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Simplifying a Retirement Bucket Portfolio

A reader writes in, asking:

If you were developing different “buckets” for a portfolio in retirement, what funds would you use for each bucket?

For our immediate 1-3 years, I have assigned that duty to the Vanguard Ultra Short Bond Fund. It has a duration of one year, and does not have any government bonds.

Do you think that fund is too risky – both in terms of duration and in terms of risk? Should we have at least one year in money markets?

For our 3-6 year buckets, we use a variety of short term bond funds – such as the Short Term Bond Index Fund, Short Term Investment Grade Fund, and the Short Term Corporate Bond Fund.

For 6-10 years, we use a variety of funds such as the Target Retirement Fund, and Wellesley (because the stock allocation is of extra large Value stocks). Also for this category we would consider the Life Strategy Conservative Growth Fund. Of course with this group our main investment is in the Total Bond Market Fund, with the others hopefully boosting returns over time.

For more than ten years, stock funds such as the Total Stock Market Funds, Total International Stock Market Fund, and the S&P 500, with a few exotic funds to spice things up such as the REIT. This portion is relatively small, as we will allocate our retirement duties to primarily bond funds, with a few funds such as what I mentioned before in the 6-10 year period. I look at the stocks as a really long term investment in the event more money is needed, but I will do some rebalancing of that bucket to take profits and put money in when the market falls.

What would be your suggestions? How many buckets and which funds go into each bucket?

Principle number one when it comes to crafting a portfolio is that it’s the whole portfolio that matters. This is why, for instance, it rarely makes sense to look at one account in isolation. And it is why the overall portfolio allocation is the important question here — both what allocation you want now, and how/if you want that allocation to change over time (i.e., your intended glide path).

Bucket strategies are psychological tools, not financial ones. That is, a bucket strategy can be helpful if:

  1. It helps you to arrive at an overall allocation (and glide path) that you’re happy with, or
  2. It helps you to stick with your overall allocation (and glide path).

For example, some people may find that the easiest way to settle on an allocation is to think of it in terms of buckets (e.g., “I want 3 years in short-term bonds, 7 years in intermediate term bonds, 15 years in stocks”).

And some people may find that having a bucketing strategy helps them to feel more comfortable sticking with the plan during a bear market (e.g., “I don’t have to worry about my stocks going down, because I have X years worth of spending in short-term bonds and Y years in intermediate term bonds”).

And some people may find that a bucket strategy may be the most intuitive way for them to implement a desired glide path. For instance, if you like the idea of a “rising equity” glide path (i.e., one in which your stock allocation rises over time, as suggested by Wade Pfau and Michael Kitces here), you might find that the most intuitive way to implement that glide path is via a bucket strategy in which you do not “refill” the shorter-term (bond-heavy) buckets (by selling stocks and buying bonds) as they get depleted over time.

But if you find that managing/crafting a bucket-based portfolio is harder than just focusing on the overall allocation, then it’s best to forget about the buckets.

What you’re describing sounds to me like it may be more funds and complexity than is necessary. Maybe that’s because of the buckets; maybe not.

For instance, you asked whether the Vanguard Ultra Short Bond Fund is too risky, and whether the portfolio should have at least one year in money markets. My questions there would be: how much of the portfolio is in the Ultra-Short Bond Fund? And how much would the portfolio’s overall volatility be affected by moving part of that money into a money market fund? (My guess would be “a relatively small portion” and “hardly at all.”)

And with regard to what you consider the 3-6 year bucket, what is the specific advantage (to the overall portfolio) of having three different short-term bond funds rather than just one?

Or more broadly I might ask, can you achieve the overall risk profile that you want using just a few funds (e.g., Total Stock, Total International Stock, Total Bond)? If not, why not? What specifically do you feel would be missing? (Alternatively, what do you feel that you’d have too much of?) And how could you fill that gap in as simple a way as possible?

For instance, if you like the idea of a larger helping of short-term bonds than you’d have with the Total Bond Market Fund, what about those three funds, plus a short-term bond fund? Would anything feel distinctly missing (or overweighted) then? (And if so, again, how could you correct whatever feels “off” in as simple a way as possible?)

Let’s assume for a moment that you would find those four funds to be sufficient. In that case, the portfolio could be thought of as a short-term bucket with a short-term bond fund, an intermediate-term bucket with a total bond fund, and a long-term bucket with total stock and total international stock funds. Or we could achieve the same thing by looking at it from the overall portfolio allocation perspective (e.g., 15% short-term bond, 25% total bond, 40% total stock, 20% total international stock).

