Asset Allocation is the Most Important Decision in Personal Finance (1,2) – it explains 90%+ of returns
Marcus Schafer (00:05.902)
Asset allocation is one of the most important decisions you can make in personal finance. It controls somewhere between 90 and 96 % of returns is based upon the asset allocation decision. So that’s what we’re going to talk about today. This is going to be episode 20, if you could believe it, of Greenstream where logic meets life and investing. I’m Marcus Schaefer, Greenspring advisor, director of growth. This is Pat Collins, our CEO.
Pat, think this is obviously gonna be a great conversation, because it is one of the biggest decisions you can make in personal finance.
If you probably go back through our first 20 episodes, my guess is this maybe is the most frequently discussed topic because it is such an important decision. Maybe the most important decision when it comes to financial planning and investing is how much risk are you taking? How much return do you need? Are you on track to meet your goals? All of these tie back to asset allocation. So this is going to be a great conversation. think for anyone who’s starting to think about or is investing.
maybe is approaching retirement. One of the big questions we get is should I be adjusting my asset allocation? When should I do that? How much should I do that? So we’re gonna talk a lot about those types of conversations, those questions, because they’re, like I said, maybe the most important decisions that you make as an investor.
Yeah, and I think this is probably going to be the start of a little series and we’ll talk. This is really a stock bond mix. We’ll probably come back next episode, talk about how to decide the appropriate amount of international diversification and then how to think about the art and science of rebalancing. So obviously if you want to stay tuned for those, figure out a way to stay in touch with us. All right. So Pat, this topic of
The 3 Major Inputs of Asset Allocation (3,4)– risk tolerance, risk capacity, and risk need
Marcus Schafer (01:53.848)
picking the right asset allocation. Obviously it’s an important topic and as such, there’s a lot of different frameworks that have been established. think there’s probably three major considerations that most everybody should be thinking about. And those three are your risk capacity, your risk tolerance, and your need of risk. So,
risk capacity is really the ability. It’s kind of like a cashflow based. Hey, if you’re going to buy a house in a year.
Can you invest that in all stocks? Probably not. Risk tolerance is more the behavioral, right? The most important thing is you could stick with it. So if you take more risk than you can withstand and you get out, that is probably the most destructive decision you can make. And then your risk need is what required rate of return do you need to live the lifestyle you want to once you start drawing down your funds? So let’s maybe just start with.
Risk capacity, riskability.
Before we get into that, the couple of things I would just mention there too is, this is kind of, I’ve always found this as a blending of art and science as part of our role as advisors, or even if you’re doing this on your own, because when you think about some of these risk and return kind of metrics that you’re thinking about, on the risk or on the return requirement, how much do I need to earn to be able to achieve my goals?
Pat Collins (03:22.156)
That’s kind of more of a science question of I can take a spreadsheet and figure out, if I earn a 5 % return, I’m going to be able to achieve all of these goals that I’ve set forth because I know how much it’s going to cost and I can just project that out. Risk tolerance, how much risk am I willing to take? That is definitely, I’ve found more of an art than a science. I don’t know if any of us can really tell you with any degree of certainty how much risk that we can take ahead of time.
A lot of times we have to be in that situation and know how we’re going to react. So while we can ask questions and we can try to use past experience as some guide, there’s definitely an art kind of to that. And it’s sometimes difficult, but you know, if we kind of look at those three, obviously risk capacity, like you said, I look at that as heavily based on time horizon. So longer I have the more risk I can take because I can weather the ups and downs. Obviously the shorter I have.
We talked about this when we talked about the investing and gambling in a prior episode, just probabilities. So probability of loss goes up. If I have a very short time horizon with risky investments, it goes down a bit as my time horizon expands. So I think that’s an important thing to note. And that also means when you’re thinking about these questions of asset allocation.
you could have different asset allocations for different goals that you have in your life because they’re all going to have different risk capacities. If I’m buying a house to your example in a year, I’m going to have a totally different asset allocation for that pot of money I’m saving versus my retirement that’s 30 years from now. So I think thinking about that, that there could be different kind of buckets of money and different asset allocations per bucket. And then as you move on to risk tolerance, that one,
again, think blends with risk capacity. How much risk am I really willing to tolerate variability in returns if I need this money in a year versus can I tolerate some more variability if I don’t need this money for 30 years, if I think that accepting that variability is going to lead to higher returns. So I think that’s a component. How you figure that out, we were talking about this a little bit earlier.
Pat Collins (05:38.06)
I don’t know, know, the traditional method has been kind of questionnaires. How would you react if this happened? What is your feeling about this? If the market were to drop 15%, what would you do? Those can be somewhat helpful. What I’ve found is kind of, it’s that old quote from Mike Tyson that everybody has a plan until they get punched in the mouth. It is very similar with investing. If you’re in the midst of a bull market and you give somebody one of those questionnaires,
A lot of times the risk tolerance is yes, of course I can take risk. I want these high returns. I’m more than willing to accept the volatility. As soon as you get into this kind of the actual, we are in a downturn. There is scary news coming out every single day in the media. I don’t think I can take this anymore. All of a sudden your risk tolerance may shift a little bit. So there’s been research on this. Some people think it doesn’t really change. Other people do. So
I think that’s just an important consideration is how you, how you kind of determine that. And then the final is, my opinion, the easiest one, which is your requirement for return. That’s just kind of a spreadsheet math. You can do some of, know, there’s lots of tools you can create, you know, use to create, to figure out what kind of return do I need to earn all my money?
