Tag Archives: Balanced Portfolio

Dumping Stocks at Retirement

Have you ever considered selling all your stocks or stock mutual funds when you retire?  Who wants to have to deal with the ups and downs of the markets when you are no longer dollar-cost-averaging?  Are you afraid of a major market crash when you are drawing down your portfolio?

The market is near its all-time high.  With retirement right around the corner, are you tempted to sell all your stock holdings and call it a day?  It might sound tempting.  This market cannot keep going up, can it?

Every investor has the right to feel exactly how they feel about all of the scary things that are going on in the world.  Don’t lose your head.  The world has always been a volatile place and unfortunately, it always will be.  If it is not one thing, it is something else.

Yes, it might be tempting to pull the trigger and sell high.  You would walk away as a winner.  Before you do that.  Let’s look at how an all-bond portfolio might serve you in retirement.

For this exercise, let us assume that you are now sitting on $1,000,000 in your 401K.  At retirement, you want to draw down 4% per year.  How would an asset allocation of 100% in bonds hold up over the course of 30 years?  To find out, I am going to run this test based on the Monte Carlo method by using the Vanguard Retirement Nest Egg Calculator.

There is a 69% chance that your savings will last 30 years.  I do not like those odds.  I especially do not like them for a person who retires early.

What about if a person wants that $1,000,000 to last 40 years?  The percentages are getting much worse.  There is now only a 36% chance that money will last 40 years.

Could you imagine going broke after being retired for 40 years?  What would you do?  Would you go back to work?  Who would hire you at such an advanced age?  Sure, employers cannot discriminate, but let’s be honest about the opportunities for someone who has been unemployed for that long.

What could an investor do to improve the chances of their savings lasting 30 years or even 40 years for those who enter early retirement?  In Benjamin Graham’s book The Intelligent Investor, he gave a few suggestions for defensive investors.  He suggests that a balanced portfolio made up of 50 in equities and 50% in bonds is a good place to start.  He also suggested that an investor should never exceed an asset allocation of 75/25.  In other words, an investor should never have more than 75% or less than 25% in equities or bonds.

I know that you are seriously considering selling your equity holdings and exchanging them for bonds.  You have told yourself that you are finished with the market.  Volatility is no longer for you.  You want to enjoy your retirement without having to worry about how stocks are performing.  If you do that, the odds are still not in your favor of not running out of money.

How would your $1,000,000 fair if you followed what the late Benjamin Graham suggested in his classic investment book?  How would keeping only 25% in equities change the projected outcome?  Would adding a more volatile asset class help or hurt the likely hood of running out of money?

By keeping 25% in equities, the percentages have dramatically improved.  There is now a 78% chance that your money will not run out over the course of 30 years with a 4% drawdown rate.  Over the course of 40 years, there is 57% chance that your money will last.  By keeping 25% of the portfolio in stocks, there was an improvement of 9% over the course of 30 years and an improvement of 21% for 40 years.

Holding a small allocation of equities sure goes a long way.  What about if you took it a step further and went with a mix of 50% in stocks and 50% in bonds?  I know, I know. You are finished with stocks.  Keeping 25% of your money in stocks is one thing, but going to 50% is just too aggressive for your retirement account.

I understand how you feel.  You do not want to own stocks when the next recession occurs.  A long stock market correction can be scary.

During a drawdown period, how does having 100% in bonds compare to an asset allocation of 50% in stocks and 50% in bonds?  Over the course of 30 years, the 50/50 mix has an 85% chance of success.  Over the course of 40 years, the 50/50 mix has a projected success rate of 74%.  Compared to the portfolio made up of 100% in bonds, the 50/50 mix has a 16% better chance to not run out of money over the course of 30 years.  For the period of 40 years, the 50/50 mix has a 38% better chance of not running out of money.

There are many factors to consider when selecting the asset allocation that is right for your retirement.  How old will you be at the time of retirement?  How long does your money have to last?  How will RMDs impact your drawdown?  What type of lifestyle do you want to live during retirement?  Are you planning on leaving a legacy?

