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Changing Bond Allocations

A reader writes in:

“Overall, I’m happy with my 50% stock, 50% fixed income allocation. I don’t fool with the equity side much at all (a Total Stock fund and an international fund at Vanguard).

But I am having a devil of a time settling on my fixed income allocation.  I carry 10% cash (in a 403b fixed account earning 3%). I like that one.  So what to do with the remainder?

I’m currently at 20% Vanguard Total Bond Market and 20% Vanguard Inflation-Protected Securities (TIPS) fund.  But I feel an urge to change it to 25% TBM and 15% TIPS.  I am concerned about the drag that TIPS may present.  And the TIPS fund is the only fund of my four that I question regularly.  I read and read about TIPS but can’t process the information to a solid conclusion.”

As I’ve said before, I don’t like using past performance figures to make estimates regarding what a given fund will earn in the future, but I do think past performance can be useful for seeing how similar/different two funds are.

For example, the following graph shows the total performance of Vanguard Total Bond Market Index Fund (blue) as compared to Vanguard’s TIPS fund (orange) over the last 10 years. As you can see, the two funds are different, but they behave fairly similarly most of the time.

Just for comparison, the next graph shows the same two funds, with Vanguard’s Total Stock Market Index Fund (green) thrown into the mix:

Now that’s a a real difference.

This is not to say that Vanguard’s Total Bond Market Fund and TIPS fund are nearly identical. They aren’t. But they’re still bond funds. And more specifically, they’re both high credit quality intermediate-term bond funds.

Asset Allocation is Not Precise

To get an idea of how a 5% shift typically affects a retirement portfolio, you may want to try out the “Retirement Nest Egg Calculator” from Vanguard. It runs Monte Carlo simulations based on historical data to show the probability of a portfolio surviving through a given length of retirement at a given withdrawal rate.

Frankly, I don’t like that they present the results as “probability that your portfolio will last for __ years.” Because that’s not true unless we assume future returns look like past returns.

But I still think it’s useful for getting a rough idea of how much difference a 5% change in allocation tends to make. And if you spend a little time using the calculator, you’ll see that the answer is usually, “very little.”

For example, for a 30-year retirement with a 4% withdrawal rate, the calculator shows a 90% success rate for a 50% stock, 40% bond, 10% cash allocation. If we bump stocks up by 5% and bonds down by 5%, the resulting success rate is…

[drum roll please]

90%. No visible difference at all.

If we set the withdrawal rate to 5% rather than 4%, the success rate for a 50% stock, 40% bond, 10% cash portfolio is 73%. If we then do the same test by bumping stocks up 5% and bonds down 5%, the success rate moves to 74% — a change of just 1%.

And these are shifts between stocks and bonds — two very different asset classes. A 5% change from one intermediate-term bond fund to another intermediate-term bond fund should make an even smaller difference.

Conclusion: Asset allocation is important. It’s worth taking the time to do some real thinking about your personal tolerance for risk and to set an allocation that’s a good match for you. But it’s generally not worth worrying about whether your results would be improved by shifting your allocation a few percent in one direction or another — especially when we’re talking about shifts within a broad asset class (e.g. stocks or bonds).

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  1. Nice analysis. I appreciate the calculated numbers for success rates at different allocations. Conclusion: 5% shifts in allocation just don’t matter that much. This parallels similar research I’ve seen for rebalancing — notably Bogle’s study for the New York Times. It showed very small long-term benefits from rebalancing. He advised not worrying about “small” changes (5-10%) in allocation.

  2. Francis T. Nicosia says

    I think bonds are going to get a real drubing in the next ten yrs. I’m in 50% cash and will be 50% total world stock fund. It will always have enough to satify my rmd and enough to buy bargins. I really can’t find a history of this allocation can you? Thank you

  3. Francis,

    Unfortunately, I do not have any ready-made analysis to answer your question.

    As I understand it, the FTSE Global All Cap Index isn’t very old at all. The MSCI ACWI index goes back to 1987, but I’d still be wary about drawing any conclusions based on one 25-year period.

  4. I’m always questioning why the TBM (10 yr return 5.58) is used so frequently as it is far from representing all bonds. With that, why not focus on better returns such as Vanguards Intermediate Index (10 yr return 6.72) or if one can tolerate the volatility the Long Term Index (10 yr return 8.41)? I’m all for simplicity and indexing but I think people gravitate to TBM because they believe it provides more diversification than it really does.

  5. Steve,

    You asked, “why not focus on better returns such as Vanguards Intermediate Index?” The answer of course is that Vanguard Intermediate-Term Bond Index Fund is higher risk (both interest rate risk and credit risk).

    That’s not to say that it’s a bad choice (or a worse one), but it’s not as if its higher expected return doesn’t have an associated cost.

  6. I guess it comes down to where is the risk/return sweet spot. Just seems to me the “default” position of using TBM (again, when it’s far from representing all bonds and does so in name only) is one that is not given enough analysis and potentially costing investors a significant missed opportunity.

  7. A couple years ago, after reading all the popular books on Asset Allocation, I was obsessing about what the perfect “bands” for rebalancing were [i.e. if your target is 60% stocks, should you rebalance at +/- 5, or 10, or??]. I was also dismayed during the market recovery that due to my wife’s extreme fear of ANY loss we were allocated at 40/60 when I thought 50/50 was a better guesstimate of where we should be [this used to be 0/100, so it wasn’t that bad!].

    I finally decided to stop worrying about this after carefully examining historical returns [Vanguard has some model asset allocations and shows historical returns for each here: ].

    I decided that worrying about 5 or 10% either way on Asset Allocation is “nibbling around the edges”. Also, the difference between a 60/40 and 40/60 asset allocation is just under 1% performance each year, which is less than I save by using low cost Vanguard Admiral Class index funds, compared with the average cost of other mutual funds!

    As Jack Bogel likes to say, worry only about the things that you can control, like COSTS.

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