If you find buckets to be helpful, great. But be sure, after creating a bucket-based plan, to step back and look at the whole thing at once.

  • How does the overall allocation look? Does it seem reasonable?
  • How will it change over time (i.e., will the equity allocation be roughly steady, increasing, or decreasing)? Do you like that?
  • Is there a way to achieve the same overall goal with fewer funds?

“Don’t Sell Stocks During a Downturn”

A reader writes in, asking:

“I’ve read everywhere that, if retired, one should have money to live on, invested in other than equities to protect against a market downturn (to reduce sequence of return risk, and to try to avoid locking in big losses, especially in the first 10 years of retirement).

My first question is: what would you consider enough of a downturn (amount and/or duration?) that you would recommend not selling equities if possible? I’ve yet to see anyone clarify this. A market drop of 15%? More?

My second questions is this: my taxable account has an all stock allocation because that is what Vanguard says is optimal. If there is a big market downturn/crash/recession, I will be selling stocks as that’s all I have in my taxable account. This is contrary to much of what I’ve read as recommended. When I asked my Vanguard CFP about this, his response was that yes I’d be selling stocks in the taxable account but my portfolio will be rebalanced so the portfolio as a whole will be selling bonds to buy more stock. That does seem to make sense to me. Is there some flaw to this explanation?”

Firstly the one easy part: the Vanguard CFP is correct. It’s the overall allocation of the portfolio that matters, rather than the allocation of any individual account. And from an overall asset allocation standpoint, selling stocks (or anything else) in your taxable account doesn’t (usually) matter, because you can simultaneously make transactions in retirement accounts to adjust the overall allocation back to whatever you want it to be.

And he is correct that if your portfolio is rebalanced during a stock market downturn, you will not only not be selling stocks but will in fact be buying them.

For anybody attempting to use “don’t sell stocks during a downturn” as a stand-alone rule though, it’s a challenge. It’s one of those vague statements that sounds like it makes great sense — hard to argue with, even. But once you try to turn that into an actual plan of action, you start to realize that you need something more specific/concrete than that.

There’s the question you noted: how bad does a downturn have to be, before I should avoid selling stocks?

There’s also the question of how many years worth of spending you want to keep in bonds, in order to avoid selling anything other than bonds when the stock market is doing poorly. That is, exactly how long of a downturn should you plan for? (Though if you prefer a conservative allocation anyway, this generally wouldn’t be an issue in early retirement, as you already prefer to have many years of spending in bonds.)

This doesn’t mean that “not selling stocks during a downturn” is a bad strategy, but you will have to choose some answers to the above questions. And — just like any other asset allocation question — there is not one answer that everybody agrees upon. There’s no consensus as to the specifics.

About as close as you can get to a consensus for managing asset allocation in retirement is something along these lines:

  • Diversify, in the sense of “not having a large percentage invested in any one company.”
  • Diversify, in the sense of “own stocks and bonds, and own some international too.”
  • Keep costs low.
  • Make sure that your asset allocation does not make you uncomfortable — and will not make you uncomfortable even when the market is doing poorly.
  • Have a specific plan for how you will change (or not change) your allocation as you age and in various market circumstances. For example, will you rebalance into stocks when the market falls, or not? And will you rebalance out of stocks as the market rises, or not? Having a specific plan is better than making it up as you go along. (If nothing else, it helps you keep your sanity: “I’m sticking to the plan” — whatever the exact plan happens to be.)
  • Keep your spending rate low-ish if at all possible (below 4% in early retirement — ideally even below 3.5%; a higher rate is OK later in retirement).
  • If your spending rate is low-ish, then any diversified allocation should be OK. A higher stock allocation is likely to result in a larger bequest (and/or higher spending late in retirement) and a bumpier ride along the way.

Asset Allocation and Risk Tolerance

The following is an adapted excerpt from the 2018 edition of Investing Made Simple.

When putting together a portfolio, the first thing to decide is your desired asset allocation. That is, how much of your portfolio should be invested in each asset class (e.g., U.S. stocks, international stocks, and bonds)?

Your tolerance for risk is the most important factor in determining an appropriate asset allocation. The primary factors determining your risk tolerance are:

  1. The degree of flexibility you have with regard to your financial goals, and
  2. Your personal comfort level with volatility in your portfolio.

Financial Flexibility

Example 1: Jason is a construction worker. He’s 57, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered — but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.

