Chapter 14
Selecting your asset allocation
Life is balance and choice. Add more of this, lose a little of that. When it comes to investing, that balance and choice is informed by your temperament and goals.
Financial geeks like me are the aberration. Sane people don’t want to be bothered. My daughter helped me understand this at about the same time I was finally understanding that the most effective investing is also the simplest.
Complex and expensive investments are not only unnecessary, they underperform. Fiddling with your investments almost always leads to worse results. Making a few sound choices and letting them run is the essence of success, and the soul of The Simple Path to Wealth.
Reading this book so far you already know this. You also know that, with simplicity as our guide, we look at our investing lives in two broad stages using just two funds:
The Wealth Accumulation Stage and the Wealth Preservation Stage. Or, perhaps, a blend of the two.
VTSAX (Vanguard Total Stock Market Index Fund) and VBTLX (Vanguard Total Bond Market Index Fund).
The wealth accumulation stage is when you are working and have earned income to save and invest. For this stage I favor 100% stocks and VTSAX is the fund I prefer. If financial independence is your goal, your savings rate in these years should be high. As you invest that money each month it serves to smooth out the market’s wild ride.
You enter the wealth preservation stage once you step away from your job and regular paychecks and begin living on income from your investments. At this point, I recommend adding bonds to the portfolio. Like the fresh cash you were investing while working, bonds help smooth the ride.
Of course, in the real world the divisions might not always be so clear.
You might find yourself making some money in retirement. Or over the years you might move from one stage to the other and back again more than once. You might leave a high-paying job to work for less at something you love. In my own career there were many times I chose to step away from working for months or even years at a time. Each time changed my stage.
Using this framework of two stages and two funds, you have all the tools you need to find your own balance. In determining that balance you’ll also want to consider two additional factors: How much effort you are willing to apply and your risk tolerance.
Effort
For the wealth accumulation stage an allocation of 100% stocks using VTSAX is the soul of simplicity. But as we’ve seen, some studies suggest that adding a small percentage of bonds—say 10-25%—actually outperforms 100% stocks. You can see this effect by playing with the various calculators found on the internet. As you do, you’ll notice that adding much beyond 25% bonds begins to hurt results.
Remember that these studies are not carved in stone and all calculators rely on making certain assumptions about the future. The difference in projected results between 100% stocks and an 80/20 mix of stocks and bonds is tiny. How those results actually unfold over the decades is likely to be equally close and the ultimate winner is basically unpredictable. For this reason, and favoring simplicity, I recommend 100% stocks using VTSAX.
That said, if you are willing to do a bit more work, you could slightly smooth out the wild ride and possibly outperform over time by adding 10- 25% in bonds. If you do, about once a year you will want to rebalance your funds to maintain your chosen allocation. You might also want to rebalance any time the market makes a major move (20%+) up or down. This means you will sell shares in whichever asset class has performed better and buy shares in the one that has lagged.
Ideally you will do this in a tax-advantaged account like an IRA or 401(k) (we’ll be talking about those shortly) so you don’t have to pay tax on any capital gains. Having to pay capital gains taxes would be a major drawback and another reason to focus on holding just VTSAX. This rebalancing is simple and can be done online with Vanguard or most other investment firms. It should only take a couple of hours a year. But like changing the oil in your car, it is critical that you actually do it.
If you are unsure you’ll remember to rebalance or simply don’t want to be bothered, TRFs (Target Retirement Funds) are a fine option. These allow you to choose your allocation and then they will automatically rebalance for you. They cost a bit more than the simple index funds you’d use doing it yourself—you are paying for that extra service—but they are still low-cost.
We’ll discuss them in more detail in Chapter 16.
Risk Factors
Temperament. This is your personal ability to handle risk. Only you can decide and if ever there was a time to be brutally honest with yourself, this is it.
Flexibility. How willing and able are you to adjust your spending? Can you tighten your belt if needed? Are you willing to move to a less expensive part of the country? Of the world? Are you able to return to work? Create additional sources of income? The more rigid your lifestyle requirements, the less risk you can handle.
