What do you think of this asset allocation?

[joer1212]

Is this a good asset allocation for my employee Roth 401K and 457 plans?

45% bond index fund

20% large-cap index fund

10% mid-cap index fund

5% small-cap index fund

20% international index fund

I have about 8-10 years until retirement (I am 42, but want to retire early).
I have low to moderate risk tolerance.
I was thinking to increase the small-cap index fund to, maybe, 10% to make it worth the fees for this asset class (0.06%), but I would have to reduce something else, and I don't know what.
The fees for my entire portfolio is 0.35%.
I have two contradicting concerns. One is that my bond-heavy portfolio may suffer losses as interest rates rise, and bonds lose value.
The second concern is that 8-10 years is not a long enough time line to load my portfolio with  more stocks. I need some stability in my portfolio, as I will be quitting my job and counting on steady income.
What should I do?

[sol]

I think that 8-10 years IS long enough to load up on a higher percentage of stocks, particularly because bonds will do less well once interest rates begin to rise.  I expect that to happen before 8 years are up.

[COguy]

If you are set on increasing your small-cap, you could probably reduce the large-cap fund to 15%.  I don't know your reasoning behind your cap choices, but if you have the choice, you may want to consider an total US stock market index.  Over a a long time it will probably perform as well as any US asset allocation you pick. 

I am a John Bogle, William Bernstien school of investing kind of guy.  So, if you prefer to try to time more then just disregard my advice as mine comes from a low maintenance passive point of view.

[trammatic]

I'd move more of the bonds into a short maturity fund...they have less interest rate risk. (I agree with Sol that rates are likely to be higher in 8 years than they are now, and that they are so low, a move of 3 points would be practicially doubling them.) 

If it were me, I'd focus more on dividend-producing stock funds than general ones.

Or perhaps move some of the bonds into other dividend producers.

[sol]

I do not believe modern portfolio theory (asset allocation) offers the best chance of success.

Despite what you may have read, MPT is not a load of crap.  It is, however, predicated on some assumptions that definitely do not apply to all investors, so there is certainly room for alternatives.

Plus, as long as you're only playing with your own money, go crazy.  Make your investment decisions based on tea leaves or the lunar calendar if you like.  Some days I think your odds of success would be just as good.

[joer1212]

Thanks for the suggestions, however some of the funds you recommend are not offered at my job (I work for the MTA, NYC Transit).
The only investment choices I have are:

* actively-managed mutual funds (individual, and Target-Date Funds)

* index funds

* a "stable" fund

That's it.
I didn't choose any of the actively-managed funds because the fees are too high. The stable fund yields too little, so the only logical choice was low-cost index funds.
I came up with my asset allocation by trying to copy the Target Date funds.
I examined the asset allocation of the "2020 Target Date Fund", and tried as closely as possible to match that allocation on my own, without the management fees.
Actually, the 2020 Target Date Fund invests 52% of the portfolio in bonds, TIPS, and the Stable Fund. I thought that was a little TOO conservative, so I increased my stock exposure a bit.
If we were living in a more typical investment climate, I would go with conventional wisdom and keep my portfolio as it is (45% bonds/ 55% stocks). The only reason I am questioning this is not because I think this is a bad ratio, but because interest rates are at an all-time low, and can only go up from here. When they inevitably do, 45% of my portfolio (which I plan to retire on in about 8 years) may take a massive hit.
Similarly, if I increase my stock exposure, volatility can derail my retirement plans.

[Mr Mark]

Even though you plan to retire in 8-10 years, that's just the start of a long retirement, right? So actually you're looking at an effective timeframe of 30 - 40 years.

45% bonds, especially right now, seems heavy to me and way sub-optimal over your actual investment timeframe.

[Sacadoh]

I have no bond exposure - substituting a UK real estate fund with a 6.5% dividend I know well for diversity from a vanguard UK 100% equity lifestyle tracker & other low TER funds.

When bond yields start to move back up a bit, I'll increase my bonds weighting closer to 30% as my position is not unlike the first poster mid 40's with c10 years to go.

Risky, though.

[smedleyb]

I agree with Sol.  OP is way to top heavy in fixed income.  If feels like the  bottom in rates is right around here, and the great bond market rally of 1980-2113 may just be over.  I have a hard time not imagining rates being much higher ten years from now.   

But given the massive uncertainties regarding our capital markets (credit shocks, government intervention, central bank shenanigans, etc) I'm also content to keep the majority of my long term nest egg in cash.  Sometimes not losing is just as good as winning. 

[joer1212]

Yes, Mr. Mark, I plan on being in retirement for decades. However, I'm afraid that if I get too aggressive in my investments, I may not be able to retire in 8-10 years to begin with. This is critical for me, as I don't want to have to work longer than this because my portfolio took a nosedive too close to my retirement date. I understand your point about having a long time frame after retirement, but I want to treat this as if I didn't have a long time frame, because, like I said I definitely want to retire within a decade and not ever have to go back to work. I'd rather have a slightly smaller income that is stable in retirement and stay in retirement, than get greedy and have to go back to work for several years because I thought I could make more money, but lost it in a volatile market. 