Yeah, the first two, can control, right? You can say, hey, here I know this with more certainty around my expected cash flows for the next five years and my time horizon. And the risk tolerance is you learn from experience and what changes over time too is maybe not a…
I think people’s risk tolerance is probably pretty steady. What changes is how much money you have at stake. And when I lost money in COVID, because everybody, the markets went down, it was less painful because I had paychecks coming in. And as a younger investor, it just feels less painful. Whereas now, if I lost it and the markets went down the same amount, I think it would be less painful. So you kind of learn some of this stuff over time.
Marcus Schafer (07:48.204)
Now, what you can’t control is the market does not care about your feelings, about how much money you want to spend. So I do think that the risk requirement, it’s probably more like a check over whether or not your spending assumptions are doable because it’s not like in investing, you can really control that. There’s a ton of uncertainty around expected returns. So that’s where
I just think investors should be really, really cautious around, I’m going to take more risk because I want to live this lifestyle. Past 100 % equities, fully diversified, you can’t really go beyond that from all the evidence we’ve seen.
Yeah. And kind of going back to just, just, this is something that I found that can be somewhat helpful. And I think you could do this if you can be, you know, self-aware enough to try to think about what, what really am I willing to accept from a risk standpoint or the best things we’ve been through some tough periods. And if you’ve been an investor over the last, 20 years, in some respect, at least the starting point could be, did I be, what did I do?
during some of these past really challenging periods. So COVID is a good example. The best one obviously is the financial crisis in 2008. If you were investing during that stretch, what did you do? And if you said, you know, I did nothing, okay, that’s probably a good sign that you had a pretty reasonable asset allocation that you could live with. If you said, I…
I actually did make some tweaks to my portfolio. Go back and look what those tweaks were. If they were selling stocks and maybe waiting for things to kind of, you know, kind of get better before you got back in, more likely than not, you were taking more risks than you were comfortable with. And, you know, on, on the flip side, if you were kind of taking the approach of, no, actually I took every dollar that I had in cash when the market, you know, dropped 30 or 40 or 50 % and I reinvested it back into the market. Maybe you can.
Pat Collins (09:54.798)
afford some more risks. I would go back and look a little bit at least at past behavior and how you handled that. Now the thing that we’re, there’s a little bit challenging there is we’re now 17 years from the financial crisis. Your risk tolerance when you were 17 years ago could be different. If you were 40 during the financial crisis and you kind of said, I don’t have, Hey, I don’t have that much money I’ve invested so far. Cause I haven’t hit my peak earnings years yet.
And B, I never really looked at it because I was so much stuff going on at that point versus now you’re approaching 60. Your risk tolerance may have changed a bit. So I don’t want, don’t use that as a complete end all be all of here’s what my risk tolerance is based on what I did 17 years ago, but at least it gives you an idea of how did I behave.
Yeah. And one area I found eye-overlooked and I think investors overlooked too is it’s kind of easy to say, I didn’t sell out, but did you change how you were allocating your contributions? Did you pick a different target day fund for some of your cash contributions? That behavior, those actions are also insightful around, were you maybe a little too risky or not risky enough? And you and I talked about, have a…
Belief is informed by the paper money doctors, but advisors should help you take more risk than you’re comfortable taking on your own in terms of suck. I think that’s a big value add from us is helping you take a little bit more risk, but still having the same level of comfortability. So also, you know, think about, Hey, what’s me on my own verse was the advisor helpful? And by the way, if we weren’t being helpful, that’s an issue. got to…
Deciding on the Right Mix: Stocks vs. Bonds (5) – use a financial plan to define your goals and then work backwards to build a glide path
get better and that’s something that you learn over time. Okay. So Pat, it’s kind of like an art, it’s kind of a science at the end of the day, you still got to select, Hey, how much stocks? I think asset allocation, way we’re describing it for this is really just that stock first bond mix to try to get less variables in the picture. Portfolios are going to be much more diverse than that, but how does somebody take those three things and then say, well, I’m going to decide how much
Marcus Schafer (12:10.614)
equities versus bonds or cash to invest in.
As you can imagine, this is a question that probably has been really interesting to finance people in our industry where pensions have really started to subside over the last several decades. Obviously, this idea of asset allocation, figuring out how you can achieve your goals with a pot of money versus somebody just giving you income is really important. So, there’s all sorts of different methods of doing it. Maybe we could…
touch on a few at a high level though. do want to touch, touch on the, the trade-offs that you are thinking about typically through this process of selecting your asset allocation. In many cases, as we go through this with our clients, we find that they are in a position where they’re going to have enough. And so they have to think about, you know, that’s, that’s one decision point is what if I have enough to meet all my goals? How do I, you know, how do I think about asset allocation? The other side of it is.
