Author Topic: Asset allocation  (Read 1082 times)

Goanywhere

  • 5 O'Clock Shadow
  • *
  • Posts: 63
Asset allocation
« on: October 26, 2021, 05:54:24 PM »
Hi all

My wife and I are 4 years away from FI.  At this point we'll be 40 and 38 years old.

Our FI plan is based on a 3.25% SWR, assuming no income in retirement and no social security - so fairly conservative.

Currently our asset allocation is:
Bonds 15%
Equities 85%  (60:40   US: non-US)

Once we hit FI we plan to leave our high paying / high stress corporate jobs.

In "retirement" I suspect over time we'll end up earning income from passion projects or consulting work that will contribute to our expenses.  Potentially as much as 50%.

Since we are 4 years away from FI and because we expect to not be withdrawing at 3.25%, should we / would you be considering a more aggressive asset allocation? For example moving to 100% equities.

Appreciate any thoughts on this.

Thanks


MustacheAndaHalf

  • Walrus Stache
  • *******
  • Posts: 5845
Re: Asset allocation
« Reply #1 on: October 26, 2021, 06:32:09 PM »
Most people increase bonds as they approach retirement, to avoid "sequence of returns" risk.  If the stock market plunges 50% (like in 2008), your living expenses don't change.  Your 3.25% withdrawal rate becomes 6.5% of your stocks.  That's the sequence of returns risk, in a dramatic example.  The higher withdrawal rate after a crash can ruin a retirement.

You need to switch thinking from accumulating to safety.  If you double your retirement assets, you don't get double the retirement.  But if you lose those assets, your retirement ends.  The downside is much worse than the upside, which is why bond allocations are generally higher in retirement - for safety.

If you really like high equity allocations, read up on a "bond tent".  In that approach, you allocate more bonds as retirement approaches.  Then, when you start retirement, over a number of years you ramp your equities back up.  The greatest risk is when you first retire, so a "bond tent" provides a higher bond allocation only for those years.

In any event, most advice would be a lower equity allocation than 85% when you're about to retire.  Look at Vanguard Target Retirement 2025, or the Fidelity or Schwab versions.  Unlike me, if they get retirement allocations wrong, they can be sued.  So their allocations have a lot more weight behind them.

Goanywhere

  • 5 O'Clock Shadow
  • *
  • Posts: 63
Re: Asset allocation
« Reply #2 on: October 26, 2021, 07:27:51 PM »

In any event, most advice would be a lower equity allocation than 85% when you're about to retire.  Look at Vanguard Target Retirement 2025, or the Fidelity or Schwab versions.  Unlike me, if they get retirement allocations wrong, they can be sued.  So their allocations have a lot more weight behind them.


Thanks very much. 

The part I struggle with, is that bonds are performing badly at the moment relative to stocks. I.e. my long term bonds they are at a negative return for the last 12 months.    That Vanguard TR 2025 is very interesting, 52% stocks and 48% bonds.  Quite different to where we are currently.



harvestbook

  • Stubble
  • **
  • Posts: 237
Re: Asset allocation
« Reply #3 on: October 27, 2021, 04:34:02 PM »


The part I struggle with, is that bonds are performing badly at the moment relative to stocks. I.e. my long term bonds they are at a negative return for the last 12 months.   


Down a couple percent on bonds in 4 years might look spectacular next to a possible stock market decline of 30-50 percent. I hate bonds, too, but it's nice to know I will have X-ish dollars that I can pretty much count on.

boarder42

  • Walrus Stache
  • *******
  • Posts: 9332
Re: Asset allocation
« Reply #4 on: October 27, 2021, 04:39:45 PM »
With a 3.25% wr and income of up to 50% further lowering it there isn't much if any reason to be in bonds. Your wr is far low enough alone.

Financial.Velociraptor

  • Handlebar Stache
  • *****
  • Posts: 1913
  • Age: 50
  • Location: Houston TX
  • Devour your prey raptors!
    • Living Universe Foundation
Re: Asset allocation
« Reply #5 on: October 27, 2021, 05:53:36 PM »
My opinion on "bond allocation" is it should be renamed "fixed income allocation".  Historically, that has meant mostly bonds.  Today, i think it makes a lot of sense to layer in preferreds, REITs, BDCs, and buy/write funds.   Most of my bonds right now are super conservative municipals held in leveraged Closed End Funds (CEF)s.  It can be hard to justify locking in a return around 2% but preferreds bringing in sustainable 6-7%, some VNQ, etc. provide some yield and price stability. 

@MustacheAndaHalf nailed it regarding SoRR.  You don't hold fixed income to beat the market.  You hold it to "beat the downturns". 

Also valid is an allocation to just plain old cash in a bank CD ladder.  Alternatively, a single premium annuity that guarantees your "skinny FIRE" budget no matter what can have a lot of appeal.  Like I said, think in terms of fixed income and asset protection, not total return.

