, I would consider it an attempt at controlling risk.

I think every individual's situation is unique. I agree with the recommendations above about reviewing your situation every few years. Money you know you will need over the next 5-10 years should have little if any equity exposure.
" Successful investing involves doing just a few things right, and avoiding serious mistakes." - J. Bogle

neverknow
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Post by neverknow » Tue Mar 09, 2010 12:50 pm

..
Last edited by neverknow on Mon Jan 17, 2011 10:52 am, edited 1 time in total.

conundrum
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Post by conundrum » Tue Mar 09, 2010 1:43 pm

We did not change our portfolio based on our age but adjusted our asset allocation as our need to take risk changed (based on portfolio size, life circumstances, etc.). Once our portfolio would support 3% spending/withdrawal rate we shifted to a 40% equity/60% fixed income allocation. After doing lots of reading and studying this seemed to be the lowest risk (lowest % equity) portfolio that would give us a relatively high probability (90%+) of longterm (>40 year) portfolio survival.

Good luck

Drum :D

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tetractys
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Post by tetractys » Tue Mar 09, 2010 2:09 pm

I think earlier on, independent of age. when contributing income in a downturn can make up for losses or substantiate gains during the upturn, then a static allocation is fine. For older workers, that could definitely supersede the age in bonds rule of thumb. But Later, when there is an obvious risk that a market downturn could do permanent damage, then age in bonds, or something even more conservative, should be seriously considered.

Best regards, Tet
RESISTANCE IS FRUITFUL

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DiscoBunny1979
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Post by DiscoBunny1979 » Tue Mar 09, 2010 2:14 pm

I think it's all about the Need and Ability to take risk at the age you're at and the amount of money in question.

Metalman wrote "Try a test at the boundaries: Suppose you are 60/40 both at age 65, with $1M, and at age 21 with $10K . If the stock market plunged 50% over a prolonged period, which would affect your retirement the most: The $300K loss in retirement or the $3K loss at age 21?"

The problem is that many folks when reaching 40 or 50 or 60 years old don't have $1M! They are lucky to have $100K! That means to me that many folks will have to take additional risk to reach a goal such as having $1M. The additional risk is having more stocks and keeping stocks in the mix at a rate that total return can be somewhere between 7-10% annualized so that money can double at least every 10 years. This means to me that a static portfolio of 60/40 might very well be optimal for that set of folks, while a 40/60 might be optimal for those that have already reached that higher level of investable assets.

There is no loss unless you panic and sell. This last downturn proves that point. If you had made investments in the stock market throughout the decline, you most likely would not have lost any money. You probably would be even or maybe a little ahead. I know that for a fact because my Friday contributions throughout the downturn shows that result in my account.

If the key to investing is savings rate, then taking more risk (80/20) when younger doesn't make sense to me. What makes sense is even when young a 60/40 mix so that when downturns happen, the volatility isn't as harsh and contributions made during those downturns still work in one's favor. So, in my opinion a simple approach like investing in the STAR Fund as the only investment for a ROTH IRA is a perfect vehicle at any age.

dbr
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Post by dbr » Tue Mar 09, 2010 2:34 pm

Without reference to the details of a specific investor, the average outcomes for 50/50 from age 20 to age 90, age in bonds, and 70/30 from age 20 to age 55 and 30/70 from age 55 to age 90 might well all be the same.

The elusiveness of actually computing a number for the stock/bond allocation given that said number is supposed to be fearfully important still stands as one of the great conundrums in this whole investment discussion.

I think an individual can make a thoughtful estimate of what proportions make sense all details considered. I don't think it is possible to make a generic statement beyond 50/50 simply grounded in the existence of two choices. That said, age in bonds seems pretty harmless, though I refuse to discuss what happens to that when we play the pension as bonds game.

metalman
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Post by metalman » Tue Mar 09, 2010 3:42 pm

