Why is everyone showing up with an aggressive AA?

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TimDex
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Why is everyone showing up with an aggressive AA?

Post by TimDex » Sun Sep 23, 2007 6:47 pm

I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim

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Post by xenial » Sun Sep 23, 2007 7:12 pm

Tim, I'm partial to the your age in bonds rule of thumb myself. The aggressive asset allocations are probably due to excessive reliance on the historical record, as well as enterprises (including Vanguard) which oversell it. All the backtesting which goes on here is very reassuring to some investors, because it involves hard numbers rather than just opinions. The fact that bad stuff hasn't occurred in the past is taken as a guarantee that it won't happen in the future. Even well respected posters imply that a 50% decline in equities is a worst case scenario. The funny thing is the historical record employed is for the most part pretty recent and US-centric. The Great Depression in the US, WW2 in many countries, as well as more recent equity declines in the UK and Japan are largely ignored.

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Re: Why is everyone showing up with an aggressive AA?

Post by MossySF » Sun Sep 23, 2007 7:32 pm

TimDex wrote:I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim
What's pushing people this direction is:

1) Poor saving habits
2) Disappearance of pension plans
3) Assured drops in social security & medicare benefits

Somebody saving 10% of their salary for 30 years in a 60/40 asset allocation will not have enough to retire. Might as well just live it up and wait for a government bailout.

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Post by nisiprius » Sun Sep 23, 2007 8:11 pm

I think many people underestimate the risk.

Advocates of very aggressive asset allocations talk as if there were a virtual certainty of stocks earning their historical rate of return if held for a long period of time. Let's suppose stocks' "historical rate of return" is 10%.

Why is it that nobody is offering an investment vehicle that looks like a 9% zero coupon 30 year bond? That is, why isn't there anyone who will promise you that if you give them $10,000 in 2007 they will give you back $132,000 in 2037?

It seems easy, right? Just put the $10,000 in an S&P index fund... let them earn that 10% historical rate... in 2037 it will be worth $174,500... hand the investor the $132,000 you promised and pocket the $42,500.

Or if you don't think 30 years is long enough... why isn't anyone offering a 50-year investment that invests in common stocks and pays out a guaranteed 8%. There are many institutions that work on that long a time frame and would have a use for such an investment if it existed.

As far as I know, such investment products do not exist. Why not?

Because the "historical rate of return" is interesting to talk about, but not something that anyone ought to rely on.

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Two Hypotheses

Post by grok87 » Sun Sep 23, 2007 8:15 pm

1) It has been too long since the last true market correction (did we in fact have one this summer or was it a near miss?)

2) There is a "self selection bias" going on in terms of who posts on these boards (at least in terms of the newbies that post). People newly interested in investing may have become so because of the great returns equities have had recently. So they naturally think equities are the place to be.

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Re: Why is everyone showing up with an aggressive AA?

Post by watchnerd » Sun Sep 23, 2007 8:25 pm

TimDex wrote:I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim
Assuming they went to college, most people in their early-mid 20s weren't even in the workforce yet during the 2000-2001 crash, let alone investing retirement savings. Thus, they didn't suffer personally.

Folks 27-29 now would probably be about the youngest to have taken any kind of meaningful hit in 2000-2001.

A good portion of risk tolerance is emotional, and living through a crash is completely emotionally different from reading about it or witnessing it from a distance.
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Post by watchnerd » Sun Sep 23, 2007 8:32 pm

nisiprius wrote: Why is it that nobody is offering an investment vehicle that looks like a 9% zero coupon 30 year bond? That is, why isn't there anyone who will promise you that if you give them $10,000 in 2007 they will give you back $132,000 in 2037?
Actually, if your cajones are big enough, you can buy a Ford Motor Co bond with a coupon of 9.98, a current yield of 10.918 at the asking price, a CCC+ grade, and a maturity of 2047. CUSIP 345370BW9.

:shock:
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Markets

Post by nick22 » Sun Sep 23, 2007 8:33 pm

When was the last truly terrible market? And not the 90s tech boom/bust that was inevitable, but a truly bad market with pervasive pessimism.

It was likely the 73-74 crash and the ensuing 8 years of stagflation. Risk hasn't really shown up in 30 years, and is just currently mispriced. I am at 80% equity, 10% RE, 10% bonds and I am willing to assume these risks. But mostly because I am early in the accumulation phase and 25-30 years from retirement. But I do think most Monte carlo simulations (I know based on past results) would support the 60:40 split.
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Re: Markets

Post by watchnerd » Sun Sep 23, 2007 8:37 pm

nick22 wrote: It was likely the 73-74 crash and the ensuing 8 years of stagflation.
I was only a kid at the time, but I remember the pervasive economic malaise, fear of inflation, gas lines, rampant unemployment....hard times. I think those memories stick with you for a long time.