Example 2: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $50,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $50,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a greater ability to take risk.

Comfort with Volatility

Your risk tolerance is also affected by your comfort level with volatility. One way to estimate this comfort level is to ask yourself, “How far could my portfolio fall before I started losing sleep, feeling stressed, or wanting to sell everything and move to cash?”

When answering this question, be sure to answer both as a percentage and as a dollar value — otherwise you may come to inaccurate conclusions. For example, you may remember that at age 25 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 10-times the size that it was at age 25, a 40% loss could be an entirely different experience.

When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative for your tastes, you’ll only be missing out on a relatively small incremental return.

In contrast, if you end up with a portfolio that’s too aggressive, you might end up panicking during periods of high volatility. Even one instance of getting out of the market after a sharp decline can be more than enough to eliminate the extra return you were hoping to earn from having a stock-heavy allocation.

Stocks vs. Bonds

Once you have an idea of your risk tolerance level, it’s time to move on to the first (and most important) part of the asset allocation decision: your stock/bond allocation.

One rule of thumb that serves as a reasonable starting point for analysis is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, said differently, assume that your stocks can lose 50% of their value at any time.

The most important thing to remember with asset allocation guidelines, however, is that they’re just that: guidelines. For example, with regard to this particular rule of thumb, 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.

U.S. Stocks vs. International Stocks

It’s not terribly surprising to learn that the U.S. stock market isn’t the best performing market in the world every single year. In fact, it’s often not in the top 10.

The difficulty in international investing — as with picking stocks or actively managed mutual funds — is that it’s nearly impossible to know ahead of time which countries are going to have the best market performance over a given time period. The solution? Own each (or at least many) of them.

The primary goal of investing a portion of your portfolio internationally should not be to increase returns, as there is no guarantee that international markets will outperform our own. Rather, the primary goal is to increase the diversification of your portfolio, thereby reducing your risk.

In total, the U.S. stock market makes up roughly half of the value of all of the publicly traded stocks in the world. However, most investment professionals recommend allocating more than 50% of the stock portion of your portfolio to domestic equities. Why? Because investing internationally introduces an additional type of risk into your portfolio: currency risk.

Currency risk is the risk that your return from investing in international stocks will be decreased as a result of the U.S. dollar increasing in value relative to the value of the currencies of the countries in which you have invested.

EXAMPLE: A portion of your portfolio is invested in Japanese stocks, and over the next year it earns an annual return of 8%. However, over that same period, the value of the yen relative to the dollar decreases by 3%. Your annual return (as measured in dollars) would only be roughly 5%.

So how much of your portfolio should be invested internationally? There’s a great deal of debate on this issue, with investment professionals recommending a very wide range of international allocations.

The trick is that without knowing how the U.S. market will perform in comparison to markets abroad, there’s simply no way to know what the “best” allocation will be. In my own opinion, allocating anywhere from 20% to 40% of the stock portion of your portfolio to international index funds would be reasonable for most investors.

Rebalancing

No matter how perfectly you craft your portfolio, there’s little doubt that in not too terribly long, your asset allocation will be out of whack. The stock market will have either shot upward, thereby causing your stock allocation to be higher than intended, or it will have experienced a downturn, causing your stock allocation to be lower than intended.

Rebalancing is the act of adjusting your holdings to bring them back in line with your ideal asset allocation. A periodic rebalancing program helps keep the risk level of your portfolio in line with your goals.

It’s worth noting that rebalancing can be extremely difficult from a psychological standpoint. It can feel as if you’re selling your “good investments” to put money into your “bad investments.” The key is to remember that just because something has performed well (or poorly) recently doesn’t mean that it will continue to do so in the immediate future.

How often should an investor rebalance? That’s a tricky question. Some people advocate in favor of rebalancing once your portfolio is off balance by a certain amount (such as your stock allocation being either 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals (annually on your birthday for instance) regardless of how off-balance your portfolio becomes in the interim.

Unfortunately, the best-performing rebalancing strategy varies from period to period, and it’s no easy task to predict which one will do best over the course of your investing career. Rather than spending a great deal of time and effort thinking about it, my suggestion is simply to pick one method and resolve to stick with it.

Simple Summary

  • Your tolerance for risk should be the primary determinant of your stock/bond allocation. Your risk tolerance is determined by how comfortable you are with investment volatility and how flexible your financial goals are.
  • Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.
  • For the sake of additional diversification, most investment professionals recommend investing somewhere from 20% to 40% of your stock holdings internationally.
  • Rebalancing is the act of bringing your portfolio back to its targeted asset allocation (and, therefore, its targeted risk level).