[Mr Mark]

Yes, Mr. Mark, I plan on being in retirement for decades. However, I'm afraid that if I get too aggressive in my investments, I may not be able to retire in 8-10 years to begin with. This is critical for me, as I don't want to have to work longer than this because my portfolio took a nosedive too close to my retirement date. I understand your point about having a long time frame after retirement, but I want to treat this as if I didn't have a long time frame, because, like I said I definitely want to retire within a decade and not ever have to go back to work. I'd rather have a slightly smaller income that is stable in retirement and stay in retirement, than get greedy and have to go back to work for several years because I thought I could make more money, but lost it in a volatile market.

I think you're confusing the issue by differentiating the next 8 years as being so distinct from the subsequent 'retirement' phase. They are the same, IMHO, except for tax & logistical considerations (eg having time to self manage a rental). In the end it's all about cash flow.

The investment income via dividends (real) & capital gains (notional) in your suite of investments will be used to grow the portfolio in the first phase, and live off + grow a little in the second 'retirement' phase. But the volatility you fear now will not magically go away when you 'retire'.

In both cases the focus is on yields and producing a net positive cash flow that you use initially to reinvest, and later to bleed off enough cash to provide income while maintaining the value of the portfolio. Unfortunately, a portfolio of bonds produces such low returns right now you'd need a very large stash to live off if your return is 2% before inflation!

[sol]

I don't want to have to work longer than this because my portfolio took a nosedive too close to my retirement date.

I'd say stick with your conservative allocation, then.  As Jacob so aptly pointed out, when you're on the EXTREME early retirement path, your investment returns become less important.  With only a few working years before retirement, you have so little time for compound interest to work that the vast majority of your nest egg comes from your high contribution amounts.

Yes, you will have to save longer to reach your goals.  But a person saving 90% of his income has nine years of savings after one year of work, and earning a 10% return on his money helps him a little but not by much.  Conversely, a person saving 10% of his income asolutely requires a high rate of return to be able to retire in 40 years, so investment return is much more important to him.

[joer1212]

"I think you're confusing the issue by differentiating the next 8 years as being so distinct from the subsequent 'retirement' phase. They are the same, IMHO"


No, they are the same. That's why I didn't want to get too aggressive the first 8 years before I retire, and more conservative after. I think I should be fairly conservative before retirement and in retirement.
But, that isn't as much my concern as the dilemma of being damned if I'm conservative and damned if I'm aggressive. The problem I'm facing is interest rate risk if I go conservative with a bond-heavy portfolio, and volatility risk if I go aggressive with heavy investments in stocks.
This is a unique investment climate we're in. Had it been typical, I would just go with 45% bonds, and 55% stocks, and just ride that .

[sol]

But, that isn't as much my concern as the dilemma of being damned if I'm conservative and damned if I'm aggressive. The problem I'm facing is interest rate risk if I go conservative with a bond-heavy portfolio, and volatility risk if I go aggressive with heavy investments in stocks.

On the time frame of your retirement, I think volatility is the prefereable risk to accept. 

I suspect that bond rates will start to drop as interest rates rise.  And I'm not too worried about inflation, as the stock market tends to largely cancel out inflation risks for anyone who's in it.  High inflation means the economy is churning along nicely, so it "should" translate into higher interest rates on your savings and higher returns for your stocks.

Meanwhile, I'm having a hard time picturing a scenario in which bonds have a bright future much beyond 2015. 

[joer1212]

Thanks, Sol, for having the honor of being the first person to actually address my questions and concerns directly.
This is not the first place where I have posted this question, and many people, while having good intentions, have not really addressed my concerns. I really appreciate you giving me the specific reasons why I should do what you suggest. It makes a lot of sense, and gives me the confidence to know why I'm doing something.
With your advice in mind, I think I will invest about 75/25 in favor of stocks. I might throw in some percentage of a stable fund.  I'm reluctant to do this because of yet another fee for  another fund, but I might do it, anyway, just to provide some anchoring and stability to my portfolio.
I might do something like this:

15% bond index fund

10% stable fund

40% large-cap index fund

10% mid-cap index fund

5% small-cap index fund

20% international index fund

One more thing: Is it really necessary for me to have exposure to all of these asset classes? I mean, could I just go with large-cap, stable fund, and international, or, any other three funds? Is there any real advantage to have a stake in all these categories? My fees would be 0.52% if I do the above portfolio. If I just do 3 of them, it would be about 0.29%.



 

[sol]

Thanks, Sol, for having the honor of being the first person to actually address my questions and concerns directly.

Thanks, I guess, but there's a reason why people don't generally say "you should invest your money in this particular way" to strangers on the internet.

Predicting which market segment will exceed the norm is always a crapshoot, and if you take my advice and then lose your shirt I'm going to feel like crap.  Which is why the only people who commonly give out specific advice are the doom and gloomers.

One more thing: Is it really necessary for me to have exposure to all of these asset classes?

If you're paying additional fees to be in more funds, then most people would advise you to just buy a total market fund that will already give you some exposure to all of these segments.  Unless your chosen allocation is significantly different than what's in the market at large, I don't see much advantage to buying each segment individually.  Many successful investors hold just a total stock index, a total bond index, and an international fund.

[joer1212]

"Many successful investors hold just a total stock index, a total bond index, and an international fund."

But, the problem is that my employer does not offer a "total stock index". I wish it did. The only way I can get exposure to certain segments of the market is to purchase a separate index for them.