But you left out the most damaging, horrible thing: disco
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Post by adave » Sun Sep 23, 2007 9:12 pm

For me, it is a worry that I would be "missing out" on the gains of the stock market - which in my lifetime has been 12% per yr for the S&P 500 (born in 1976). While that may not be sustained forever - if it has been the case since I was born it just doesn't "feel" like a lot of risk.

I have heard that with 80/20 you pretty much capture all the returns of the stock market while reducing risk, so it would be a good option.

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Post by woof755 » Sun Sep 23, 2007 9:27 pm

I definitely would consider giving someone 10,000 bucks today to ensure that there was no more disco for the next 50 years.

We all would profit from that!
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Post by stratton » Sun Sep 23, 2007 9:40 pm

A 100% stock is very valid when getting your very first mutual fund. Say you're straight out of school and accumulate 6 months worth of expenses. Then you take $3000 and get Total Stock Market. At that point the emergency fund is bigger than your equities. Normally we don't count emergency funds in an asset allocation, but this is someone first starting out.

However, I agree that a lot of people around here are pretty aggressive. I think they'd be better served with a Target fund until they can accumulate $10K and then get multiple funds.

Paul

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Post by Index Fan » Sun Sep 23, 2007 9:43 pm

10 years ago I was 80/20 equity/fixed, I moved to 70/30 a few years ago, now I'm down to 60% equities max a few years away from early retirement with a pension.

I'm a believer in a balanced allocation approach when you have a decent amount at stake anyway.

The 60/40 solution
by Peter L. Bernstein
http://web.archive.org/web/200303161714 ... in6040.pdf
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Post by market timer » Sun Sep 23, 2007 11:25 pm

Brilliant paper by Bernstein. He tells investors to cut back on equity exposure in March 2003 at Dow 7500, when the Fed funds rate was 1%, and bond yields were similarly awful. I'm sure people who followed his advice are happy that 60/40 backtested to a mere 2% discount to all-equity.

Those were the days to borrow at long term fixed rates and invest in the market, exactly the opposite course of action to that prescribed by Bernstein. Though his timing leaves something to be desired, his books are very good.

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Why is everyone showing up with an aggressive AA?

Post by YDNAL » Sun Sep 23, 2007 11:28 pm

When was the last truly terrible market? And not the 90s tech boom/bust that was inevitable, but a truly bad market with pervasive pessimism.

It was likely the 73-74 crash and the ensuing 8 years of stagflation. Risk hasn't really shown up in 30 years, and is just currently mispriced.
Many great responses. I believe that Nick22 hit the nail on the head.

The Arab oil embargo in 1973 and the worse recession in 40 years in 1974 were unquestionably 2 events that influenced the behavior of most that lived through it and were impacted by them. Right out of college, I remember working at a retail store while searching for my first job in public accounting. IMO, the 20- to 40-something generation hasn't been economically affected in similar fashion.
http://woodrow.mpls.frb.fed.us/pubs/ar/ar1974.cfm?js=0

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Landy
Last edited by YDNAL on Sun Sep 23, 2007 11:31 pm, edited 1 time in total.

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Post by Index Fan » Sun Sep 23, 2007 11:29 pm

I think timing was the furthest thing from Bernstein's mind in giving that advice :wink:
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Post by market timer » Sun Sep 23, 2007 11:36 pm

Index Fan wrote:I think timing was the furthest thing from Bernstein's mind in giving that advice :wink:
That's the brilliance of modern asset managers. They've managed to create an environment that minimizes the probability of their recommendations being falsified by the real world, while maintaining a veil of scientific credibility. As an economist, I'm familiar with this charade.

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Post by kiki » Sun Sep 23, 2007 11:54 pm

I'd also recommend looking at this from another perspective. Over the long-term, do you think you'll lose that much more than bonds would give you? Sure, it might not pan out, but why not give it a shot? In 30 years when I need the money, could it be much worse than anything else? And I know it can be much better - but I'll admit, it might take some luck and getting their will definitely involve more volatility.

When I calculate my long-term rate in my planning, I use about 4% (real) for equities, which is about what I read is estimated for bonds. Is this too high?

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Aggressive AA

Post by Plainsman » Mon Sep 24, 2007 12:38 am

By most forum members' standards, I have an agressive AA...
(85% equity/10% cash/5% bonds).

My reasons:

1. I experienced the 2000-2002 bear market first-hand, and know my risk tolerance.

2. I have 20-30 years until retirement. I will likely be 40-50% bonds upon retirement, and will shift my AA as I get older and approach retirement age. For now, I want to get money into the market and accumulate fund shares while the prices are "low."

3. I have no pension...only a defined contribution plan from work plus taxable investments. Building my nest egg is my responsibility. One can argue that this is a reason to be conservative, but I view it as a reason to take on more risk early in the accumulation stage, then shift to a more conservative AA later on. Just as one can have an overly-aggressive AA, one can also have too conservative an AA (factoring in one's overall situation).