What if on the other side of I don’t have enough, what I’m doing is not going to help me achieve my goals. Or when I do that math of trying to think about the three levels of risk and I get a return requirement, I recognize I’m going to need to earn a 15 % return to achieve my goals. And I have a fairly moderate risk tolerance. What do you do in those scenarios? So these are all kind of the decisions that go into the asset allocation decision. Let me just first start on something that maybe even pre-
proceeds the asset allocation. If you’re in that camp where you go through this exercise and you realize I am not saving enough to get to the goals that I want to get to without taking massive amounts of risk or that I’m comfortable with, I think at that point, it becomes less of an asset allocation decision and it becomes more of a behavioral decision of how do I actually change my goals in the future? So that means that
Pat Collins (14:07.118)
you know, if this used retirement, for example, I might have to push my retirement out several years. I might have to save more, which means less consumption for me today. I might have to spend less in retirement. There’s lots of different levers you can pull, but figuring out the right asset allocation is never going to save you from a bad plan, basically. So first things first is make sure it’s reasonable. And if you need a return more than 8%, let’s say,
I would say to achieve your goals, if that’s your return requirement, I would say be very careful and I would be revisiting my goals versus trying to come up with an asset allocation plan that can meet that. you know, when you get into kind of, let’s go kind of to the second scenario, which most of our clients are in when they come to find us or kind of great to this point is, okay, I’ve done my work.
the savings I’ve put in the savings, the portfolio is grown, what’s the correct asset allocation for me to select? So I think one of the ways you can kind of think about this is, you know, there’s very basic rules of thumb that we just don’t really adhere to. That’s like the hundred minus your age, just pick that as your asset allocation. But it’s more what that does, it creates kind of an equity glide path. So meaning, well,
at what age, you know, typically younger years, you have a long time period, you’re going to take more risk, you’re to have higher equity allocations and it’s going to, you know, that, that equity glide path is going to go down. You’re going to have less inequities as you get older because your time horizon shrinks. You don’t have as much time to make up for things. That’s typically, we’re going to talk about these. That’s like target date funds are very popular. I think I’ve read something like
over 75 % of all new contributions in 401k plans are going into these target date funds. it’s very, people are probably very familiar with those, but that is kind of a out of the box. build you this asset allocation. So that’s certainly one way is you can just look at a target date fund and kind of emulate that to a degree. We like to actually create financial plans for clients and factor in all of the considerations. So for example, if someone’s going to have, we have a lot of clients that might have lots of income in retirement.
Pat Collins (16:24.61)
they’re not going to have much of a need to pull from their portfolio because they have, you know, a deferred comp and a pension and other types of income that are coming from social security. And so when we do the math, we say, wow, you really aren’t going to need to pull much from your portfolio. They’re probably not going to be a traditional target date, fun glide path type of client because why invest in
go lower and lower risk when your time horizon is almost infinite at that point, because you don’t really need to pull money from your portfolio. So I would encourage everybody to think about more customization when they’re coming up with this, create a financial plan, look at the needs that you’re going to have in retirement for pulling from the portfolio and then design a portfolio and an asset allocation around that. The last thing I’ll just mention on that same front that I think can be valuable.
is this idea of asset liability matching when you’re thinking about your asset allocation. So what does that mean? Well, liabilities are just expenses you’re going to have in the future. So again, if I use a retirement example, my first year of retirement, maybe I’m going to need $100,000. That’s a liability I have in the future. The next year, maybe I start taking social security. So really all I need to pull is 50,000 from the portfolio because the social security is going to… So you can see how that’s going to build over time.
A lot of times what we’ll look at is let’s take a look at say the first 10 or 15 or so years of money that you have to pull from your portfolio, the liability and match it up with an asset. That match up should be something pretty stable because we don’t want an asset that’s really volatile to fund a liability that’s very short-term in nature. So that could be one way of looking or checking to see
do I have the right mix of stocks and bonds? I wanna have the expenses I’m gonna have coming out of the portfolio over say the next 10 years. Perhaps I wanna look, make sure I have at least that amount in bonds. And then the remainder amount I could have in more growth assets, but that could be a place to start. But again, if you use a rule of thumb, the problem is there’s all sorts of problems with that. It’s not custom to you. So.
Pat Collins (18:35.03)
going through a financial planning process. We talked about this in some of the early episodes of how we do this and how you could do this even on your own. Go through that planning process, figure out your needs, then develop the asset allocation to meet that.
Personalization of the Asset Allocation – although research suggests equity heavy allocations are optimal, individuals enter retirement at vastly different asset allocations due to risk tolerance and risk capacity
Yeah. And what’s super interesting is we have clients coming into retirement that end up at so vastly different asset allocations, depending on their risk ability, meaning what you were talking about. Hey, if you have a pension that’s funding a lot of your needs, you can take more risk and then also risk tolerance. Like some people are just not quite as comfortable. So we might see somebody entering retirement.