The problem is that many folks when reaching 40 or 50 or 60 years old don't have $1M! They are lucky to have $100K! That means to me that many folks will have to take additional risk to reach a goal such as having $1M.
No, it means they will have to continue working or cut down on expenses or a mix of the two. It is far better to find this out before retirement than after. I doubt the difference in, say 60% bonds and 60% stocks is likely to be that great, and if it is, the stock-heavy portfolio is more likely to result in the $100K. By continuing to work just one extra year, most probably at or near your peak earnings, you increase your savings by a year, reduce the number years you need to save for by one, and get that much closer to SS at a higher payout rate. The best thing is you can get all those benefits without a heavy equity exposure.
It makes a lot of sense to structure your AA as you age so that you minimize the risk of having to work beyond 62 or 65, and hoping if you are reasonably lucky you beat that goal, rather than aiming for 50 and if you are very unlucky having to work forever, which can happen in catastrophic stock markets.
Without reference to the details of a specific investor, the average outcomes for 50/50 from age 20 to age 90, age in bonds, and 70/30 from age 20 to age 55 and 30/70 from age 55 to age 90 might well all be the same.
Well, that makes for a lovely academic model, but the former is much riskier because the magnitude of loss can be greater and it can occur at the worst possible time. There you are at age 65 or 70 floating along with 70% in stocks and feeling rich because of the latest bubble, and then you lose 90% in a couple years. Now what? At age 20 or 30 or even 40 or 50, it may be no big deal, and you don't panic and sell. Time and personal energy are still on your side.

dbr
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Post by dbr » Tue Mar 09, 2010 4:10 pm

metalman wrote:
Without reference to the details of a specific investor, the average outcomes for 50/50 from age 20 to age 90, age in bonds, and 70/30 from age 20 to age 55 and 30/70 from age 55 to age 90 might well all be the same.
Well, that makes for a lovely academic model, but the former is much riskier because the magnitude of loss can be greater and it can occur at the worst possible time. There you are at age 65 or 70 floating along with 70% in stocks and feeling rich because of the latest bubble, and then you lose 90% in a couple years. Now what? At age 20 or 30 or even 40 or 50, it may be no big deal, and you don't panic and sell. Time and personal energy are still on your side.
Uhm, that was 30% in stocks at age 65-70. The 70% stocks was only up to age 55. Age 55 in turn is just a simple dividing point offered, as explained next, as an example of how not very relevant generic advice is likely to be.

The comment has nothing to do with lovely academic models and everything to do with trying to point out that there is no particularly effective general advice about what an individual's asset allocation should be.

metalman
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Post by metalman » Tue Mar 09, 2010 4:31 pm

Uhm, that was 30% in stocks at age 65-70. The 70% stocks was only up to age 55. Age 55 in turn is just a simple dividing point offered, as explained next, as an example of how not very relevant generic advice is likely to be.
The comment has nothing to do with lovely academic models and everything to do with trying to point out that there is no particularly effective general advice about what an individual's asset allocation should be.
OK, but you miss the broader point. Going a constant 50/50 is bad advice, as it incurs high magnitude risk later in life rather than shifting the burden of risk to an early age. 50% equities at age 21 is very little risk, at age 70 it is quite a lot. (For that matter, 70% at age 55 is too much for most, also. That's why age in fixed income is a good starting point. And if you "have to" put much more in equities, it's not necessarily the rule that's bad, it may be you are saving too little.) There are of course exceptions to every rule, but the idea of taking on investment risk (volatility) early in life rather than later is just common sense.

dbr
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Post by dbr » Tue Mar 09, 2010 4:52 pm

metalman wrote:
Uhm, that was 30% in stocks at age 65-70. The 70% stocks was only up to age 55. Age 55 in turn is just a simple dividing point offered, as explained next, as an example of how not very relevant generic advice is likely to be.
The comment has nothing to do with lovely academic models and everything to do with trying to point out that there is no particularly effective general advice about what an individual's asset allocation should be.
OK, but you miss the broader point. Going a constant 50/50 is bad advice, as it incurs high magnitude risk later in life rather than shifting the burden of risk to an early age. 50% equities at age 21 is very little risk, at age 70 it is quite a lot. (For that matter, 70% at age 55 is too much for most, also. That's why age in fixed income is a good starting point. And if you "have to" put much more in equities, it's not necessarily the rule that's bad, it may be you are saving too little.) There are of course exceptions to every rule, but the idea of taking on investment risk (volatility) early in life rather than later is just common sense.
You could look at all those models, for whatever they are worth, that pretty consistently show that the probability of running out of money during withdrawal at moderate rates is very insensitive to stock/bond allocation as long as stock allocation is not below 40% or so. The models that run the problem using historical periods include some time frames that have very severe market declines. It is a misunderstanding that a single large decline in equities dooms a retirement. The outcome depends on the subsequent history. On the other hand, a retirement can be doomed by a long period of low returns without a major crash. One example of a long period of low returns would be the experience of someone excessively invested in nominal bonds. This all assumes the investor does not make a fatal mistake such as panic selling of a large equity holding at a severe market low. The outcome can be significantly affected by what use the investor makes of TIPS and annuities.