4. Current savings rate lends itself to high equity exposure. If my portfolio loses 50% in value over the next 2 years, at my current savings rate, I will have replaced those losses with new contributions.

5. Planning for long retirement. Many, Bogle himself I believe, have shifted their thoughts to a bond allocation of "age-10" to account for longer retirements. The Target Retirement funds tend to reflect the idea of taking on more risk and being more aggressive.

Just my $0.02.

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Post by MossySF » Mon Sep 24, 2007 3:03 am

Let's say you have somebody who starts working at 25 and plans to retire at 65. If his target expense if 85% of today's 50K salary, he will need a portfolio of about 4.2M to fund a 4% withdrawal rate. So let's see how much he needs to save to hit 4.2M with different portfolio configurations:

100/0 @ 10% = 12% of annual salary
75/25 @ 9.25% = 14.5%
50/50 @ 8.5% = 17.5%
25/75 @ 7.75% = 21%
0/100 @ 7% = 25%

Hardcore Bogleheads might be saving more than 17% of their salary but I don't know about everybody else. (Poll time?) Somebody investing 10% of salary in a 50/50 portfolio will end up about halfway to their goal which means instead of retiring at 65, they have to last in the workforce until 75-80. With this in mind, let's put the outcomes in a truth table:

100/0 portfolio, stocks perform well == Retire at 65
100/0 portfolio, stocks perform poorly == Retire at 75-80 (if you don't die first)
50/50 portfolio, stocks perform well == Retire at 75-80 (if you don't die first)
50/50 portfolio, stocks perform poorly == Work until you die

When viewed in this manner, a 100/0 portfolio is not risky. If you went to Vegas and they had two games -- one paid a guaranteed $500 while the other paid either $1000 or $500 -- would you pick the $500 game just because it had less volatility?

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Re: Why is everyone showing up with an aggressive AA?

Post by Valuethinker » Mon Sep 24, 2007 3:54 am

TimDex wrote:I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim
Short answer, we haven't been through a truly brutal bear market yet.

Taylor has some good stories about 1972-74, when stocks like GE & P&G dropped by 75-80%. In the context of a period, 1968-1979, when the market lost 60% of its value, after inflation.

(bond market also got killed at that time. Inflation is bad for stocks, and all bonds except TIPS, which did not exist at that time).

The pattern based on the 1960s and 70s is first the market stops rising, then small caps start to fall away, the final selling crescendo is when the big cap growth stocks take the pounding. Then individual investment in equities is pretty much dead.

People think 200-03 was bad, but that was only a 50% market fall and only for 2.5 years. What will really kill markets is a Japan-style situation, where stocks go down year, after year, after year.

These things go in cycles. In 1950, it was conventional wisdom that sound investing was about bonds. This is after a generation of wealthy people got wiped out in 1929-33.

It's now almost conventional wisdom that equities are king, and produce the highest long run returns (they do, but the definition of 'long run' is longer than most personal time horizons).

Stocks used to yield over 4%, even over 5%. Now, if there is an extended weak period in stocks, with yields down around 2%, it's going to be *very* painful.

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Re: Why is everyone showing up with an aggressive AA?

Post by Valuethinker » Mon Sep 24, 2007 3:59 am

TimDex wrote:I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim
I should add, I usually suggest even the most aggressive 20-something investor be 15% in TIPS. Even if they are then 85% in equities.

TIPS are the safest investment in the market there is (discard paranoid conspiracy theories about the US government fixing the inflation rate: it's not a perfect measure of true inflation, but it is the best we have. If there is constant misstatement of the inflation rate, then over time the TIPS yield will adjust to reflect that).

I call this the 'I won't eat cat food' portfolio. Or at least the 'it will be premium quality cat food' portfolio ;-).

Zvi Bodie suggests, by contrast, it should be 90%. He has good reasons to make that argument.

I also suggest voting for whatever or whoever can be voted for, to keep Social Security in its current form, even if this means higher taxes (the projected deficit would be removed by a 1-1.5% increase in employer and employee payroll taxes; of course, there are other ways of solving the problem). Because SS is an almost perfect diversifier against stock market investing and against risks that you have difficulty insuring fully against personally (permanent disability, risk to your wife of your early death, etc.).

You can bet all this talk of putting SS into the stock market in individual accounts (the Bush proposal was that individuals borrow at a 3% real rate from their SS benefits, to invest in the market-- if they underperformed, their overall benefit would be lower) will disappear if we get a really wrenching bear market.

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Post by nisiprius » Mon Sep 24, 2007 4:54 am

stratton wrote:A 100% stock is very valid when getting your very first mutual fund. Say you're straight out of school and accumulate 6 months worth of expenses. Then you take $3000 and get Total Stock Market. At that point the emergency fund is bigger than your equities. Normally we don't count emergency funds in an asset allocation, but this is someone first starting out.