I am not trying to convince you on how you should allocate your portfolio during retirement.  That is ultimately your decision.  Everyone has a unique financial situation.  The purpose of this post was to examine how different conservative portfolios might perform during the drawdown period.  I am just trying to convince you to do your due diligence before you rush to any financial decisions that will impact your quality of life down the road.

After reviewing these results, it shows that diversification is still important during the drawdown period.  Just as holding 100% in stocks is too aggressive for most investors during their working years, holding 100% in bonds might be too conservative for investors during the drawdown period.  When an investor is working on building their wealth, holding a percentage of bonds helps to reduce the impact of how stock market volatility impacts a portfolio.  During the drawdown period, holding a small percentage of equities greatly improves the likelihood of not running out of money in retirement.

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The Benefits of a Balanced Portfolio

Balance is important in almost every area of life.  We should eat a balanced diet including food from every food group to ensure our bodies get proper nutrition.  We should balance the type of exercise we perform including strength training, cardio, and stretching.  Having a good work-life balance leads to improved productivity and happiness.  There should also be a balance in how we invest.

To add balance as an investor means to invest in different asset classes that have an inverse relationship.  A balanced portfolio is an asset allocation that has balanced percentages of stocks and bonds.  It could be 50% invested in stocks and 50% invested in bonds.  Most balanced portfolios utilize an asset allocation of 60% in stocks and 40% in bonds.  However, the asset allocation might be outside of those bands.

The concept of the balanced portfolio was made popular by Harry Markowitz.  In 1952, Harry Markowitz wrote a paper in the Journal of Finance where he introduced his hypothesis on Modern Portfolio Theory (MPT).  The basic theory of Modern Portfolio Theory is that an investor can balance the expected return of a portfolio and risk by using diversification.

Modern Portfolio Theory suggests that an investor can construct an efficient frontier based portfolio by investing in more than one equity or fund.  Portfolios that are based on the efficient frontier are highly diversified.  The efficient frontier is a balance of diversifying across risky investments with a high potential for return with a low-risk investment that produces a lower return.  The optimal portfolio is designed to strike a balance between securities that produce the highest potential returns with securities that have a lower potential for return but balance out the risk.

 

Sample Balanced Portfolios

There are many ways to construct a balanced portfolio.  Below are two popular and simple balanced portfolios.  They are both based on a 60/40 asset allocation.  They incorporate a slightly different approach based on market capitalization.

Value Tilting

The Coffee House Portfolio was created by a Bill Schultheis.  Bill is a Seattle based financial advisor who created the Coffee House Portfolio for investors to build wealth, ignore Wall Street, and get on with their life.  The Coffee House Portfolio is considered a lazy portfolio.  Bill also published a book The Coffeehouse Investor that covers The Coffee House Portfolio in greater detail.  The Coffee House Portfolio uses a tilt towards small cap stocks as well as value stocks.  Small and value stocks have historically outperformed growth stocks.  Value stocks are undervalued based on fundamental analysis.  Please keep in mind, however, that there is no guarantee of this moving forward.  This asset allocation is well suited for investors who prefer a slice-and-dice approach to asset allocation.

Portfolio:

Large Blend – 10%

Large Value – 10%

Small Cap Blend – 10%

Small Cap Value – 10%

REITS – 10%

Total International – 10%

Total Bond Market – 40%

Performance:

1-Year Return = 10.94%

5-Year Return = 6.63%

10 Year Return = 5.97%

Market Capitalization Weighted

Another lazy portfolio is the three-fund portfolio.  While I am not sure if it was created by Taylor Larimore, it was made popular by him and the other Bogleheads in their book The Bogleheads’ Guide to Investing. The three-fund portfolio is made up of three mutual funds.  Even though it only invests in 3 mutual funds, it invests in 10,000 stocks.  This portfolio is highly tax-efficient because there is little turnover.  It contains every domestic and international large-cap, mid-cap and small-cap stock.  The three-fund portfolio is market cap weighted to prevent any front-running.  There is not any risk of underperforming the market like with value tilting because this is the market.  It is truly a simple portfolio to manage.  It can be allocated in many ways to suit an investors goals and risk tolerance.  Below is an example of how it can be used as a balanced 60/40 portfolio:

Portfolio:

Total Stock Market – 40%

Total International Stock Market – 20%

Total Bond Market – 40%

Performance:

1-Year Return = 7.05%

5-Year Return = 8.62

10-Year Return = 5.26

The Benefits

The best aspect of a balanced portfolio is that it allows the investor to control risk.  It is not risk-free like an FDIC backed certificate of deposit.  The risk is controlled by way of rebalancing.  A balanced portfolio is easy to manage and rebalance when it falls out of alignment due to market performance.

Let us assume that there is a market correction and a decrease in the price of stocks.  The portfolio that was once 60% in stocks and 40% in bonds is now out of alignment.  The asset allocation is currently 55% in stocks and 45% in bonds.  By rebalancing, the investor can sell bonds high and rebalance to the original asset allocation.

This systematic approach takes emotions out of the process and stands in the way of an investor making a poor decision.  This prevents investors from chasing performance.  It always forces the investor to buy low and sell high.

Just keep in mind that if this is done in a taxable account, it could trigger a tax consequence.  It is best to rebalance in a 401K or IRA because it has zero impact on taxes.  It is also wise to limit rebalancing to only once every year or no more than once every six months.

Unlimited Options

When it comes to investing, there is no such thing as having the perfect portfolio.  By using a balanced portfolio, an investor can avoid putting all of their eggs in one basket.  If an investor only invests in bonds their holdings will be secure, but the low returns might not keep up with the long-term rate of inflation.  On the other hand, if an investor only invests in equities, a major market crash could cut the value of their life savings in half.

A balanced portfolio is a diversified portfolio.  It reduces risk and can increase returns over the long term.  A balanced portfolio can be customized to meet the risk tolerance and investment goals for investors in every age group.  It can be created for both growth investors and for those who are seeking income.

A balanced portfolio can be constructed with many different funds or ETFs across various asset classes like the two above examples.  Individual securities can be used as well.  A balanced portfolio can also be made up of one mutual fund.

There are many options for investors who want to just use a single mutual fund.  There are options for investors who like to use low-cost index funds.  There are balanced funds for investors who prefer active management.

For investors who are near or in retirement, the Vanguard Wellesley Income Fund (VWINX) is a good option.  The Wellesley Income Fund (VWINX) is actively managed and is composed of 40% in stocks and 60% in bonds.  Even though it is an active fund, the Wellesley Income Fund (VWINX) has a low expense ratio of  0.22%.

Younger investors might want to own more stocks than bonds.  A more aggressive balanced fund for them to consider is the Vanguard LifeStrategy Growth Fund (VASGX).  The Vanguard LifeStrategy Growth Fund (VASGX) uses index funds for its allocation of 80% in stocks and 20% in bonds.

Conclusion

Just be aware that there is still a risk when investing in a balanced portfolio.  A balanced portfolio just helps to reduce risk.  It does not eliminate it.

An investor can design their own balanced portfolio.  There are also mutual funds that allow investors to own a balanced portfolio with one single fund.  There are options for investors of every age and risk tolerance profile.  A balanced portfolio is a good option for both new as well as experienced investors.

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Please consult with a financial professional before you ever make any investment decisions and read the Disclaimer page.

How to Invest A Million Dollars

While a million dollars might not have the purchasing power that it once had, it is still a large sum of money.  If you watch professional sports on ESPN, follow entertainment gossip on TMZ, or read Forbes, you are sure to come across stories about the huge salaries that some high-profile people earn.  NFL quarterbacks earn over $25M per year.  Hollywood actors earn over $22M per movie.  The CEO’s of the Fortune 500 earn 600 times more than the average employee.  The late Dr. Thomas J. Stanley would refer to those people as the “glittering rich”. Compared to the salary that the average person earns, those people are more along the lines of a rare commodity.  While it is interesting to pay attention to what those people earn, it is not something that the average person should use as a benchmark of their financial success.