Please don't misunderstand. I am not necessarily advocating that retirees SHOULD hold a 50% equity allocation. I am pointing out that running the numbers over a long term holding, contributions withdrawals, market history (or future) would not necessarily show that a successful outcome is highly sensitive to stock/bond allocation within reasonable bounds. I doubt a retiree holding a 50% equity allocation would be likely to come to much harm compared to one holding much less in equities, the balance going into nominal bonds. Such an investor would have to stay the course through portfolio volatility, and that is not necessarily a desirable experience. The solution to that starts with TIPS and annuities, however, and not with nominal bonds.

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Post by KyleAAA » Tue Mar 09, 2010 5:00 pm

My current plan is to revisit my allocation ever 5 years. From about 20% bonds at age 30, I plan to add 5% to my bond allocation ever 5 years. But that could change.

Triple digit golfer
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Post by Triple digit golfer » Tue Mar 09, 2010 7:07 pm

I like static because you stick to one allocation and get a bigger rebalancing bonus. If you're 70/30 and want to be 69/31 the next year, and stocks do worse than bonds, you won't be doing anything if you end up at 69/31 due to market fluctuations, and in that case you're not buying stocks when stocks are "cheap."

But this is very, very, very small potatoes. Do what feels right.

strafe
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Post by strafe » Tue Mar 09, 2010 7:16 pm

Time Diversification and Horizon-Based Asset Allocations

^ I recommend reading the above Vanguard research paper
Time diversification, the phrase used to refer to the concept that investments in stocks are less risky over longer periods than shorter ones, has been the subject of spirited debate for decades. While the foundation of the time diversification debate was laid much earlier, three works published successively in 1994—Mark Kritzman’s article “What Practitioners Need to Know . . . About Time Diversification,” Jeremy Siegel’s book Stocks for the Long Run, and Paul Samuelson’s article “The Long-Term Case for Equities— And How It Can Be Oversold”—seem to have set the inflection point for the discussion that continues today. Some of the finest investment minds have participated on both sides, without providing a conclusion.

Over the last few years the growing acceptance of life cycle investment products, such as target retirement mutual funds, has renewed interest in the topic. The objective of this paper is not to prove or disprove time diversification, but to evaluate whether the concept must be valid for a horizon-based asset-allocation framework to be viable and appropriate. Our findings suggest that there is little evidence to support the notion that time moderates the perceived volatility inherent in risky assets. However, we would expect the risk-reward relationships of the
past to prevail in the future, and if that is the case, a longer investment horizon may support a willingness and ability to assume the greater uncertainty of equity- centric asset allocations. This may be true particularly for younger investors for whom the allocation to human capital and the risk posed by the erosion of purchasing power by inflation can reasonably be assumed to be greatest.

dbr
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Post by dbr » Tue Mar 09, 2010 7:19 pm

A very good illustration of the nature of risk and time is presented here:

http://homepage.mac.com/j.norstad/finan ... -time.html

I think the best overall analysis and presentation of investing in retirement is presented in the book here:

http://www.retirementoptimizer.com/

There is excellent discussion of many aspects of this problem here:

http://bobsfinancialwebsite.com/

walkinwood
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Post by walkinwood » Tue Mar 09, 2010 7:47 pm

This topic is addressed in this article in this month's Journal of Financial Planning in the context of target date funds.

http://www.fpajournal.org/CurrentIssue/ ... etirement/

They analyse some strange scenarios like showing that being 100% in stocks until 10 years before retiring, and then doing an "age in bonds" allocation yields the best results.

Zvi Bodie chimes in with this artcle on glide paths of target date funds in the same issue
http://www.fpajournal.org/CurrentIssue/ ... tAnySpeed/

JFP articles are available for free only during the current month.