85 % stocks and another person entering retirement at 50 % stocks. And that’s the challenge of blending the art in the science. If I take a step back and think, well, how do you get too much? Simple thing. The research is pretty clear. Stocks have a higher return than bonds. If you’re super broadly diversified, that narrows your range of outcomes with stocks as well.
Not just US, but global, not just large caps in US, small. So if you own kind of the market of stocks, that’s going to have a higher expect return. So statistically speaking, that’s going to help you get into a position where you have more flexibility to then as you narrow in on retirement, make some of these trade-offs around how much do you want to…
Do that asset liability matching for your future cash flows? How much do you want to think about the other things you could do with your money? That’s a very unfulfilling answer to tell somebody as much stocks as you could possibly bear, but that’s kind of the truth. And then what you and I talk a lot about is maybe it’s less than about, hey, let’s fine tune that stock allocation and more about liquidity planning. Like let’s focus on that shorter end and making sure that you have enough
Marcus Schafer (20:41.864)
especially for business owners to think about to managing lifestyles. So maybe just talk a little bit if instead of focusing on the stocks, you kind of focus on liquidity, how does that change the equation?
What to do if You Have More Than ‘Enough’ – can either increase risk for legacy or decrease for comfortability
Yeah. And just one last point before we get into the liquidity that I think is important. We seem, we seem to have this conversation a lot with clients is kind of what you were talking about there. We haven’t like we’ve determined we have enough and you’re right. We have clients when they have enough and we’ve determined that they have enough. Then they have another decision to make, is kind of an interesting one is what do I do now? So I have, I have enough.
One way you could can, yeah, and there’s not a right or wrong way to do this. So this is definitely more of a preference, I guess. And you have to understand the trade-offs. But if I’m a, I’m an investor and I saved enough and I have more than I need for myself, how do I handle that? So number one, the first way you can do it is you can look at it as I have more than enough than I need. I can afford to take risk. I can take a higher allocation in stocks, maybe throughout my retirement.
Great. I, and, what’s the benefit there? Well, the benefit is that I’m going to leave a legacy for whoever I care about or organizations I care about. can, I’ll have more potential flexibility down the road because I’ll have more assets that I could give away or I can use for myself. So that’s one way to look at it. And that’s fine. That’s it’s because people that have gone through that exercise where we show them even in bad times, which is what you have to expect with that. You can have some really bad periods.
really underperforming periods, you’re still gonna be okay. Yes, you might not have as much wealth, but if we go through an extended period of a downturn, which is possible when you invest in volatile assets, you’re still gonna be okay. So that’s one option. The other option is you could say, I have more than enough. I don’t have to take risk. I can basically take risk off the table. I can earn a lower return.
Pat Collins (22:44.322)
The benefit for that is I can sleep at night. I don’t have to worry about variability and returns. I don’t have to see it go up and down a lot. And yes, I will have less money to pass on to my, to the next generation. That’s a good trade off for me is the sleep at night factor. So just thinking about that as a client or as an investor, that’s something for you to think about is what’s that trade off. Most of our clients are somewhere in the middle. would say nobody, I rarely see people that take the ultimate extreme of
Oh my gosh, I have more than I need. I’m putting all my money in cash because I don’t even need to earn a return or I can only, I can earn one or 2 % and be fine. The other side of it is most of our clients, I would say, don’t take the approach of, have enough. Let’s just try to make as much money as we can. And yeah, if I lose 50 % cause the market goes down, I’m fine with that. Most people don’t want to deal with that in retirement. So just something to think about, but getting to your point of liquidity, this is definitely something.
Cash Liquidity – creates peace of mind, especially with volatile income often present in business owners
you know, no matter what decision you make there on stock versus bond, there’s kind of like another decision we find, is how much liquidity should you hold in your portfolio? And that’s going to be very dependent on your circumstances. And I think there’s also a little bit of art to this as well. I can’t put my finger on it. I found that it’s probably goes very deep into people’s upbringings of what their comfortability is with risk and cash and whatnot. Some people
We found that you talk to them and if they don’t have a half a million dollars of cash in the bank, they are having a hard time sleeping at night. They are worried. And usually maybe they had a really bad experience with stocks and the idea that all their money is very volatile, gets them very scared. We have other clients that almost led paycheck to paycheck. It feels like every dollar that comes in is either being saved or being spent and they keep very little in cash. So what’s the right decision? It really depends on you. I’d say a starting point.
is somewhere of three to six months of expenses and cash. That’s kind of a starting point. And then I would gross it up or down based on your personal circumstances. So if I am in a situation where I have a lot of variability in my income, I have the potential that I’m going to have big expenses. So that could be like a business owner that might have to put money back into their business from time to time. I would say there you could have massively higher amounts of cash that you might want to hold.
