Archives for August 2011

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Asset Allocation: Maximum Tolerable Loss

Mainstream investing advice is packed with rules of thumb. Some are helpful, albeit imperfect: “Don’t withdraw more than 4% of your portfolio per year at the beginning of retirement.” Some are, to put it plainly, garbage: “In retirement you’ll need to replace 80% of your pre-retirement income.”

One rule of thumb that I do find helpful is related to asset allocation:

Set your stock allocation equal to your maximum tolerable loss, times two.

Or, said differently, assume that your stocks can lose 50% of their value at any time.

Asset Allocation for Accumulation Stage

The tricky part of implementing this rule of thumb is determining what, exactly, your maximum tolerable loss is. For investors a long way from retirement, it’s a purely emotional question: How much loss can you stomach without losing sleep or feeling terribly stressed?

Naturally, this isn’t something you can calculate, per se. All you can do is consider how you’ve responded to portfolio declines in the past and try to imagine how you’d deal with declines of a certain size in the future.

When answering this question, be sure to try to answer it as both a percentage and as a dollar value. Otherwise you may come to inaccurate conclusions. For example, you may remember that at age 30 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 6-times the size that it was at age 30, a 40% loss could be an entirely different experience.

Asset Allocation In and Near Retirement

For those in (or near) retirement, maximum tolerable loss includes the same emotional aspect as well as an obvious financial aspect: Declines in value can be a real, tangible problem when you’re selling off your portfolio bit by bit to pay the bills.

Takeaway: The closer you’re cutting it with regard to using an unsafely-high withdrawal rate, the more of your portfolio you should think about putting into low-risk things like TIPS and fixed lifetime annuities.

Important Caveats

As with any rule of thumb, this one has some important caveats.

First, I’d encourage highly risk tolerant investors to put an upper limit on their equity allocation. Even if the formula says 100% stocks would be appropriate, I think it’s usually wise to go no higher than 90%. The additional expected return from putting that last 10% in stocks isn’t terribly significant, while the reduction in volatility that comes from having at least a little bit in bonds is significant.

Second, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

Third, this rule of thumb only deals with your ability to take risk. It says nothing about the other aspect of risk tolerance: your need to take risk. If you have little need for risk in your portfolio, then you may want to adjust your stock allocation downward from what this rule would suggest.

In short, “stock allocation = maximum tolerable loss x 2” can be helpful in that it gives you a starting point for analysis when determining what asset allocation you want to use. Just remember that that’s all it is: a starting point.

More Funds Does Not Mean More Diversified

One mistake I see repeatedly in emails and online discussions is the assumption that holding more funds automatically makes your portfolio more diversified.

For example, in a recent discussion I participated in on the Bogleheads Forum, a new investor was looking for feedback on his proposed portfolio. In addition to a few bond funds and international stock funds, the proposed portfolio included all three of the following U.S. stock index funds (all in the same account):

  • Vanguard Total Stock Market Index Fund
  • Vanguard 500 Index Fund
  • Vanguard Extended Market Index Fund

See the mistake here? The Extended Market Index Fund is basically the Total Stock Market Index Fund, minus the holdings that appear in the 500 Index Fund. In other words, the investor owns multiple U.S. stock funds, but that’s not adding anything meaningful to his underlying holdings. He’s no more diversified than he’d be if he just bought the Total Stock Market fund.

It’s akin to going to your favorite pizza joint, ordering a slice of cheese pizza, paying for it, then ordering and paying for another slice of the same thing–and repeating the process until you’ve purchased 8 slices. It would have been easier (and probably less expensive) to just buy one pizza.

Other Cases of Unnecessary Fund Duplication

The same sort of thing occurs frequently with international stock funds. Vanguard’s Total International Stock Index Fund already includes emerging markets, European markets, and Pacific markets. There’s no need to hold individual funds for each region.

Ditto for bonds. If you own a fund that tracks the Barclays Capital U.S. Aggregate Float Adjusted Bond Index (e.g., Vanguard’s Total Bond Market Index Fund), you already own Treasury bonds, government mortgage-backed bonds, and corporate bonds. So adding category-specific bond funds won’t necessarily make you any more diversified.

“Slicing and Dicing” to Achieve a Specific Allocation

Despite the above, there are cases in which it would make sense to own a fund that invests in a particular sub-category of stocks or bonds. For example, if your 401(k) has access to a low-cost S&P 500 index fund, but no low-cost small-cap or mid-cap funds, it would be perfectly reasonable to hold the S&P 500 fund in your 401(k) and complement it with an extended market index fund in your IRA.

Or, you may have a legitimate reason to overweight a particular industry or style of stocks or bonds relative to its market weighting. For example, many investors choose to overweight small-cap and value stocks because they want the additional expected return that comes with the increased risk.

The key distinction here is that it makes sense to increase the number of funds you own if that’s what it takes to achieve your target asset allocation. But owning more funds does not, in itself, make you more diversified.

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