Today, the average household salary in the U.S. is about $58,000.  With that being the current financial situation, having one million dollars would be a game changer for most people.  It would not be enough to live as the rich and famous do.  It is enough, however, to give the average person some financial freedom and peace of mind.

One million dollars is seventeen times the annual earnings of the average household salary.  Many financial experts consider having 25 times your annual expenses in savings to qualify as being financially independent.  If you had one million dollars, you would be well on your way as long as you do not drastically upgrade your lifestyle.

How would I suggest that someone invests a million dollars?  For me, I like to follow a keep it simple approach.  The core of the portfolio should be largely invested in stocks.  Stocks are important for growth and keeping ahead of inflation, I also believe that there should be some fixed assets in a portfolio.  Bonds are used to reduce the market volatility that comes with investing in stocks.

How should you construct this portfolio?  You should consider your age and your risk tolerance.  A young person has more time to recover from a major market correction than a person who is retired and is drawing down money from the portfolio to pay for living expenses.  The second factor to consider is how much of a loss can you can tolerate before you sell off your equities at the wrong time.  If you can stomach a 50% loss in value, consider investing 100% the money in stocks.  If you are more risk adverse and think that you could handle a 20% loss in value, consider a balanced portfolio of 60 invested in stocks and 40 percent invested in bonds.

Jack Bogle suggested that an investor should subtract their age from 100 and that would equal how much they should invest in equities.  For example, if you are 25 years old, you should have 75% of your portfolio in equities.  If you are more aggressive or not a fan of the current bond yields, subtract your age from 110 instead of 100.

While bonds might not be an attractive option for growth, they do serve a role in almost every diversified portfolio.  They allow investors to buy low and sell high in the form of rebalancing.  If the stock portion of a portfolio has a negative return for the year, an investor can exchange money from the bond portion of their portfolio and take advantage of buying stocks low while selling bonds high.

I am not a financial planner or a professional investor.  I can only share my experience, what I have learned, and what I hope to achieve as an investor.  When I was a new investor, I held 100% of my portfolio in stocks for over ten years.  That period included three years of negative returns from 2000 until 2003.  I have also followed the rule of 110 minus your age in equities.  By adding bonds to my asset allocation, it helped to smooth out the market volatility of the great recession. 

Since the purpose of this post is to give advice on how to invest a million dollars, I would suggest the Sweet Dreams Portfolio.  The Sweet Dreams Portfolio is my current asset allocation.  It is a balanced-growth asset allocation of 65% in stocks and 35% in bonds.  This portfolio allows you to own every U.S. and international stock including emerging markets.  It is based on 110 minus the average age of my wife and myself in equities.  Let’s examine the growth and performance of one million dollars over the course of the past 20 years.

The Sweet Dreams Portfolio

Vanguard S&P 500 or Large Cap Index Fund = $380,000

Vanguard Extended Market or Small Cap Index Fund = $110,000

Vanguard Total International Stock Market Index Fund = $160,000

Vanguard Total Bond Market or Inter-Term Tax-Free Bond Fund for a taxable account = $350,000

20 Year Performance

5-years = 8.16%

10-years = 6.82%

15-years = 6.88%

20-years = 7.18%

Best Year = 23.93%

Worst Year = (23.32)

$1,000,000 grew to = $4,188,631 (Rebalanced Annually)

Average Expense Ratio = 0.06% (Admiral Shares)

Conclusion

Dr. William Bernstein wrote, “that if you won the game, quit playing”.  While a million dollars might not be enough to declare victory for everyone, it is a nice lead to have.  For me, I recommend holding on to that lead by running the ball and playing great defense.  To translate that football analogy into financial advice would mean to shoot for a nice conservative return of 6.8%.  That would enable you to double your money about every decade.  

