To start, there is no “correct” asset allocation by age. But there is an optimal asset allocation I’d like to share in this post. Your asset allocation between stocks and bonds depends on your risk tolerance. Are you risk averse, moderate, or risk loving? I’m personally risk loving or risk averse, and nothing in between. When I see “Neutral” ratings by research analysts, I want to slap them upside the head for having no conviction. Then the optimist in me thinks what a great world to have occupations that pay well for providing no opinion!
Your asset allocation also depends on the importance of your specific market portfolio. For example, most would probably treat their 401K or IRA as a vital part of their retirement strategy because it is or will become their largest portfolio. Meanwhile, you can have another portfolio in an after-tax brokerage account like E*Trade that is much smaller where you punt stocks. If you blow up your E*Trade account, you’ll survive. If you demolish your 401K, you might need to delay retirement for years.
I ran my current 401K through Personal Capital to see what they thought about my aggressive asset allocation. To no surprise, the below chart is what they came back with. I essentially have too much concentration risk in stocks and am underinvested in bonds based on the “conventional” asset allocation model for someone my age. To run the same analysis on Personal Capital, simply click the “Investment Checkup” link under the “Investing” tab.
I am going to provide you with five recommended asset allocation models to fit everyone’s investment risk profile: Conventional, New Life, Survival, Nothing To Lose, and Financial Samurai. We will talk through each model to see whether it fits your present financial situation. Your asset allocation will switch over time of course.
Before we look into each asset allocation model, we must first look at the historical returns for stocks and bonds. The goal of the charts is to give you basis for how to think about returns from both asset classes. Stocks have outperformed bonds in the long run as you will see. However, stocks are also much more volatile. Armed with historical knowledge, we can then make logical assumptions about the future.
HISTORICAL RETURNS FOR STOCKS
* The 10-year historical average return for the S&P 500 index is roughly 7%. The 60 year average is also roughly 7% after the most recent 38.5% drubbing in 2008. The S&P 500 closed up roughly 13% in 2014.
* The S&P 500 has been extraordinarily volatile over the past 20 years. The golden age was between 1995-1999. 2000-2002 saw three years of double digit declines followed by four years of gains until the economic crisis. In other words, there looks to be a 3-5 year run until performance reverses so watch out.
* The S&P 500 index is now over 2,000+, a record high as of 1/1/2016 as the stock market sanguinely marches on in the face of a slowdown in Europe, new quantitative easing in Japan, and continued low interest rates in the US. Oil prices have collapsed, and there are some issues in Russia. But with the US on a Fed rate hike course, things are going to be dicy for 2016.
HISTORICAL RETURNS FOR BONDS
* When things get good for stocks, they can get really good. Don’t forget to rebalance!
* From the first chart, you can see that the 10-year Bond Yield has been going down since 1982. In other words, 10-year bond prices have been going up for 35 years given there is an inverse relationship, making US Treasuries one of the best risk free performers.
* The second chart shows how stocks have trounced bonds since 1994. Unfortunately the chart cuts off at 2008 where the crisis occurs because this chart is from a bond shop called BondGroup. Their goal is to sell bonds, not stocks.
* Bonds have never returned more than 20% in one year. The two times the BarCap US Aggregate index came close was in 1991 and in 1995 when inflation was in the high single digits. Inflation is now around 1-2%, which puts a cap on bond yields.
CONVENTIONAL ASSET ALLOCATION MODEL
The classic recommendation for asset allocation is to subtract your age from 100 to find out how much you should allocate towards stocks. The basic premise is that we become risk averse as we age given we have less of an ability to generate income. We also don’t want to spend our older years working. We are willing to trade lower returns for higher certainty. The following chart demonstrates the conventional asset allocation by age.
* You believe in conventional wisdom and don’t want to overcomplicate things.
* You expect to live to the median age of 78 for men and 82 for women.
* You are not very interested in the stock market, bond market, or economics and would rather have someone manage your money instead.
NEW LIFE ASSET ALLOCATION MODEL
The New Life asset allocation recommendation is to subtract your age by 120 to figure out how much of your portfolio should be allocated towards stocks. Studies show we are living longer due to advancements in science and better awareness about how we should eat. Given stocks have shown to outperform bonds over the long run, we need a greater allocation towards stocks to take care of our longer lives. Our risk tolerance still decreases as we get older, just at a later stage.
* You plan to live longer than the median age of 79 for men and 82 for women.