Pat Collins (25:08.3)
just to counteract this tremendous amount of risk associated with the volatility of your income. And then the flip side is, is if you’re in a job that is completely steady, you feel very low risk of any variability of that income or losing that job, you could probably be on the lower end of that cash liquidity. So again, the art is how comfortable I am with amounts of cash. The science is really starting to think about…
Okay, my personal situation, what are the likely risks that could cause like massive amounts of cash that I might need to pull out of or the fact that no, there’s very low risk that I would ever need to tap into any cash because I can pay all my bills from my paycheck. So those are some of the considerations to think about with liquidity.
Yeah, I think that’s super interesting. I’m almost thinking we have to do a whole episode on cash and liquidity because as long as you have a big enough taxable investment account, there’s ways to get liquidity out of that using some new lending products that might mean you have to hold less cash because you can tap that without any adverse consequences. Now we’re talking about appropriate amounts of leverage and how do you think about yourself as if you were
or at business to make sure you don’t put yourself over the edge, which is one of the dangers with some of these newer tactics.
The main thing I think when you’re thinking about cash and liquidity is you just never want to be put in a position where you’re forced to liquidate investments at an inopportune time. That’s kind of the way I think about it. So if I have very low amounts of cash and, but I, at the same time, I am coupled with lots of variability in my income. And at some point I need to tap into my cash and I blow through the cash cause I don’t have that much of it. And now I have to start selling investments.
Pat Collins (27:02.414)
That’s not a great spot to be in. It might be okay. Maybe the market’s high. Maybe it’s a period like right now and it’s great, but maybe it’s that March of COVID where all of a sudden it’s like, gosh, the market just dropped 35%. I lost my job. I don’t have any cash sitting around. I need to sell $50,000 worth of investments. And I just really, really did it at a terrible time. That’s an extreme example because it literally dropped and then popped back up. But
That’s what we want to avoid. So if you think that there’s a situation where you may have to sell your investments, that’s where you probably are like, I don’t have enough cash basically.
Yeah. And one of the big things that investors come to us for and advice and what they’re pursuing and one of our mutual arrangements is a lot of times like, hey, I never want to get into a situation like that because that’s the worst case running out of money too early in retirement. That’s a big concern. And this is kind of where it gets to one of the challenges of
Asset Allocation Over Time – revisiting asset allocation 5-10 years before retirement, at retirement, and after social security kicks in
Why we still, I think, see a lot of clients having a little bit more equity type exposure is to hedge against some of these long-term risks. And by the way, it is super, super challenging when you look at historical data to have too much confidence going 30 years in the future about expected returns. mean, look at Japan, right? 30 years of kind of no returns in the headline benchmark. You just really have to be thinking about
balancing all these different trade-offs. One question we often get, Pat, is when do I make adjustments to that stock bond mix? And it’s typically somebody’s coming into retirement, they’re thinking, hey, when do I make this adjustment? Once they get in it, hey, at what point would we make this change?
Marcus Schafer (29:01.922)
So how are we helping people think about this is in the industry, this is called the glide path. lot of target day funds have glide paths. How are we thinking about that glide path and just communicating that so people know, Hey, when you make a change, this is why you’re, why you’re doing it.
Again, little bit of art and science to this. Let’s go to the art part. That’s just going to be tolerance for risk of how much volatility they’re seeing in their portfolio, especially leading into retirement. that’s it. It’s obviously, yeah, I think most people, when you’d explain it, there’s definitely a little bit lower appetite for risk when we say, Hey, you could stay in this 80 20 portfolio, 80 stock, 20 bonds, you know, into retirement. But the risk is, is that we have a big drop.
that 20 % in bonds, you know, may not be enough to cover the expenses that we have coming. So I would say typically it’s around five to 10 years before you start pulling money out of your portfolio. The science part would be, yes, you could retire next year. But again, going back to, if you have all sorts of income coming in and retirement, maybe you’re working part-time, maybe you’ve got social security, maybe you have some other like deferred comp payout from your business or from your company.
But when you do the magic, like, actually, we’re not gonna have to touch our portfolio for five or six years into retirement. Then, you then you might take a different approach and say, okay, well, that’s our, even though I’m retiring, my time horizon is still pretty long before I actually need to pull money out of the portfolio. So I think that’s important to kind of think through that. But the one, there’s been research out on this and I actually think it’s really fascinating research because the traditional target date fund.
is lowering the equity allocation into retirement and then in a lot of cases through retirement. So it may take it down to some level, you know, maybe it’s 30 % stocks or 40 % stocks or something like that, but it, keeps on lowering it till you get to a certain age and then it kind of flattens out. There’s been some research recently that shows that may, that may not be as optimal as what else you could do. And
Pat Collins (31:02.222)
This is kind of foreign to a lot of people, but when you think about your retirement using this idea of like, when do I make a change to my asset allocation? What this research comes out and says is that actually the point at which you are the safest, meaning you have the most exposure to bonds should be on the date of your retirement. And we’ve talked about this a little bit in the past. That’s kind of the riskiest day of your financial life because when you think about it, you have, at that point in your life, you have the longest time horizon where you will have no income coming in.