However, I agree that a lot of people around here are pretty aggressive. I think they'd be better served with a Target fund until they can accumulate $10K and then get multiple funds.

Paul
If you have a "six months' emergency fund" of, say, $27,000, then your allocation is not 100% stock, it's 10% stock.

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Re: Why is everyone showing up with an aggressive AA?

Post by Ted Valentine » Mon Sep 24, 2007 9:15 am

watchnerd wrote:
Assuming they went to college, most people in their early-mid 20s weren't even in the workforce yet during the 2000-2001 crash, let alone investing retirement savings. Thus, they didn't suffer personally.
This is so true. This is also why I laugh at all these financial bloggers that track their net worth (mostly consisting of 401k and Roth IRA accounts) monthly on their website. They all started investing at the low point of the last correction in the early 2000s and have seen nothing but up up up.
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Post by grumel » Mon Sep 24, 2007 9:29 am

In 1950, it was conventional wisdom that sound investing was about bonds
2007, its still conventional wisdom in Germany where only around 10% of the population has stock market exposure.

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Post by grumel » Mon Sep 24, 2007 9:31 am

In 1950, it was conventional wisdom that sound investing was about bonds
2007, its still conventional wisdom in Germany where only around 10% of the population has stock market exposure in the one or other way - stocks bonds or warrents.

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Re: Why is everyone showing up with an aggressive AA?

Post by liverust55 » Mon Sep 24, 2007 9:48 am

TimDex wrote:I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...
nisiprius wrote:I think many people underestimate the risk.
I know what you mean. I'm in my early 30's and don't think I'd stray too far above 50% equity. There's a quote from a Larry S. article which reads "Volatility destroys returns." I think a combo of a healthy savings rate and steady compound returns will get most people where they need to be.

Just one guy's opinion... :wink:

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Post by johndcraig » Mon Sep 24, 2007 9:56 am

In 20s, who cares vs can’t lose

I may be one of the more bearish posters here, but I have no problem with some in their 20s having a very high equity allocation. If the person has a good job with high advancement potential, then a high equity allocation may put them in the who cares category, i.e., who cares if I take a substantial hit, it will be insignificant in the long run. On the other hand if the person is basing the high allocations on a can’t lose assumption, then I would strongly urge them to consider the fact that they definitely can lose, and back off the high allocations if losing is likely to have long term negative consequences.

John

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Post by nisiprius » Mon Sep 24, 2007 11:01 am

adave wrote:For me, it is a worry that I would be "missing out" on the gains of the stock market
Why worry about "missing out?" I think one should worry about "having enough."

I think worrying about "missing out" is a very dangerous thing to do.

It is this fear that sucks people into bubbles, which always seem to go on and on forever.

I remember reading about the Florida land boom of the 1920s. The people participating in it pretty much knew that it was a bubble, but as it just kept going on and on and on and on, even the most level-headed people got tired of seeing their friends getting rich by doing nothing, and got in.

(IIRC what was being traded was not even real estate but real estate binders, and there was some poisonous dynamic whereby the sale was never quite final, so that long after person A had finished counting his profits, after several success sales by person A to person B to person C to person D, if person D couldn't sell to an even greater fool there was some way the whole chain could break and snap back on person A. A pyramid scheme where even the people who got in first eventually lost.)

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Post by beardsworth » Mon Sep 24, 2007 12:04 pm

Vanguard's site has a chart showing average annual returns and worst one-year losses/best one-year returns for various asset allocations of stocks and bonds for 1926-2006. (Sorry I can't provide a link. The first time I tried to make this post, the Diehards site responded with an automated “error" message saying that I'm not allowed to include links because I don't yet have four posts on the forum. Perhaps a more "experienced" poster, if interested, can find and post the link. That page is titled "Vanguard Model Portfolio Allocations.")

The chart shows that from 1926-2006 a 50/50 allocation would have achieved an average annual return of 8.5%; an 80/20 allocation, 9.8%; and 100% stocks, 10.5%. So, as might have been expected, the higher the allocation to stocks, the higher the average annual return. But, looking at those same figures through the lens of this particular Diehards conversation--level of "aggressiveness" and whether it's justified--the chart also shows that an investor with a 50/50 allocation would have achieved 86.7% of the average return of the 80/20 investor, and 81% of the average annual return of the 100% stocks investor--but with a lot less volatility.