ChpBstrd

  • Magnum Stache
  • ******
  • Posts: 4967
  • Location: A poor and backward Southern state known as minimum wage country
Re: Asset allocation
« Reply #6 on: October 27, 2021, 09:51:08 PM »
Keep in mind most of the historical data supporting a higher bond allocation comes from eras more than 30 years ago. This is how we know an AA made it 30 years in the past! These long-ago years included times when safe bonds, like 10y US treasuries for example, were yielding 4%, 5%, 6%, 7% and higher. The real yield on those bonds from decades ago was usually in the +2% to +4% range. Compare that to today's real yields in the -1.5% to -2% range and you'll note a big difference.

https://www.multpl.com/10-year-real-interest-rate
https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart

I'm wary of SORR, but I'm also wary of allocating my assets into things that can only possibly lose purchasing power. That in itself is a risky decision. If we have a Japanese scenario ahead of us here in the US, the stock market will go nowhere while one's bonds steadily bleed purchasing power. And if we have an inflationary scenario or even a normalization of interest rates, bonds are going to get clobbered and suffer double-digit losses like a stock correction. See: "bond convexity".

https://www.investopedia.com/terms/c/convexity.asp

Bonds would do well in exactly one scenario - a deflationary spiral into a great depression. In all other scenarios, you're losing purchasing power. This is a much different scenario than historical retirement cohorts were looking at. Back in their world, the real yield from a large bond allocation might cover much of one's withdraw rate. Even better, bonds and stocks could be rebalanced to juice long-term gains. Now look at today's world: Instead of earning something, one's bond allocation is a net expense in terms of purchasing power! And the same thing that would cause stocks to collapse from their lofty PE ratio - higher interest rates - is the thing which would cause double-digit losses in a bond portfolio of any significant duration. In the past 20 years, bonds have lost their key benefits: safety, real earnings, and diversification.

So how does one achieve the following goals in a near-ZIRP world?
1) protection from Sequence of Returns Risk (SORR)
2) rebalancing opportunities
3) lower portfolio volatility, so that the WR does not get too high during bear markets

The answer is to use options strategies. Our ancestors accepted lower rates of returns with their 50/50 and 60/40 portfolios, compared to what they could have earned with 80/20 or 90/10 or 100/0 portfolios, but they paid that price in exchange for the 3 benefits listed above. You can still do the same with stock options. There's no free lunch. There is a price. But to me that price is more reasonable than the real losses, real risks, and lack of actual portfolio protection involved with bonds.

Take the collar strategy for example. You sell a call and buy a put, while also holding the stock or fund. In doing so, you essentially trade away the potential for very high returns in exchange for protection from very low returns. If you use LEAPS options, you can obtain up to 2.5 years' protection per trade, although I would recommend updating the options positions at least annually to re-center the hedge. Because you are both selling a contract and buying a contract, the out-of-pocket costs offset to some degree depending on your specific strike prices. A collar can even be "costless" if the price of the call you sell is roughly equal to the price of the put you buy.

https://www.theoptionsguide.com/costless-collar.aspx

If a SORR event occurs, the put option you own multiplies in value at the same time as the call option you sold decreases in value (goal 1). In fact, the value of your pair of options is constantly fluctuating in the opposite direction of your stocks - reducing the volatility of a 90% stock portfolio to something more like a 60/40 (goal 3). At some threshold you wrote down in your IPS, you sell the put and buy back the call for a big profit. E.g. If stocks fall 25%, you exit your options positions for a gain that makes up for most of all of what you "lost" on stocks. Then you just wait for the recovery and re-establish your hedge later. You could even plan to gradually reduce your options hedge instead of dropping it all at once, as stock prices continued to fall and the risks of being long decrease. This is a very direct form of rebalancing (goal 2) that does not rely on interest rates or commodity prices or any other dependencies. If you enter a collar during a period of low volatility (i.e. VIX<15) then you'll see your hedge gain value just from increases in volatility - which is coincidentally exactly the time you'll be exiting the hedge.

Suppose you're not this bold, and you want to maintain the hedge at all times no matter what. Or perhaps you're genuinely scared by whatever is causing the SORR event - then you can just hold your hedge and enjoy the lower volatility and lower withdraw rates while everyone else freaks out. As long as you sell parts of your hedge at the same time you're selling stocks to fund your retirement lifestyle, you're enjoying a lower WR and avoiding risk to the long-term durability of your stock portfolio.