and that you have to fund all of that retirement. So let’s say that’s 65 for somebody. Let’s say they have a joint life expectancy of 30 years. Let’s just kind of round number it. So I have to fund 30 years of expenses at that point. So I am very dependent on markets. I’m very dependent on kind of what happens in the stock and buy market over that time period. I’m dependent on inflation. I don’t know what that’s gonna look like, tax rates, so many variables that they’re unsure. So with that,
I am in a high risk situation basically. have a lot of volatile, a of things that are at my control. If you fast forward and that couple is 85 years old, so they have 10 years left. Now, do they have as much risk associated with it? They only have 10 years to fund. So a big drop in the market later on in life is not as impactful as it is in the beginning of retirement because I have this risk that some people call sequence of return risk, which is
If I have a long stretch right in the beginning of my retirement of bad markets, that can derail my whole retirement. If I have a bad market at 92 years old, it doesn’t really matter that much. I don’t want to sound morbid, but my life expectancy just isn’t that long. So I can weather that a little bit more than having to spend 25 more years. need this portfolio to last. So what does that translate to into an asset allocation? Well, at least some of this research has said, actually, once you hit retirement, there’s evidence that
a rising equity glide path could be appropriate and more optimal for ending wealth than more of a flat glide path. So what does that look like? Well, in practicality, what that could mean is if I’m 50-50, let’s say, stock bonds at the date of my retirement, maybe I just spend out of my bond bucket and that will automatically kind of shift my asset allocation to be a little bit more stocks over time. So that’s one way to certainly think about it. Some clients don’t like the idea of
Pat Collins (33:28.59)
rising risk as they get older. So in that case then, what we found is usually you want to pick kind of more of an asset allocation that they’re comfortable with and keep rebalancing back to it using the distributions to rebalance. So if I pick a 60-40 portfolio in retirement and the stock market goes up that first year, I’m probably not selling any of my bonds. I’m selling stocks to get us back to 60-40 to kind of, you know, so, and then
flip side, if the market drops a lot in my first year of retirement, the nice thing about that strategy is I’m not selling stocks in that example. I’m selling bonds because the bonds are overweight compared to stocks. these are all kind of the, we’ll probably talk about that in a future episode, but thinking about your asset allocation, when to change it, I would say five to 10 years before you retire, start looking at it. What’s my cashflow going to look like this for a few years of retirement? And then start to decide
Am I gonna have a little bit more of a dynamic glide path where I might be okay raising the equity glide path or do I wanna keep it more stagnant through retirement?
It’s super interesting just to think about the stages of life and how your goals kind of change and your portfolio allocation probably changing as it’s tailored to meet certain goals. So, hey, you want to buy a house or hey, you want to upgrade your house. That’s a slightly different goal while you’re also remembering retirement. And then retirement’s a year point. Which wall rates don’t stay constant over time as well. A lot of clients.
On the day you retire, which tends to be kind of around 65, it’s peak earning year. So you come from a really high tax bracket to a low tax bracket. So we tend to fund out of investment accounts. So it naturally can lend to the increasing applied path as well. But there’s just so many different factors. kind of incorporating all of these, I think it’s super, super impactful. And then just deciding what like
Pros and Cons of Target Date Funds – outsourcing portfolio construction is cheap and easy, but losing control has limitations too
Marcus Schafer (35:30.358)
What vehicle do you want to implement this portfolio? how should you try to build the pieces yourself? Should you go into a target date fund structure? I do think target date funds, by the way, like just like indexing, amazing innovation for the vast majority. And when I say vast majority, probably 90 % plus of Americans, and they’re super helpful for us just to think about, Hey, here’s where experts are kind of deciding.
a decent stock bond mix relative to ages. And that kind of can give you a baseline to think, hey, can I take a little more risk than that? Or should I, am I a little more conservative than the average American? like, if you’re listening to this and you’re kind of thinking, hey, I’m not quite ready for an advisor, that might be a decent place to start is looking at the glide path of something like a Vanguard index target date fund.
I agree with you. It’s interesting. most people, because like I mentioned, the majority of flows in retirement plans, new money is going into these target date funds. I think they’re heavily used in the accumulation phase of people’s lives. So they’re saving all throughout their working years. I agree with you that I think that target date fund is a great innovation, maybe less about the glide path.
quite honestly, and more about the simplicity of how to invest. And it gets people not thinking about, my gosh, this, my international funds down, so I’m gonna trim this experience, I’m gonna do this. It’s all packaged in one. There’s some benefit to that where it just gets you not thinking about trying to tinker with the portfolio that much. It’s gonna kind of blend a bunch of different asset classes together, keep you diversified. It’s really important. There are some.