Caveats: In keeping with both Vanguard's traditional philosophy and with the availability of statistics back to 1926, the chart information is apparently all domestic, i.e., excludes the international stocks which many investors would now routinely expect to include in their portfolios. The chart also overlaps a period widely known--for a variety of business, cultural, and military reasons--as "the American century." In view of current international monetary conditions, extraordinary domestic public and private indebtedness, and military exhaustion, I seriously doubt that the 21st century ahead of us will prove to be "American" like the one behind us. Nevertheless, if past investment performance provides any useful guidance for future investment choices, the chart is useful in illustrating that a particular increase in percentage of stocks is not matched by the same percentage increase in expected return, even if an investor is able (both financially and emotionally) to tolerate the magnified risk.

Marc

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Post by mudfud » Mon Sep 24, 2007 12:20 pm

MarcMyWord wrote:
The chart shows that from 1926-2006 a 50/50 allocation would have achieved an average annual return of 8.5%; an 80/20 allocation, 9.8%; and 100% stocks, 10.5%. So, as might have been expected, the higher the allocation to stocks, the higher the average annual return. But, looking at those same figures through the lens of this particular Diehards conversation--level of "aggressiveness" and whether it's justified--the chart also shows that an investor with a 50/50 allocation would have achieved 86.7% of the average return of the 80/20 investor, and 81% of the average annual return of the 100% stocks investor--but with a lot less volatility.
Just keep in mind that the numbers are annualized returns. Over the time span you quoted, the 50/50 would have made about 23% of the 100% allocation, and the 80/20 would have about 60% of the 100% allocation.

The link is below
https://personal.vanguard.com/VGApp/hnw ... ontent.jsp
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Post by gt4715b » Mon Sep 24, 2007 12:35 pm

MarcMyWord, you can't just divide geometric annual returns; that's almost meaningless. If we look at the actual returns generated in 20 years from your provided returns another story emerges:

Over 30 years, $1 invested at:
8.5% = $11.56
9.8% = $16.52
10.5% = $19.99

So the 8.5% annual return generates 70% and 58%, respectively of the 9.8% and 10.5%, which is a lifestyle altering difference for most people.

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Post by zhiwiller » Mon Sep 24, 2007 12:59 pm

Us young folks can have risky portfolios because many of us earn more in a year than the value of our portfolios. I'm sure when my portfolio hits six figures, I'll start thinking more about risk.

(85/15)

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Post by unclemick » Mon Sep 24, 2007 1:34 pm

Psssst! - Recency!

Notice the long term trend down since circa 1982('Stocks are Dead') in overall interest rates vs the stock market(read 'irrational exuberance).

Add in - as other threads have attested Jason Zweig, investor behavior studies, and the shear joy of driving into the future while looking in the rear view mirror and badda bing badda boom ya got bad to the bone cats like me(who after forty years should know better) who have set aside Mr Bogles relavent wisdom thru rationalization:

85% Target Retirement 2015 at 64 which should be more possibly 2005 but I have a small pension/early SS and the illusion of being young at heart - notwithstanding males in both family trees had heart problems.

Yes - I know better - but like a moth to the flame?

Surviving the 2002 stock dip, exercise, quit smoking finally, defensive backstop of SS/Pension/current yield of portfolio and some dividend stocks gives that 'bullet proof' illusion.

heh heh heh - sometimes I go back and reread some of the wisdom of Bogle should the 'go at throttle up' urge hit too hard.

Pssst! - when you think you are not rationalizing/then you are! :lol: :lol:

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Post by JRA » Mon Sep 24, 2007 2:55 pm

As I understand it, the percentage of bonds is only part of the risk equation and perhaps not even the most important part. A portfolio that has 50% in bonds made up of long term corporates or even junk bonds has a much higher standard deviation and a higher correlation with equities than a much smaller allocation to 3 mth or even 1 year treasuries. Isn't this what Larry has been trying to tell us all along? What is "safer," a portfolio with 50% in long term bonds or 30% in 1 year treasuries? Or, is a portfolio that merely consists of 50% TBM/50% TSM "safer" than one that has money in multiple asset classes but a much smaller allocation to bonds, including international, international small cap, emerging markets, treasuries and TIPS, and real estate? I'm not sure how risk is being defined here, but the assumption by many seems to be that bonds reduce risk, and this isn't necessarily the case.
JRA

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Post by nisiprius » Mon Sep 24, 2007 3:28 pm

JRA wrote:As I understand it, the percentage of bonds is only part of the risk equation and perhaps not even the most important part. A portfolio that has 50% in bonds made up of long term corporates or even junk bonds has a much higher standard deviation and a higher correlation with equities than a much smaller allocation to 3 mth or even 1 year treasuries. Isn't this what Larry has been trying to tell us all along? What is "safer," a portfolio with 50% in long term bonds or 30% in 1 year treasuries? Or, is a portfolio that merely consists of 50% TBM/50% TSM "safer" than one that has money in multiple asset classes but a much smaller allocation to bonds, including international, international small cap, emerging markets, treasuries and TIPS, and real estate? I'm not sure how risk is being defined here, but the assumption by many seems to be that bonds reduce risk, and this isn't necessarily the case.
JRA
In my naïve way, I always understood the conventional wisdom to be that that bonds in general were less risky than stocks, and that they were reasonably uncorrelated with stocks, with a 60/40 ratio giving the smoothest ride.