This post was entered into the “How to invest a million dollars” contest.  

Please visit www.howtoinvestamillion.com to check out all of the sample portfolios. 

Please remember to check with a financial professional before you ever buy an investment and to read the Disclaimer Page.

 

Balanced-Growth Portfolio

Welcome to Part-3 of my series on asset allocation.  In my last post, I wrote about Adding Bonds To Reduce Volatility in the portfolio that my wife and I held for the past ten years.  In this post, I am going to write about our new asset allocation.  This is the allocation that we will hold until we reach early retirement (FIRE).

As a Financial Independence (FI) blogger, I have always been a portfolio nerd.  The Lazy Portfolios made popular by Paul B. Farrell on marketwatch.com and his book The Lazy Person’s Guide to Investing have always been something that I have enjoyed following.  It is interesting to analyze the performance of famous portfolios like the Coffeehouse Portfolio, Yale’s Unconventional Portfolio, the Second Graders Starter Portfolio, as well as others.

The portfolio that I would like to introduce to you is what I call The Sweet Dreams Portfolio.  The portfolio is named after what it provides for us.  It is a portfolio that allows us to sleep well at night in spite of all the scary headlines that can easily cause nightmares from the sensationalized financial and political media.

This portfolio has a balanced-growth asset allocation.  Based on the Vanguard portfolio allocation model, a portfolio that is made up of 60% stocks and 40% bonds is classified as a balanced portfolio.  Vanguard classifies a portfolio of 70% stocks and 30% bonds as a growth portfolio.  The Sweet Dream’s portfolio is 65% stocks and 35% bonds.  The Sweet Dreams portfolio is made up of the same funds that we used in our previous asset allocation.

The Sweet Dreams Portfolio:

S&P 500 – 38%

Extended Market Index Fund – 11%

Total International Stock Market Fund – 16%

Total Bond Market – 35%

You might be asking, why not just use the total stock market instead of using an S&P 500 and an extended market fund?  The answer to that question is that these are the options that my wife and I have available in our 403B accounts.  A total stock market fund has the same market weighted allocation of a 4:1 ratio and can be used in place of those two funds.  There are many different ways to approximate the total stock market with a combination of other funds.

Our Roth IRA’s and taxable funds are invested with Vanguard.  My 403B has index funds from Fidelity.  My wife’s 403B plan has index funds from Charles Schwab.  This asset allocation can be created with index funds from any of those companies.

In my first two posts in this series, I wrote from a position of experience.  In those two posts, I was able to look back at how my asset allocation performed over long periods of time.  Those posts were also about how I responded to different market conditions.

The Sweet Dreams Portfolio is a brand new asset allocation model for us.  There is no such thing as a crystal ball that I can use to see into the future.  We can only look backward at how an asset allocation performed during different market conditions.

Over the past 10 years, The Sweet Dreams Portfolio returned an average of 6.34% per year.  The largest one-year loss was in 2008 with a -24% loss.  An initial investment of $10K would have grown to nearly $20K if rebalanced annually.

Over the past 20 years, The Sweet Dreams Portfolio returned an average of 6.91%. The worst one-year loss over the period of 20 years was still in 2008.  An initial investment of $10K would have grown to more than $38K if re-balanced annually.

At the age of 40, I still have a long investing horizon.  It is not as long as others because of our goal to retire in less than 12 years.  We are comfortable with the 65% invested in equities for growth.  We are also comfortable with the 35% invested in bonds to use as a re-balancing tool during market corrections.  Ultimately, we are comfortable with the thought of having restful nights and sweet dreams as we work toward our next goal on this financial journey.

Please keep an eye out for the 4th and final part of this series.  The final post in this series will be about how we plan on structuring the asset allocation of our retirement portfolio when we reach early retirement (FIRE).  The final post will also include how we plan on funding our retirement based on investment withdrawal rates, pensions, and Social Security.

Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.