How much do you have? As we’ll discuss in Part IV, the basic 4% rule is a good guideline in deciding how much income your assets can reasonably be expected to provide over time. If you need every penny of that just to make ends meet, your ability to handle risk drops. If, on the other hand, you are spending 4% but a big chunk of it goes towards optional hobbies like travel, you can handle more risk.
After considering effort and risk, here are some questions you’ll want to consider.
When should I make the shift into bonds?
This is very much a function of your tolerance for risk and your personal situation.
For the smoothest transition, you might start slowly shifting into your bond allocation 5 or 10 years before you are fully retired. Especially if you have a fixed date firmly in mind.
But if you are flexible as to your retirement date and more risk tolerant, you might stay fully in stocks right up until you make the change. In doing so the stronger potential of stocks could get you there sooner. But if the market moves against you, you’ll have to be willing to push your retirement date back a bit.
Of course, any time you shift between the accumulation and preservation stages, you’ll want to reassess and possibly adjust your allocation.
Balance and choice. Yin and yang.
Does age matter?
Overall, I prefer to divide our investment stages by life stages rather than using the more typical tool of age.
This is an acknowledgment of the fact that people are living longer and much more diverse lives these days. Especially the readers of this book.
Some folks are retiring very early. Others are retiring from higher paid positions into lower paid work that more closely reflects their values and interests. Still others, like I did, are stepping in and out of work as it suits them, their stages fluidly shifting.
So age seems not to matter, at least not as much as it once did.
With that said, age does begin to limit your options as it advances. Age discrimination is a very real thing, especially in the corporate world. As you get older, you may not have all the same options readily available as you had in your youth. If your life journey involves stepping away from highly paid work occasionally, you’ll do well to consider this.
Further, as you age you steadily have less time for the compounding growth of your investments to work and to recover from market plunges.
Both these considerations will influence your risk profile and you might well want to consider adding bonds a bit earlier if that’s the case.
Is there an optimal time of year to
rebalance?
Not really. I’ve yet to see any credible research indicating a particular time of year works best. Even if someone were to figure it out, once known everybody would rush to it, negating the effect.
I do suggest avoiding the very end/beginning of the year. It is a popular time for rebalancing and many are engaged in tax selling and new buying. I prefer to avoid the possible short-term market distortions this might cause.
Personally, we rebalance once a year on my wife’s birthday. Random and easy to remember.
I have some of my investments in tax-
advantaged accounts and some in regular
accounts. How can I rebalance across those?
This can be cumbersome and you’ll just have to work with what you have.
While it is best to hold bonds in tax-advantaged accounts, it does complicate rebalancing.
First, you should be considering all your investments as a whole when figuring your allocation.
Next, as a rule it is better to buy and sell in tax-advantaged accounts to avoid creating taxable events. I recommend this unless you happen to have capital losses in a given year. Then it is best to take them in your taxable accounts when possible.
For instance, you might own VTSAX in both an IRA and in a taxable account. Should you need to sell to rebalance that year, sell in the taxable account to capture the loss. You can deduct it against any other gain you happen to have, including any capital gain distributions. You can also deduct up to $3,000 against your earned income. Any loss left over you can carry forward to use in future years. (But be careful not to buy more VTSAX in your IRA, or any other of your investment accounts, within 30 days of selling. If you do, the IRS will consider this a “wash sale” and your tax loss would be negated.)
Does more frequent reallocation improve
performance?
Investment firms that provide the service contend it can over time, but I’m not sure I buy the premise. If anything, my tilt is in the opposite direction.
Which aligns me with Jack Bogle.
Mr. Bogle points to research Vanguard has done comparing stock and bond portfolios that were annually rebalanced and those not rebalanced at all. The results show the rebalanced portfolios outperformed but by a margin so slight it can be attributed to noise as much as the strategy. His conclusion:
“Rebalancing is a personal choice, not a choice that statistics can validate.
There’s certainly nothing the matter with doing it (although I don’t do it myself), but also no reason to slavishly worry about small changes in the equity ratio.”
We still rebalance annually, but were I to make a change it would be to not bother with it at all.
There you have it: The considerations you’ll need to review and the tools you’ll need to use to create the asset allocation that best fits your situation.
Now why in the world haven’t I included international funds in the mix like most every other writer on investing? We’ll look at that next.