People are now slicing and dicing asset classes into many different categories, and I'm not clear on whether this is "fine tuning," or whether the Boglehead wisdom is fundamentally different from the conventional wisdom, or whether I fundamentally misunderstood the conventional wisdom.

If TIPS are simply "better" than the Lehman Brothers Aggregate Bond Index, so be it, but does that mean the Lehman Brothers index is actually bad? Or that stocks are not stocks and bonds are not bonds?

Whenever I look at the "ten year hypothetical growth" chart of anything with "bond" in its name I think I see the same thing: an inexorable fairly smooth upward almost-monotonic growth, as the bonds pump out their interest payments.

Whenever I look at the chart for almost anything that seems to be a stock fund--US, international, large-cap, small-cap, whatever--I see peaks at around the year 2001 and 2007 and dips at around 2003.

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Post by mptfan » Mon Sep 24, 2007 4:17 pm

MossySF wrote: When viewed in this manner, a 100/0 portfolio is not risky. If you went to Vegas and they had two games -- one paid a guaranteed $500 while the other paid either $1000 or $500 -- would you pick the $500 game just because it had less volatility?
I do not equate investing for my retirement with casino gambling.

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Post by Valuethinker » Mon Sep 24, 2007 4:33 pm

nisiprius wrote:
JRA wrote:As I understand it, the percentage of bonds is only part of the risk equation and perhaps not even the most important part. A portfolio that has 50% in bonds made up of long term corporates or even junk bonds has a much higher standard deviation and a higher correlation with equities than a much smaller allocation to 3 mth or even 1 year treasuries. Isn't this what Larry has been trying to tell us all along? What is "safer," a portfolio with 50% in long term bonds or 30% in 1 year treasuries?

The only way to answer that question is to run a backtest simulation.

On almost any set of assumptions, if you throw TIPS in, you lower the risk and volatility of your portfolio (bonds and total portfolio).

This is because TIPS have a positive correlation with inflation, whereas straight bonds and stocks have a negative return correlation with inflation.

Also because TIPS prices respond to changes in real interest rates, not nominal rates, they have lower volatility and low correlation with conventional stocks and bonds.

It's a mantra for me. Most portfolios (all?) with the tax exempt room should be 15% in TIPS. I would also argue for long duration TIPS, if you can buy them (I hold the Canadian equivalent, which mature in 2028 in the case of this specific issue).

There are timing issues on when best to buy them as the real interest rate moves in and out.
Or, is a portfolio that merely consists of 50% TBM/50% TSM "safer" than one that has money in multiple asset classes but a much smaller allocation to bonds, including international, international small cap, emerging markets, treasuries and TIPS, and real estate? I'm not sure how risk is being defined here, but the assumption by many seems to be that bonds reduce risk, and this isn't necessarily the case.
JRA
In my naïve way, I always understood the conventional wisdom to be that that bonds in general were less risky than stocks, and that they were reasonably uncorrelated with stocks, with a 60/40 ratio giving the smoothest ride.
Yes. But certain kinds of bonds are as risky as stocks or nearly so:

- emerging market bonds historically
- bonds in foreign currencies (unhedged currency)
- high yield bonds and the bonds of lowly rated corporates
- very long term US Treasury bonds
- zero coupon bonds
- some of the higher risk asset backed securities (eg subprime mortgage bonds) are about to show this characteristic
People are now slicing and dicing asset classes into many different categories, and I'm not clear on whether this is "fine tuning," or whether the Boglehead wisdom is fundamentally different from the conventional wisdom, or whether I fundamentally misunderstood the conventional wisdom.
I think there is a degree of Attention Deficit Disorder (ADHD) in this one.

However Larry Swedroe has convinced me I need to look at the merits of commodities again.
If TIPS are simply "better" than the Lehman Brothers Aggregate Bond Index, so be it, but does that mean the Lehman Brothers index is actually bad? Or that stocks are not stocks and bonds are not bonds?
Stress test for bonds is the 1994 year. Also the entire inflation period 1966-1981.

In both cases, in real terms (and in 1994 in nominal terms) you will see bonds fall, and in some cases, quite substantially.

One warning: those nice smooth lines on a graph, graphed besides equities, aren't so nice and smooth if you change the scale. The equity volatility conceals the bond volatility.

Note also coupon rates are much lower now. So if there is a year bonds achieve say a 10% drop in prices, your returns will be -5%, whereas in 1994 (coupons at 8%, say) your returns would have been -2%.

