Have you been thinking about your own asset allocation for your investing goals? If you haven’t, check out last week’s “How to” covering the basics of asset allocation here. And if you haven’t even figured out how much you will need for your various goals, like retirement, check out Step 1: Determining your savings goal. It’s never too late to get started.
For those readers who’ve already started, here are some of the questions we heard.
QUESTION: What is wrong with keeping my asset allocation at 50/50? Meaning 50% in equities, 50% in fixed income (bonds, CDs, etc.).
The short answer: There is no wrong asset allocation.
Answer: Asset allocation is a personal decision based on your investing timeline (i.e., how long you will leave your money untouched), risk tolerance (i.e., how comfortable you are with volatility in the value of your investments), and your own beliefs about the world.
A 50/50 allocation may make a lot of sense if your investing timeline is less than 7 years, if you do not have a lot of risk tolerance, or if you believe that the world is so different now that the market’s historical performance may not be similar to its future behavior.
However, if you are comfortable with what could be large swings in value over your investing timeline, you have more than 10 years to invest, and you believe that the market will behave in similar patterns to history, this would likely be too conservative of an allocation as it may not outpace inflation (thus your money will have less buying power when you need it) since it is equally weighted between equities and fixed income. As you saw in the initial article, an investor that fits this profile may be better off with a 70/30 (70% equities, 30% fixed income) or even an 80% equities/20% fixed income portfolio. This is because based on the information here, such as this individual’s comfort with market fluctuations, they are likely at least somewhat risk tolerant. In addition, they have a long timeframe to invest. Some people with very long timelines may even feel comfortable with a 90% equities/10% fixed income asset allocation. Again, a longer timeframe before the money is needed makes it possible to invest a higher percentage of the portfolio in equities, creating a scenario more likely to outpace inflation.
QUESTION: Asset allocation feels unscientific to me. Why should I even worry about it?
Answer: All investment advice, including asset allocation, is based on the historical performance of the stock market (and how bonds typically behave). This includes the expectation that equities and fixed income will perform over the long term with a comparable level of volatility (increases and decreases in value) and performance. Unfortunately, historical perspective is all we have and none of us can predict the future (remember Covid-19? Did you see that coming? What about Apple? When you were clicking away on your “crackberry” did you think Apple was going to end up putting Blackberry out of business and growing up to be the first $3 trillion company?)
For more on the historical performance of the stock market, check out this article from The Motley Fool:
While we are talking about “assumptions” from history, keep this in mind: Traditional investing advice also assumes that you will be in a lower tax bracket by percentage after you retire, which may or may not be the case. For example, if you have a lot of dividends or passive income, your tax bracket may never decrease. Conversely, tax brackets could go up over time, or certain tax breaks may no longer be available. Thus, even if you are in the “lowest” tax bracket, the percentage of taxes owed may be much higher 20 years from now. But assuming conventional wisdom holds, this is why tax deferred vehicles like 401(k)s may be so valuable. In those “tax deferred” accounts, you “put off” paying taxes on gains (and some contributions are “pretax”) until a time when you may have a lower “effective tax rate.” More on that in a future article.
QUESTION: Is asset allocation a “set it and forget it forever” thing, or do I have to change it a lot?
The short answer: It depends.
Answer: If your investing timeline remains long, you will probably stay pretty close to your percentage targets (we will discuss asset allocation within your equity and fixed income portfolios as well as rebalancing in a later article).
However, needs change as the timeline changes, or the timeline may change altogether. For example, if you start saving for retirement at 30 and plan to retire at 70, that 40 year timeline allows you to invest pretty aggressively resulting in a decision to invest 80% in equities, and only 20% in fixed income. Fast forward to age 60. You only have 10 years left before you will need at least some of the money in your portfolio. For the money that has 10 years or less of an investment horizon, you might shift that portion of your portfolio closer to 60/40. And as that timeline continues to decrease (meaning less time remains before you need to withdraw assets), your portfolio may move to a 50/50 asset allocation.