One last reason to do a collar instead of a big bond allocation: With a collar, you can allocate 90-100% of your assets to stocks with higher expected total returns, while locking in a risk profile that has a defined floor and ceiling on your outcomes. Thus you can invest aggressively and safely at the same time. A 95% stock portfolio with a collar is a lot safer than an unhedged 60/40 portfolio right now. The 60/40 could lose half its value, but the hedged portfolio can only lose maybe 15%, 20%, or 25% depending on how it was set up and beyond that point can lose no more. Sure, it can also only gain something like 10%, 15%, or 20% in the next year, but arguably the 60/40 is in the same boat. That's a fair price to pay in these low-interest times. As the portfolio owner, you decide how much upside you're willing to trade for downside protection.

Disclosure: I own 5 bonds backed by student loans, yielding 7.5% on my cost, and comprising about 4% of my overall portfolio. Those are my only bonds, and I won't be replacing them when they mature.
« Last Edit: October 27, 2021, 09:58:10 PM by ChpBstrd »

Goanywhere

  • 5 O'Clock Shadow
  • *
  • Posts: 63
Re: Asset allocation
« Reply #7 on: October 28, 2021, 02:24:18 AM »
Keep in mind most of the historical data supporting a higher bond allocation comes from eras more than 30 years ago. This is how we know an AA made it 30 years in the past! These long-ago years included times when safe bonds, like 10y US treasuries for example, were yielding 4%, 5%, 6%, 7% and higher. The real yield on those bonds from decades ago was usually in the +2% to +4% range. Compare that to today's real yields in the -1.5% to -2% range and you'll note a big difference.

https://www.multpl.com/10-year-real-interest-rate
https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart

I'm wary of SORR, but I'm also wary of allocating my assets into things that can only possibly lose purchasing power. That in itself is a risky decision. If we have a Japanese scenario ahead of us here in the US, the stock market will go nowhere while one's bonds steadily bleed purchasing power. And if we have an inflationary scenario or even a normalization of interest rates, bonds are going to get clobbered and suffer double-digit losses like a stock correction. See: "bond convexity".

https://www.investopedia.com/terms/c/convexity.asp

Bonds would do well in exactly one scenario - a deflationary spiral into a great depression. In all other scenarios, you're losing purchasing power. This is a much different scenario than historical retirement cohorts were looking at. Back in their world, the real yield from a large bond allocation might cover much of one's withdraw rate. Even better, bonds and stocks could be rebalanced to juice long-term gains. Now look at today's world: Instead of earning something, one's bond allocation is a net expense in terms of purchasing power! And the same thing that would cause stocks to collapse from their lofty PE ratio - higher interest rates - is the thing which would cause double-digit losses in a bond portfolio of any significant duration. In the past 20 years, bonds have lost their key benefits: safety, real earnings, and diversification.

So how does one achieve the following goals in a near-ZIRP world?
1) protection from Sequence of Returns Risk (SORR)
2) rebalancing opportunities
3) lower portfolio volatility, so that the WR does not get too high during bear markets

The answer is to use options strategies. Our ancestors accepted lower rates of returns with their 50/50 and 60/40 portfolios, compared to what they could have earned with 80/20 or 90/10 or 100/0 portfolios, but they paid that price in exchange for the 3 benefits listed above. You can still do the same with stock options. There's no free lunch. There is a price. But to me that price is more reasonable than the real losses, real risks, and lack of actual portfolio protection involved with bonds.

Take the collar strategy for example. You sell a call and buy a put, while also holding the stock or fund. In doing so, you essentially trade away the potential for very high returns in exchange for protection from very low returns. If you use LEAPS options, you can obtain up to 2.5 years' protection per trade, although I would recommend updating the options positions at least annually to re-center the hedge. Because you are both selling a contract and buying a contract, the out-of-pocket costs offset to some degree depending on your specific strike prices. A collar can even be "costless" if the price of the call you sell is roughly equal to the price of the put you buy.

https://www.theoptionsguide.com/costless-collar.aspx

If a SORR event occurs, the put option you own multiplies in value at the same time as the call option you sold decreases in value (goal 1). In fact, the value of your pair of options is constantly fluctuating in the opposite direction of your stocks - reducing the volatility of a 90% stock portfolio to something more like a 60/40 (goal 3). At some threshold you wrote down in your IPS, you sell the put and buy back the call for a big profit. E.g. If stocks fall 25%, you exit your options positions for a gain that makes up for most of all of what you "lost" on stocks. Then you just wait for the recovery and re-establish your hedge later. You could even plan to gradually reduce your options hedge instead of dropping it all at once, as stock prices continued to fall and the risks of being long decrease. This is a very direct form of rebalancing (goal 2) that does not rely on interest rates or commodity prices or any other dependencies. If you enter a collar during a period of low volatility (i.e. VIX<15) then you'll see your hedge gain value just from increases in volatility - which is coincidentally exactly the time you'll be exiting the hedge.