some cons to a target date fund. When you get to the point when you’re trying to really tinker with your asset allocation, tinker is probably a word, but with your asset allocation, really make an appropriate decision around how you should allocate. The problem with target dates, obviously, is it’s a one size fits all. Everybody’s a little bit different. So as I mentioned, a lot of your asset allocation is going to be determined by
Pat Collins (37:41.432)
your outflows, your cashflow in retirement. do I need to pull? Maybe what I don’t need to pull anything, because I have other income sources. So it may either make you more aggressive or more conservative than you should be, and you don’t really have any control over it, because it’s all gonna be done inside of this fund. So, I good examples of that would be, I’ve already mentioned some of this. It could be that someone,
could be in a situation where the first five years or 10 years of retirement, they have no real needs to pull from the portfolio. Their target date fund has made them extremely conservative and that’s not the right asset allocation for them. They don’t really have a control over that. You can go to the flip side. We see this sometimes too, where somebody retires and the first five years of retirement, they actually are gonna have been a very high withdrawal scenario because them and their spouse have not started collecting social security yet.
could account for $100,000 of income. They’re not gonna tap into their retirement accounts. So we just have like one account that we need to pull from. We might wanna be really conservative with that account at that point, because we’re gonna be pulling, making a high withdrawal amount out of that account. We don’t have a lot of time to make up for losses. So that would be another one where I’d say target date funds may not be appropriate. And then the other part, I guess I would say is the tax piece. This is more getting into the nuance. you make…
make changes at the margin to really benefit you. But an asset allocation fund obviously is going to own stocks, bonds, everything into one wrapper. And oftentimes there’s some benefits of locating assets in different accounts. I might want to own my bonds in certain accounts. I might want to own my stocks in other accounts for tax reasons. Target date funds aren’t going to allow me to break it up and do it that way. So I would agree with you that target date funds are very great innovation. They simplify things for people. I think I also agree that
great starting point if you want to kind of get a sense of what basically should be my asset allocation at any given point in my life. I can go look up Vanguard’s glide paths, look at my age, and it’ll tell me this is kind of what the target date fund is. The alternative is either doing it yourself or hiring an advisor to customize it for you. And all the cons that I mentioned of not factoring in cash flows, not factoring in taxes, not factoring in your personal circumstances,
Pat Collins (40:04.108)
that can all be solved if you kind of deconstruct the target date fund and build it on your own for your own personal needs, which is kind of what we do for clients is thinking through that decision and taking the pieces and customizing it.
Yeah. Anytime you kind of outsource more portfolio management decisions, you’re outsourcing control and you’re reducing flexibility and target aid funds. For the most part, they’re client baths. You can look at the general trend, but then when you switch by provider, you see differences. When you go over time, some of these are actively managed. So they’re saying, hey, we actually want to increase equity exposure.
And this is just generally when you outsource to more of an active approach. And sometimes the, blame between active and passive is kind of misleading. Hey, it’s an index, but there’s some flexibility to increase this part of the allocation for this. Optionality has value. And when you outsource that optionality, you kind of lose some, control in the accumulation phase. You might have bonds when you don’t really want them in your taxable account because you got incoming.
cash flows, right? It might be 90, 95 % stocks, 5 % bonds. That’s still some amount of expected return at the earliest point you’re investing that really has implications. That being said, if you’re going to go in there and I’ll use the word you mentioned, but if you’re going to go in there and tinker at any point, then you probably want to default to a target date fund. you know, one of the other challenges of kind of like a build it yourself approach is
Are you using tools that enable you to do it? And what I mean by if you say, Hey, I want to go use index funds to build my equity allocation. Fine. No problem. You know why? Cause those should have a hundred percent exposure to the piece you want. Sometimes somebody will use an active fund and fill that bucket. Okay. So you don’t have quite the diversification. Those active funds might have a huge amount.
Marcus Schafer (42:11.852)
of things that are not what you intended and you just outsource control. One time I was looking at a, there was a big international fund. had 30 % cash and gold bullion. That’s not really what you wanted that, that position to play in your portfolio. If you want to allocate the cash, you want to do that on your own. You don’t want to pay somebody expensive funds to do that. If you want to allocate the bullion on your own, you don’t need to pay the fees that you were paying to.
to get that done, I just think optionality has value.
Common Mistakes in Asset Allocation – lack of diversification, exposure to behavioral biases, erosion factor from costs, and a mismatch between goals and your portfolio
The point that you made there at the end, I thought it might be a good idea for us just take a few minutes and talk about some of the most common mistakes we see when building an asset allocation, and hopefully people can avoid this. You touched on one right there, which is, I would call that lack of diversification. I’m building this asset allocation, if I keep it high level, stocks and bonds. And then when I look at the stock exposure, it’s seven stocks. That is a major mistake. You are not gonna get the returns of the market necessarily.