* You’re not that interested in actively managing your own money, but depend on your portfolio to live a comfortable retirement.
* You plan to work until the conventional retirement age of 65, plus or minus 5 years.
* You are a health fanatic who works out regularly and eats in a healthy manner. Sugar is synonymous with poison, while raw is synonymous with utopia.
SURVIVAL ASSET ALLOCATION MODEL
The Survival Asset Allocation model is for those who are risk averse. The 50/50 asset allocation increases the chances your overall portfolio will outperform during a stock market collapse because your bonds will be increasing in value as investors flee towards safety. Bonds can also rise when stocks rise as you’ve seen in the historical chart above. That said, bonds sold off during the 2008-2010 economic crisis because investors lost all confidence in stocks and bonds. Money fled to money market funds instead.
* You believe the stock market has a higher chance of underperforming bonds, but are not sure given historical data points to the contrary.
* You are within 10 years of full retirement and do not want to risk losing your nest egg.
* You depend on your portfolio to be there for you in retirement due to a lack of alternative income streams.
* You are very wary of the stock market because of all the volatility, scams, and downturns.
* You are an entrepreneur who needs some financial safety just in case your business goes bust.
NOTHING TO LOSE ASSET ALLOCATION MODEL
Given stocks have shown to outperform bonds over the past 60 years, the Nothing To Lose Asset Allocation model is for those who want to go all-in on stocks. If you have a long enough time horizon, this strategy might suite you well.
* You are rich and don’t count on your stock portfolio to survive now or in retirement.
* You are poor and are willing to risk it all because you don’t have much to risk.
* You have tremendous earnings power that will continue to go up for decades.
* You are young or have an investment horizon of at least 20 more years.
* You believe you are smarter than the market and can therefore choose sectors and stocks which will consistently outperform.
FINANCIAL SAMURAI ASSET ALLOCATION MODEL
The Financial Samurai model is a hybrid between the Nothing To Lose model and the New Life model. I believe stocks will outperform bonds over the long run, but we’ll see continued volatility over our lifetimes. Specifically, I’m preparing for a new normal of 5 to 7% returns for stocks (from 8-10% historically) and -5 to 4% return on bonds from 4-7% historically. In other words, I believe bonds are expensive and have a higher risk of staying flat or losing money for investors who do not hold to maturity.
* You have multiple income streams.
* You are a personal finance enthusiast who gets a kick out of reading finance literature and managing your money.
* You are not dependent on your portfolio in retirement, but would like it to be there as a nice bonus.
* You enjoy studying macroeconomic policy to understand how it may affect your finances.
* You are an early retiree who won’t be contributing as much to their portfolios as before.
THE RIGHT ASSET ALLOCATION ALL DEPENDS ON YOU
By providing five different asset allocation models, I hope you are able to identify one that fits your needs and risk tolerance. Don’t let anybody force you into an uncomfortable situation. Ideally, your asset allocation should let you sleep well at night and wake up every morning with vigor. When it comes to investing, you need to calculate realistic risk reward scenarios and invest accordingly.
I encourage everyone to take a proactive approach to their retirement portfolios. Ask yourself the following questions to determine which asset allocation model is right for you:
* What is my risk tolerance on a scale of 0-10?
* If my portfolio dropped 50% in one year, will I be financially OK?
* How stable is my primary income source?
* How many income streams do I have?
* Do I have an X Factor?
* What is my Money Strength?
* What is my knowledge about stocks and bonds?
* How long is my investment horizon?
* Where do I get my investment advice and what is the quality of such advice?
Once you’ve answered these questions, sit down with a loved one to discuss whether there is congruency with your answers and how you are currently investing. Just because we’ve been in a four year bull run doesn’t mean you’re now an investment guru. It’s important not to overestimate your abilities when it comes to investing. We all lose money eventually, it’s just a matter of when and how much. Let’s just hope the party continues in 2015 and beyond!
Recommendation To Help Achieve Financial Independence
One of the best ways to build wealth is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts on their Dashboard so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.
One of their best tools is the 401K Fee Analyzer which has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. You just click on the Investment Tab and run your portfolio through their fee analyzer with one click of the button. Their Investment Checkup tool is also great because it graphically shows whether your investment portfolios are property allocated based on your risk profile. Aggregate all your financial accounts in order to get a good over view of your net worth and start building those passive income streams! It only takes a minute to sign up.
About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income.
Updated for 2017 and beyond.