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Post by bolt » Mon Sep 24, 2007 5:26 pm

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Post by SmallHi » Mon Sep 24, 2007 5:52 pm

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties
I haven't read every post on this thread, but the ones I did read I disagree with.

There is no good reason in my mind for an investor in their 20s or early 30s to not be 100% in stocks if the money is earmarked for retirement.

Sure, we may see a 20 or 30 year period at some point where stocks don't beat bonds, small doesn't beat large, or value doesn't beat growth....but I don't agree with the idea of betting on that hunch.

If nothing else, for the young investor, so much of their future portfolio will derive from ongoing contributions, one should almost root for a 20 year period of poor equity returns so money can be continually added at lower or at least slightly higher prices.

If you are afraid of how bear markets are going to impact money you won't be using for 25 or 30 years, your best investment is more time spend understanding the behavior of markets, why capitalist economies make for good long term investments, and the study of how markets price risk and return.

Over a 30 year period, the difference in potential returns to a 100% equity portfolio vs a 50/50 stock/bond portfolio could very well mean the more aggressive investor may have 2X as much end period wealth as the very conservative investor.

Assuming $10K to start + $3,000 per year at the following returns over the next 30 years:

10% = $670,000
7% = $360,000

I also don't think a 10% expected return for a reasonably small/value tilted global equity portfolio is overly optimistic. That would be a 20% decrease over what a similar US only portfolio has achieved dating back to before the great depression.

Have faith in the markets, folks!

SH

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Re: Why is everyone showing up with an aggressive AA?

Post by Chinwhisker » Mon Sep 24, 2007 6:07 pm

TimDex wrote:I'm curious why all of a sudden it seems that everyone is showing up requesting advice on a very aggressive asset allocation (of 90 to 100% equity)?

I know I'm ridiculously conservative, with my 60-40 or 50-50 recommendations for new investors in their twenties...but still...is it just me, or has everyone been reading something that recommends this type of AA? I know the TR funds for young investors are very aggressive. Are the "check your risk" Q&A stuff that fund planning websites throw at investors pushing them in this direction?

Tim
Hi all,
I hate to but in without even a “Duh huh,” but as I read this, I see a few misconceptions. Even Peter Bernstein didn’t take into consideration an increasing allocation in bonds. The 20 year old is not going to hold 100% stocks till 60. Looking at 100% as opposed to 60/40 for that period is going to offer a skewed result.

If you increase the allocation to bonds systematically as you age, you loose the benefits of holding higher percentages earlier on. In some periods you would have done better holding an increasing percentage in bonds and in some 60/40 throughout (considering starting with no or low allocations to bonds and ending with 60/40). Overall, on average, holding higher percentages in stocks early on as opposed to beginning with an allocation like 60/40 and sticking with it, the increases in return are so pathetic it would be nowhere close to the risk or loss of sleep you might face holding the higher percentages when young.

I used the S&P 500 and 5 yr. T-bonds to back test this, but you could just use a steady percentage you might expect going forward like maybe 5% in bonds and 8% in equities. Set it up in a spreadsheet and increase the bonds as you go along. You’ll see what I mean.

I’ll leave it at that, as this is a concept most cannot accept.

And, once again, forgive my just jumping in, but the conversation is growing so fast, I’m afraid the original thought might be lost.

Chin
They think they know but don't. At least I know I don't know. (Socrates)

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Post by peter71 » Mon Sep 24, 2007 6:19 pm

Hi Chin,

I can definitely accept the concept but I suspect it may depend on the particular 30-year period you test. If, for example, the early part of the 1977-2006 period was systematically worse for stocks than the latter part of the period, that could well explain the limited benefit of shifting your AA over time . . . provided you can get appropriate data on other 30-year periods, however, it shouldn't be too tough to re-run the analysis with starting points in, say, 1947, 1957 and 1967 instead.

All best,
Pete

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Post by matt » Mon Sep 24, 2007 6:55 pm

SmallHi wrote:
There is no good reason in my mind for an investor in their 20s or early 30s to not be 100% in stocks if the money is earmarked for retirement.
Inexperienced investors with aggressive equity allocations routinely sell their stocks at the bottom of a bear market. Is that not good enough reason to invest conservatively until one has experienced a bear market with real money at stake?

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Post by MossySF » Mon Sep 24, 2007 7:14 pm

matt wrote:SmallHi wrote:
There is no good reason in my mind for an investor in their 20s or early 30s to not be 100% in stocks if the money is earmarked for retirement.
Inexperienced investors with aggressive equity allocations routinely sell their stocks at the bottom of a bear market. Is that not good enough reason to invest conservatively until one has experienced a bear market with real money at stake?
I don't see how that would help either. Somebody 50/50 would have breezed through 2000-2002 and this person still would have no idea how they would respond to a 100/0 scenario. It would still be hypothetical thinking "I can stomach a 40% drop".
Last edited by MossySF on Mon Sep 24, 2007 7:15 pm, edited 1 time in total.