Do Dividend Stock Funds Belong in Your Portfolio?

A reader writes in, asking:

“What do you think of dividend funds? Do they have a place in a portfolio for a hands-off investor who is nearing retirement?”

The most important question here is what would be removed to make room for the dividend funds?

For the last several years, with interest rates stubbornly staying at low levels, some people have asserted that high-dividend stock funds can be used as a substitute for bond funds. To put it plainly, that idea is nuts.

For instance, the following chart (made via the Morningstar website) shows the performance over the last 10 years of Vanguard Dividend Growth Fund (in blue), Vanguard High Dividend Yield Index Fund (in orange), and Vanguard Total Bond Market Index Fund (in green).

Dividend and Bond Funds

There’s no question that the two dividend funds are much riskier than the bond fund. Dividend stock funds are simply not a suitable substitute for a bond fund. Bonds can play the role of the “mostly safe” part of your portfolio. Dividend stocks cannot.

But using dividend-oriented funds as a part of your stock holdings (i.e., in order to give high-dividend stocks a greater weight in your portfolio than other stocks) is a reasonable position. It’s not a position I plan to take with my own portfolio, but I wouldn’t tell somebody else that it’s a mistake to do it with their portfolio.

Before diving into dividend-stock strategies though, it’s important to be very clear on one point: it’s total return that matters, not income. A dollar of dividends is no better than a dollar of capital appreciation — even for a retiree. (And if we’re talking about holdings in a taxable account, a dollar of dividends is worse than a dollar of capital appreciation, because you have no control over when it will be taxed.)

So, when viewed from a total-return perspective, how have dividend-stock strategies performed relative to “total market” strategies? It depends what period we look at, and it depends what we use as our measure of dividend stock performance.

For instance, a piece of Vanguard research from earlier this year found that from 1997-2016, global high dividend yielding stocks and U.S. dividend growth stocks both earned higher returns with less volatility than a global “total market” collection of stocks (primarily due to dividend stocks not being hit as hard as the market overall during the decline of tech stocks in 1999-2000).

As another example, the following chart compares the performance of Vanguard High Dividend Yield Index Fund (in blue) since its inception in 2006 to the performance of Vanguard Total Stock Market Index Fund (in orange). Over this particular period, it was basically a tie. (The total market fund ends up with a very slightly higher value.) And you can see that the two index funds have tracked each other super closely.

Dividend and Total Market

Or as one final example (in the international category this time), the following chart compares Vanguard Total International Stock Index Fund (in blue) to iShares International Dividend Select ETF (in orange) since the inception of the dividend ETF in 2007. This one is essentially a tie as well. (Again, the “total market” fund ends up very slightly ahead, and the two tracked each other fairly closely over the period.)

International Dividend vs Total Market

Every time I look into this question I come to the same conclusion: if you want to hold dividend stock funds because you see that dividend strategies outperformed total market strategies over some particular period and you think the same thing will occur over your particular investment horizon, go for it. But, as always, be sure to diversify broadly and keep costs low (i.e., don’t bet your financial future on just a few dividend stocks, and don’t pay a fund manager or advisor a pile of money to pick dividend stocks for you).

And finally and most importantly: dividend stocks are not a substitute for bonds.

What Happens to Bonds in a Stock Market Crash?

A reader writes in, asking:

“I have one friend who is paying 1% to have her assets managed for her. When I looked at the portfolio the advisor had her in, it seemed riskier than one might like given that she hopes to retire one year from now. I encouraged her to ask him, ‘If the market were to crash tomorrow and drop by half, will that change my plan to retire?’

I want to give a simple example and wanted to check something with you first. Let’s say she has $1,000,000, half in stocks and half in bonds. So if the market were to drop by half, then she would wake up tomorrow having lost $250,000, right?

So my question is, when assessing risk tolerance, is it sensible to assume the bonds will hold steady?”

The “if the stock market fell by half and bonds stayed level” scenario is one that I use myself, as I think it provides a very rough but quick and useful metric of how reasonable a person’s overall allocation is.

So, yes, I definitely think it’s sensible to consider such a scenario.

However, I wouldn’t say that it’s a good idea to put oneself in a real-life situation where you’re 100% reliant on bonds not falling when stocks fall. Because they could. On the other hand, they could increase in value while the stock market falls, thereby offsetting the loss somewhat.