Ron
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Post by Ron » Tue Mar 09, 2010 7:54 pm

This is an interesting thread. I (along with my wife) have been on both sides of the "adjust as you age" exercise over many years, starting with our accumulation years (up to our mid 50's) and in early retirement (in our early 60's).

During our accumulation years, we generally held a 90/10 AA. We went through a lot of downturns (and upturns) over the years (since 1982) and one thing we learned was that nothing lasts forever. In addition, both upside and downside moves varied in intensity (as everybody knows over the last few years).

While we worked, our primary goal was to "hit our number". Now in retirement, our primary goal is to ensure that our cash flow remains consistent, regardless of what the market does. In retirement, cash flow is everything.

Upon making portfolio changes starting in our mid-50's to prepare for retirement, we changed our target AA from 90/10 to 60/40. This was done by a two-fold move of moving equities to cash and to bond holdings. The move to cash is, and remains important (cash flow - remember?)

However, as we entered retirement and started working with the "decumulation phase" (which is an entirely different animal), we need to learn to coordinate not only our portfolio, but also in consideration with our other income streams (e.g. SPIA, SS, pensions, etc.) - some that we currently have; the remainder over the next eight years.

What we discovered is as these income sources startup, our need for portfolio withdrawals starts out but quickly reduces as the years go on, to the point of taking out very little for expenses at age 70. I will not talk about RMD's - that is another point for another time.

For us, we found that it makes more sense to include the (imputed) value of our revenue streams along with our portfolio value. When we do this, we found our current 60/40 AA (the 40% includes our cash, replenished from the equity side during "up" years) will evolve to an approximately 20/80 - 30/70 actual AA without any direct portfolio changes through our retirement years.

A different way to think about it? Sure. Am I (and my wife) a bit "off" in thinking? Maybe, but there is a person by the name of Bogle that has the same idea.

See the following article (have to scroll down to see Mr. Bogle's remarks):

http://www.npr.org/templates/story/stor ... =124131819

Just another opinion on how to look at the situation from my/wife's plan.

- Ron

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Post by Lincoln » Tue Mar 09, 2010 8:08 pm

I've decided on a 60/40 allocation at age 30 and plan on keeping it forever. I plan on using this allocation for consumption smoothing (pre and post retirement spending) and I also anticipate accumulating more than I'll reasonably need. There are just so many other factors going on that I can't predict along with different theories on how to integrate known factors (i.e. social security, pensions, other income) that I figured I'd just stick with something balanced. I chose 60/40 as opposed to, say, 50/50 in no small part due to the fact that it is a common allocation for pension funds and endowments that have similar objectives and factors (balancing future/present spending) though on a different scale.

Check out this Merriman article "One porfolio for life?", which does a good job of laying out the case: http://www.fundadvice.com/articles/mark ... -life.html

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Post by TheEternalVortex » Tue Mar 09, 2010 8:25 pm

The arguments that you can suffer a large loss more earlier in your life than later assume that your future income (or more exactly, the future income that you will save) is a bond-like instrument. For example if you are age 20 and have $1 million, and plan to never save another cent for retirement, then surely your age should play no role in your asset allocation. It might change if markets do particularly well or particularly poorly, but not just because of age. In this situation a 50% loss at any age is equally bad.

If your future income is like a bond, then you should be heavier in equities earlier simply because overall your allocation is balanced. And later when you have no, or very little, future earnings, it then makes sense to have more in bonds.

But is future income like a bond? This doesn't seem to make much sense for most people. Certainly if you have tenure or some other extreme secure position it might be true, but in general your personal income is more like equity. It will probably have higher correlation to equity returns, and have much higher variance than bonds.

So if that is the case, shouldn't you have *more* in bonds when you are younger?

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Post by Ron » Wed Mar 10, 2010 10:52 am

TheEternalVortex wrote:So if that is the case, shouldn't you have *more* in bonds when you are younger?
When I was younger (e.g. I had a job, and an income), my goal was to accumulate as much as I could for the "future" (not present, which was taken care of by my job income).

You can take a risk while you are younger, IMHO. Be it getting married, having children, starting a business, etc.

Time is on your side. As you get older, that's not the case.

In my (and my wife's) accumulation years, we felt comfortable with a 90/10 AA.

Now, being retired we cannot afford the "flux" that AA represents. We value "security" over "possibility".

If you are young, take the chance (and we did). It's not necessarily and option you have, once you retire.

- Ron

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