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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).

Should Spouses Make Asset Allocation Decisions Separately?

As we’ve discussed previously, it’s often possible to save on fund expenses and/or taxes by making investing decisions at the overall portfolio level rather than at the account level — making sure, for example, that your portfolio’s overall asset allocation is in line with your risk tolerance rather than trying to achieve a diversified allocation in each individual account.

I recently came across a discussion on the Bogleheads forum in which an investor asked whether, in cases in which the spouses in a married couple have very different ages, it makes sense to implement separate asset allocation plans for each of the spouses. That is, should the spouses’ respective accounts be looked at as separate portfolios?

In my opinion, no, a large difference in ages is not, in itself, a reason to break from the “it’s all one portfolio” concept.

What’s the Goal?

In most cases, when it comes to retirement savings, the primary goal is simply to provide a certain standard of living during retirement. And that’s the case whether we’re talking about his IRA, her IRA, their joint account, etc. And to the extent that a collection of accounts are all intended for the same financial goal, it makes sense to consider them as one overall portfolio intended to meet that goal.

Said differently, tax planning aside, with regard to retirement savings, it’s the overall portfolio value (rather than the value of a given account or a given holding) that matters. And, critically, that’s true:

  1. From the perspective of either spouse, and
  2. Regardless of the age of either spouse.

So decisions — whether asset allocation decisions, savings rate decisions, or spending rate decisions — should be made with regard to how they will affect the overall portfolio value.

Possible Exceptions

While the overwhelming majority of most married couples’ accumulated assets are devoted to the goal of financing spending in retirement, there certainly are cases in which a specific account is designated as the source of funds for some other specific goal. In such cases, I think those accounts should be treated separately for the purpose of making asset allocation decisions.

Example: Bob and Jane got married at age 60. Bob has three children from his prior marriage. Bob and Jane’s combined assets exceed the amount they expect to spend during their lifetime, so they have decided to treat their Roth IRAs as “bequest money.” They have agreed to list Bob’s children as the beneficiaries of Bob’s Roth IRA and Jane’s sister as the beneficiary of Jane’s Roth IRA.

Because Bob’s IRA and Jane’s IRA are intended for different goals rather than a combined “financing our spending in retirement” goal, it makes sense to make asset allocation decisions separately for each IRA.

How Should Annuitizing Affect Asset Allocation?

A reader writes in, asking:

“If I buy a lifetime annuity after retiring, should that money come out of my bond allocation, stock allocation, or equally from all of my holdings?”

Any of those approaches can make perfect sense, depending on the situation. In short, after annuitizing, you should ask exactly the same questions you would have asked before annuitizing in order to set your asset allocation:

  • How much risk can I afford to take?
  • How much risk do I want to take?

In other words, just like always, you want to figure out what risk level is appropriate for you, then choose an asset allocation that meets that risk level. Once you know the allocation that you want to have after you’ve purchased the annuity, it will be easy to figure out which holdings to sell in order to meet that allocation.

If you were comfortable with your risk level before annuitizing, it’s likely that it makes sense for the annuity to come from the bond allocation. But that won’t always be the case. After all, for many people, the whole point of annuitizing is that they want to reduce the level of risk in their portfolio.

Example #1: Shortly after she retires, Glenda buys an inflation-adjusted lifetime annuity. Between the annuity and her Social Security benefits, she has about $30,000 of safe annual income — enough to satisfy her basic needs, given that she owns her home and has paid off her mortgage. She would like to be able to spend more than $30,000 per year, but she knows she can get by on that amount, if she has to.

Because Glenda can afford to take on a good deal of risk with the rest of her portfolio, because she has always been fairly comfortable with volatility, and because she wants to shoot for high returns, Glenda decides to use a high stock allocation with the remainder of her portfolio. (That is, she uses bond holdings to fund the annuity purchase.)

Example #2: Glenda’s twin sister Gail is in the exact same position as Glenda, but she has always been less comfortable with seeing the value of her holdings bounce around. So, despite having a high economic tolerance for risk, Gail decides to use the same conservative allocation for her portfolio after annuitizing that she used prior to annuitizing — that is, she uses both stock and bond holdings to fund the annuity purchase — thereby resulting in an overall reduction of risk, given that she has transferred a significant portion of her wealth from stocks to fixed income (i.e., the annuity).

Example #3: Tom found himself unintentionally retired at age 62. He held off on claiming Social Security all the way until age 70, but because of a modest earnings history, he still only receives about $15,000 of Social Security per year. He also purchased a fixed lifetime annuity that pays another $8,000 per year. While Tom would have liked to be able to lock in a higher amount of safe income, he felt that he couldn’t afford to allocate any more money to an annuity because doing so would have left him with very little in the way of liquid assets.

Because Tom has a level of safe income that doesn’t quite meet his needs, and because he doesn’t have a very large remaining portfolio, Tom has a low economic risk tolerance. That is, regardless of his emotional comfort level with volatility, Tom cannot afford to take on a great deal of risk with the non-annuitized portion of his portfolio — meaning the annuity should probably come out of his stock holdings or a combination of his stock and bond holdings.

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