Suppose you're not this bold, and you want to maintain the hedge at all times no matter what. Or perhaps you're genuinely scared by whatever is causing the SORR event - then you can just hold your hedge and enjoy the lower volatility and lower withdraw rates while everyone else freaks out. As long as you sell parts of your hedge at the same time you're selling stocks to fund your retirement lifestyle, you're enjoying a lower WR and avoiding risk to the long-term durability of your stock portfolio.

One last reason to do a collar instead of a big bond allocation: With a collar, you can allocate 90-100% of your assets to stocks with higher expected total returns, while locking in a risk profile that has a defined floor and ceiling on your outcomes. Thus you can invest aggressively and safely at the same time. A 95% stock portfolio with a collar is a lot safer than an unhedged 60/40 portfolio right now. The 60/40 could lose half its value, but the hedged portfolio can only lose maybe 15%, 20%, or 25% depending on how it was set up and beyond that point can lose no more. Sure, it can also only gain something like 10%, 15%, or 20% in the next year, but arguably the 60/40 is in the same boat. That's a fair price to pay in these low-interest times. As the portfolio owner, you decide how much upside you're willing to trade for downside protection.

Disclosure: I own 5 bonds backed by student loans, yielding 7.5% on my cost, and comprising about 4% of my overall portfolio. Those are my only bonds, and I won't be replacing them when they mature.

This is a great post thank you - very thought provoking.    The difficultly I have, not being in the US/UK/Europe/Other major financial centre, is that we have very limited access to any of these complex derivatives :-(

Goanywhere

  • 5 O'Clock Shadow
  • *
  • Posts: 63
Re: Asset allocation
« Reply #8 on: October 28, 2021, 02:30:35 AM »

Also valid is an allocation to just plain old cash in a bank CD ladder.  Alternatively, a single premium annuity that guarantees your "skinny FIRE" budget no matter what can have a lot of appeal.  Like I said, think in terms of fixed income and asset protection, not total return.

Good point.  Do you have a view, or are you aware of any good resources, about how many years of expenses to hold outside of stocks?  I guess what I'm asking is on average how long do bear markets last and then take to recover? I.e. the time I'd need to not be withdrawing from my stock portfolio.

vand

  • Handlebar Stache
  • *****
  • Posts: 2095
  • Location: UK
Re: Asset allocation
« Reply #9 on: October 28, 2021, 03:15:00 AM »
Flip the OP question around:

if you don't need to even intend to exhaust your retirement pot - which a 3.25% SWR & extra adhoc income will pretty much gaurantee - why do you NEED to increase your equity allocation? What is the gain to you? You've won the game. Do you need to "win" it even further.

MustacheAndaHalf

  • Walrus Stache
  • *******
  • Posts: 5845
Re: Asset allocation
« Reply #10 on: October 28, 2021, 11:00:44 AM »
Note that while I mentioned Vanguard Retirement funds to make sure you had their perspective, I think 50% bonds is excessive.  I prefer a higher allocation, myself.

Someone aiming for 80% stocks might use a bond tent approach.  They might prepare 7 years in advance by shifting 3% from stocks to bonds, every year.  So 5 years from retirement, they have 74% stocks.  When they retire, they might have 59% or 60% stocks.  After they retire, they slowly bring the stock allocation back up, again 3% per year.  So 7 years after retirement, that bond tent would be back at 80% equities.  The bond allocation goes up, then down - looking like a tent.  That approach avoids the most dangerous event: a crash right after retirement.  If that happens with a bond tent, you have enough bonds to keep your nest egg.


My opinion on "bond allocation" is it should be renamed "fixed income allocation".  Historically, that has meant mostly bonds.  Today, i think it makes a lot of sense to layer in preferreds, REITs, BDCs, and buy/write funds.   Most of my bonds right now are super conservative municipals held in leveraged Closed End Funds (CEF)s.  It can be hard to justify locking in a return around 2% but preferreds bringing in sustainable 6-7%, some VNQ, etc. provide some yield and price stability. 
Fixed income is a better term, including cash and bonds.  I personally lump REITs into stocks, because they can take big losses (like in 2008) while bonds are much less impacted.  Right now I'm only holding cash, no bonds.  I have dramatically different risk tolerances between stocks and bonds.  With stocks, I've bought out of the money call options on individual micro-cap stocks.  A high risk tolerance.  With bonds, I hate taking risk - I want to depend on bonds to be there.

Because of that lack of risk, I miss opportunities with bonds.  Like right now, most people want to avoid bonds.  The contrarian view would say "be greedy when others are fearful", and buy bonds now.  Back in March 2020, the Fed dropped it's Federal funds rate to 0%, which then showed up in bond yields.  It's likely that in 2022-2023, the Fed will raise that rate again, and push bond yields higher.  Anyone holding bonds then will watch their market value drop quickly.  So for me, I avoid the risk in bonds and don't buy them right now - event though everyone else is scared of bonds, too.