In short, what happens with the bond holdings depends on a) the immediate cause of the stock market decline and b) the type(s) of bonds in question.

For instance, it may be instructive to look at what happened with the last big market decline in late 2008. The chart below (made using the Morningstar website) plots four different mutual funds from 1/1/2008-12/31/2010.

Mutual Fund Chart

  • The blue line is Vanguard Total Stock Market Index Fund (VTSMX),
  • Green is Vanguard High-Yield Corporate Fund (VWEHX),
  • Yellow is Vanguard Intermediate-Term Investment-Grade Fund (VFICX), and
  • Orange is Vanguard Intermediate-Term Treasury Fund (VFITX).

The stock fund obviously falls by quite a bit in late 2008.

The high-yield corporate bond fund (green) falls right along with it, though not as much. This is more or less what you’d expect, as a situation in which businesses suddenly look more risky is a situation in which people might not want to hold bonds from the riskiest businesses (i.e., high-yield bonds).

The investment-grade corporate fund (yellow) also falls, though not as much as the high-yield fund. Essentially, you have the same thing going on with investment-grade corporate bonds as with high-yield bonds, but investment-grade bonds are from less risky companies, so people aren’t running from them as much as they are from the riskier choices.

The intermediate term treasury fund (orange) goes up over the period in question, as people “flee to safety” — pushing up prices for the safest bonds (and pushing their interest rates down).

So that’s how different types of bonds behaved in one particular stock market decline scenario. But other scenarios can have different results.

For instance, the following chart shows the same four mutual funds from 1/1/2000-12/31/2003. In the dot-com crash, all three bond funds did just fine — even the high-yield fund had only minor bumps. And that’s about what you’d expect given that most businesses weren’t particularly in danger of failing to pay their obligations.

Dot Com Crash Chart

Alternatively, one could imagine various scenarios in which the market decides not that “U.S. businesses look much riskier than they did a month ago,” but rather that “the United States looks much riskier than it did a month ago.” In such a scenario, it seems likely that the investors who choose to “flee to safety” would not flee to Treasury bonds — and some would even flee away from Treasury bonds. So we would see a case in which Treasury bonds would fall (to some extent) while stocks and corporate bonds fall as well.

So, to summarize, yes I think it’s often helpful to think about a scenario in which stocks fall by half and bonds go nowhere. But it’s also a good idea to think about and prepare for other scenarios. (And in general, diversification is the tool to prepare for such scenarios.)

How Pensions and Social Security Affect Asset Allocation

A reader writes in, asking:

“I am a retired government employee, and I receive a pension to the tune of roughly $50,000 annually. I have a relatively low risk portfolio; it is a mix of stuff but roughly 20-25% is in stock with the rest in bonds or CDs. I recently met with an adviser who said that my pension is essentially a big bond so it’s a mistake to have such low risk holdings in my retirement accounts. This is the first time I’d heard of this idea before. What do you think?”

It is a very common idea for people to count their pension or Social Security income as a bond holding. Many financial advisors and writers suggest doing so. Industry luminary John Bogle suggests doing so as well.

Personally, I do not like the idea because:

  1. It is confusing to many people, and
  2. It encourages people to use higher-risk allocations in their portfolios as a result of their pension/Social Security income, when in many cases the correct approach is to do exactly the opposite.

Instead, I think it is easier and more helpful to think of a pension (or Social Security) as exactly what it is: income.

For example if you plan to spend $60,000 per year, and you have pension/Social Security income of $50,000 per year, then you only have to spend $10,000 per year from your portfolio. In other words, your pension/Social Security income allows you to use a withdrawal rate that is one-sixth the withdrawal rate you’d have to use if you didn’t have such income.

What this does is it allows you to choose from a broader range of asset allocation choices.

That is, you could say, “my pension satisfies my basic needs. Therefore, I can afford to shoot for the moon with my portfolio, taking a lot of risk in the hope of achieving very high spending or a large inheritance for my kids.” Or, just as reasonably, you could say, “my pension satisfies my basic needs. Therefore, I have no need to take risk in my portfolio at all. I’ll stick to very safe holdings like TIPS, I-Bonds, and CDs, so that I don’t mess up a good thing.”

Either approach can be perfectly reasonable, and the correct answer depends on your personal risk preferences.

It is a mistake, in my view, to say that a person should necessarily take on more risk in their portfolio as a result of having a large pension (or other safe source of income).

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