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Post by market timer » Mon Sep 24, 2007 7:15 pm

matt wrote:Inexperienced investors with aggressive equity allocations routinely sell their stocks at the bottom of a bear market. Is that not good enough reason to invest conservatively until one has experienced a bear market with real money at stake?
Not good enough for me. Who knows when the next bear market will happen? Risk tolerance isn't even constant over time, so how I respond now while young and single is likely different from how I'll respond when older and with dependents. Then there are opportunity costs. With an equity risk premium of 5%, I would miss an expected $5K this year in a 50/50 allocation vs. 100/0.

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Post by matt » Mon Sep 24, 2007 7:53 pm

MossySF, it's best that no one ever reach their breaking point and abandon equities during a decline. Starting out with a 100% equity allocation guarantees that all who cannot tolerate 100% will fail. They will only convince themselves that equities are "okay" again after another bull market, thus setting themselves up for repeated disaster. Starting with a modest equity allocation allows you to scale into a higher equity allocation if you find yourself comfortable with market declines.

markettimer wrote:
With an equity risk premium of 5%, I would miss an expected $5K this year in a 50/50 allocation vs. 100/0.
Well, luckily for you, the equity premium is going to be well below 5%, so you're not going to miss out on much by reducing equity exposure. But then, you're the guy who wants to be something like 800/(700) anyway. A man with lots of theories but little experience is not where I look for guidance.

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Post by nisiprius » Mon Sep 24, 2007 8:05 pm

market timer wrote:
matt wrote:Inexperienced investors with aggressive equity allocations routinely sell their stocks at the bottom of a bear market. Is that not good enough reason to invest conservatively until one has experienced a bear market with real money at stake?
Not good enough for me. Who knows when the next bear market will happen? Risk tolerance isn't even constant over time, so how I respond now while young and single is likely different from how I'll respond when older and with dependents. Then there are opportunity costs. With an equity risk premium of 5%, I would miss an expected $5K this year in a 50/50 allocation vs. 100/0.
Or then again you might miss a $5K loss. Mightn't you?

Or do you always get what you "expect?"

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Post by watchnerd » Mon Sep 24, 2007 8:12 pm

JRA wrote:Or, is a portfolio that merely consists of 50% TBM/50% TSM "safer" than one that has money in multiple asset classes but a much smaller allocation to bonds, including international, international small cap, emerging markets, treasuries and TIPS, and real estate?
JRA
Everything I've read and the testing I've done indicates that, up to a point and with diminishing returns, adding additional asset classes (intl eq, REITS, commodities, MLPs) beyond vanilla domestic stocks and bonds does reduce risks and increase the Sharpe ratio.

Which is why my portfolio is as unorthodox as it is.
70% Global Market Weight Equities | 15% Long Treasuries 15% short TIPS & cash || RSU + ESPP

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Post by market timer » Mon Sep 24, 2007 8:26 pm

Why all the negativity?

Matt, nobody knows the value for the ERP. I was using a number that is low by historical standards. Bond yields are 4-4.5% right now, so a 5% ERP implies an expectation of 9-9.5% stock returns. That's not really a wild estimate. Incidentally, I'm not a permabull. It's just that I think bonds are really overpriced right now. Stocks are cheap by comparison.

Nisiprius, I was speaking of a mathematical expectation.

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Hi Pete,

Post by Chinwhisker » Mon Sep 24, 2007 8:28 pm

peter71 wrote:Hi Chin,

I can definitely accept the concept but I suspect it may depend on the particular 30-year period you test. If, for example, the early part of the 1977-2006 period was systematically worse for stocks than the latter part of the period, that could well explain the limited benefit of shifting your AA over time . . . provided you can get appropriate data on other 30-year periods, however, it shouldn't be too tough to re-run the analysis with starting points in, say, 1947, 1957 and 1967 instead.

All best,
Pete
Yes, different periods offered different results. This puts you in a situation where you would need know the period in order to know whether higher allocations in stocks early on would help or not -- which of course is not feasible. Considering all the data (I just used 1926 - 2004 a while back), and the average difference in return, it does not fare well for age in bonds or other systematic strategies for increasing bonds as you age.

This just shows the economic value is not necessarily there, and ignores the emotional turmoil hitting a bear market would create with low allocations to fixed income, or the risk of losing one’s source of income at the wrong time.

Figure over a 30 year period, the investor is facing pretty good odds of a gut wrenching bear market, and high stock percentages do not make sense. Someone with $50k is not going to suffer as much as someone with $500k, but the one with $50k may suffer as much emotionally and make a wrong move at the wrong time guaranteeing lower returns going forward.

You think?

BTW, the ease of posting here could get addictive. ;o)

Chin
They think they know but don't. At least I know I don't know. (Socrates)

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