Obviously it could work out your favor. Maybe you’re brilliant and you picked the best seven stocks. Hopefully if you’ve been listening to this podcast for a while, you know the probabilities are against you if you’re doing that. just making bad decisions around portfolio construction is a decision point that we see get some mistakes made there. Some of the other ones that we’ve talked about in prior episodes is what we would call cognitive biases or cognitive kind of problems, behavioral issues.
meaning I have this asset allocation, I’ve decided on it, but I haven’t thought through my own behavioral problems with like, okay, I’m not going to be able to handle a drop in the market. So I ended up selling at a bad time. get overconfident in something. So yes, I have 80 % of stocks, but to my point, it kind of goes hand in hand with diversification. I’m overweighting, you know, technology stocks because they’ve had a great run. So just making sure that you check yourself and you don’t have
Pat Collins (44:12.94)
these kinds of biases in your decision-making that could hamper returns in the future. And then what I would say, the last one is more at the margins, but it’s kind of the erosion factor, I call it, of these little things that you can do that will, yes, you might get the asset allocation right, but remember we’re shooting for an expected return here.
And everything that’s eroding that return is almost forcing me to go up in asset allocation, meaning I got to take more risk because I got to make up for all these costs. So the costs come down to taxes. not being tax efficient. I’m not asset locating my assets and their assets in the right location. I have investments that are creating too much tax or the other side of his fees. am trading a lot. I’m buying active funds. I’m increasing the fees more than is necessary. So
Anyways, long story short, these are probably some big things to think about when you’re, know, mistakes you could make, lack of diversification, behavioral biases that are kind of, you just need to check, and then erosion. Those three things kind of can factor into some mistakes that you might make with these things.
I don’t think this qualifies as a mistake, but I do think just having a good certainty of what your goals are and making sure that that is factored into your portfolio. And one of the things I see, especially for younger people is you might not have that much in a taxable brokerage account. You might be doing a great job funding your retirement in 30 years and we’ll run the projections and hey, everything looks great, but
Maybe you’re missing an opportunity to have some flexibility. And then when you get to retirement, that taxable brokerage account actually can be a really, really useful tool to be able to leverage, to be able in some cases to access 0 % capital gains. And so just having the big picture in mind and making sure each goal is kind of, you’re solving it good enough and you’re kind of getting back to the big picture.
No Perfect Portfolio in Isolation – can you stick with it?
Pat Collins (46:22.786)
great. So, you know, just kind of wrapping up some of the stuff that we’ve been talking about, I guess the main takeaway for me in thinking through this and interestingly enough, I’m sure we’ll cite some of this. We kind of read through probably about a dozen different research papers on this. And obviously we’ve had lots of experience or careers on this as well. One of things that was striking to me is that there’s definitely not a perfect asset allocation portfolio.
that there’s conflicting research even on this of how much stock should you have in retirement? How much bond should you have in retirement? Should you take a asset liability approach? Should you take more of a fixed kind of asset allocation? There’s all sorts of different strategies. In my mind, the most important decision is that you pick something that you can stick with through time because the most detrimental thing you can do
is to change things in the most of the time when you’re going to change things will be when there’s upheaval, when there’s bad things happening, that tends to be when prices have fallen. When I make changes, that’s kind of just automatically destroying wealth for myself and hopefully, and maybe even my future generations. So, you know, pick something that you know that you can live with through the ups and downs. It doesn’t have to be perfect when there is no perfect. We don’t know what we would only know perfect after the fact. So
Pick a strategy that seems reasonable that you think you can live with and then just try to stick with it as long as possible.
Yeah, I think that’s a great summary. mean, it’s picking the right asset allocation. You have those three things we talked about, your risk capacity, your risk tolerance, and your need of risk. So kind of walking through those to try to understand what you could do. I thought your conversation on bonds, how to think about five to 10 years out from retirement, really dialing that in, sometimes maybe a little bit sooner just to get some volatility down.
Marcus Schafer (48:19.438)
And then again, we’re going to come back, I think next time talking about international diversification. So this was really about that stock bond mix and next, what is the benefit of international diversification? Is there a benefit of international diversification? And then if you do choose, so that’ll be the next episode and follow on after that. If you do choose to kind of build it your own, how do you really think about rebalancing? Cause one of the great things about these commingled solutions, the Target A fund or an asset allocation fund, you don’t have to think about that at all.
We’ll probably go into details people don’t care that much about, which will be fun for us.
Well, I’m looking forward to it. I think we have a good series up ahead.
Alright, thanks, Pat.
Sources:
1 Brinson, G. P., Hood, L. R., & Beebower, G. L. (1986). Determinants of Portfolio Performance. Financial Analysts Journal, 42(4), 39–44. https://doi.org/10.2469/faj.v42.n4.39
2 Ibbotson, Roger G. and Kaplan, Paul D., Does Asset Allocation Policy Explain 40, 90, 100 Percent Of Performance?. Available at SSRN: https://ssrn.com/abstract=279096
3 Investing or Gambling? Where Do You Draw the Line? | Greenstream #17. https://youtu.be/CFbvuB4o1bk?si=HjtiukEtteLJuNAQ
4 Gennaioli, Nicola and Shleifer, Andrei and Vishny, Robert W., Money Doctors (June 11, 2012). Chicago Booth Research Paper No. 12-39, Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2133429 or http://dx.doi.org/10.2139/ssrn.2133429
5 What is a Financial Plan? | Greenstream #3. https://youtu.be/y_PX-HyRW-Q?si=ISVpYmGFudUcYr9O
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