Planning for these shifts will also involve some tax planning, because as you start to shift your asset allocation, you might be realizing gains on equities and other investments, which could yield taxable income and take a significant cut of your hard-earned gains.
Finally, traditionally fixed income investments (like bonds) have less volatility. Thus, many individuals who are close to needing some or all of the money in their portfolio will shift a larger percentage to fixed income investments because they likely will not carry as much risk of loss.
Said another way, assume you leave $100,000 invested in an 80/20 portfolio. That means $80,000 is invested in equities and $20,000 is invested in fixed income. If you need the $100,000 in two years, and there is a large correction in the stock market a year into your plan (with a drop of 25%), your $80,000 equity investment is now only worth $60,000, leaving you with little opportunity to “regrow” your portfolio before you need to withdraw $100,000. Thus, you could be sitting on a $20,000 deficit when you need the funds.
QUESTION: I don’t want to think about asset allocation or where my money is invested. Is there any sort of investing strategy that I can use to not deal with this?
Answer: “Target date” funds can help deal with this. These funds can be either a mutual fund or an exchange traded fund (ETF). They are typically designed to maximize the investor's returns by a specific date. Generally, the funds are designed to build gains in the early years by focusing on riskier growth stocks, then aim to retain those gains by weighting towards safer, more conservative choices as the target date approaches (Investopedia).
For example, if you are 30 years from retirement today, you could invest in a 2053 target date fund. The fund will then balance equities and fixed income for you over time, likely shifting from an aggressive mix (70/30, 80/20 or even 90/10) to a more neutral 60/40 or 50/50 as you reach retirement. The biggest risk of target funds is making sure that the fund itself is well managed, understanding how the fund fits into your tax strategy, and verifying that the expenses charged for this “hands off” approach are reasonable and won’t take a more significant “bite” out of your portfolio. In addition, it’s more difficult to change direction if you suddenly have a very different timeline (such as being forced to retire much earlier). And, as with any investment, income and returns are not guaranteed.
Check out this summary of Vanguard’s target date fund asset allocation as another example:
The Vanguard Target Retirement 2065 Fund (VLXVX) has an expense ratio of 0.15%. As of Q2 2022, the portfolio allocation was 90.5% in stocks and 9.5% in bonds. It holds other Vanguard mutual funds to achieve its goals. It had 53.8% invested in the Vanguard Total Stock Market Index, 36.6% invested in the Vanguard Total International Stock Index Fund, 6.7% invested in the Vanguard Total Bond Market II Index Fund, and 2.9% invested in the Vanguard Total International Bond Index Fund.2
The Vanguard Target Retirement 2025 Fund (VTTVX) has an expense ratio of 0.08%. Because it matures 20 years in advance of the 2065 fund, it is more conservative. As of Q2 2022, its portfolio is weighted 57.5% in stocks and 42.5% in bonds. It has allocated 34.7% of assets to the Vanguard Total Stock Market Index Fund, 27.6% to the Vanguard Total Bond Market II Index Fund, 22.7% to the Vanguard Total International Stock Index Fund, 12.2% to the Vanguard Total International Bond Index Fund, and 2.80% to the Vanguard Short-Term Inflation-Protected Securities Index Fund.
As you can imagine, in 2060, VLXVX will look a lot more like the 2025 fund from this example because the investor will then be very close to the target date.
The main point with all investing is that you have to handle your investments in a way that is most comfortable for you and your unique financial situation.
Now that you’ve determined your savings goal and identified the optimal asset allocation for your needs, you are one step closer to a sound financial future.
Do you have a question that hasn’t been answered yet? Drop me an email at prepovercoffee@substack.com or post a comment here:
Stay tuned next week for more Investing Step by Step, where we will wrap up asset allocation by discussing the “types” of equities that make up your overall equity percentage, a little more on fixed income, and we will start thinking about what types of accounts are best for what types of investments.
And thank you to our spirit guides, The New Kids on the Block.
For my friends in Tennessee, a different kind of “two step.”