Part III: The Stock/Bond Allocation Split and Rebalancing

Since 2008, a retired friend has put 100% of his money in cash. He recently asked if it’s time to get back into the stock market. You already recognize our friend’s major mistake–100% into anything is not diversification. Still, we can tell a lot about our friend’s investing strategy by his question, so let’s examine this in detail. Getting out of the market in 2008 seemed like a good idea for many people for obvious reasons. His first mistake before the 2008 crash was not having a plan. A plan, illustrated by this 4-part series, would have prevented him from making mistake number two, panicking and moving 100% in cash.

In the meantime, seven years flew by and the stock market has returned to glory by hitting all-time record highs. Now he considers going back into the market! Still without a plan, getting back into the market would be mistake number three. What is going to stop him from repeating the same buying when stock prices are high and bailing out when stock prices are low? The “buy high and sell low” strategy is universally agreed to be a killer of portfolios.

Investors of all ages cannot afford a reckless and unplanned strategy. Of course, our friend is not intentionally reckless. He is a smart man, but his question speaks volumes about reckless intentions. He needs a plan! We are not alone in preaching this. Vanguard wrote: Without a plan, investors can be tempted to build a portfolio based on transitory factors such as fund ratings—something that can amount to a “buy high, sell low” strategy (Click here for article). The point of this entire series is to provide a solid plan that will take us through the ups and downs of the stock and bond markets with a successful long-term strategy.

Part 3 may be the most important part of this four-part series. If our friend was diversified in all of the six asset classes, it still might have not been enough to protect him from a 20-50% loss in his portfolio. However, if he were diversified in 100% in stocks (no bonds) and stayed put he would have recovered his losses. But that creates too much market volatility and fear for most of us to endure. Dan and I experienced the volatility in 2000-2002 and we do not wish that experience on anybody.

Stock diversification itself was in question after the 2008 disaster (Click here for more information). That massive loss was catastrophic for many investors who thought their portfolio was safe because they were diversified with the 100% in equities (stock mutual funds). Diversification without a bond allocation is NOT diversification.

In Part II we discussed allocating your money into the six core asset classes, not five, or four or three, but six including a bond allocation. And we did not discuss how much to allocate in each asset class in proportion to your entire portfolio. Thus, in this part we discuss how to proportionalize your portfolio according to your age.  This is called the stock/bond split. This highly respected investment forum has a wiki that discusses this in detail: http://www.bogleheads.org/wiki/Asset_allocation. We also discuss how to keep your personal allocation in check between stocks and bonds by an annual maintenance chore called “rebalancing.”

Your Tolerance for Risk and Your Age

How comfortable would you be with a 5%, 10%, or more temporary loss in your portfolio? Without experiencing how you would react to a decline in your investments, it is difficult to exam your reaction ahead of time and it’s nearly impossible to know without an actual loss. Markets go down, some losses have been over 50%.

Fortunately, Vanguard founder and industry giant, John Bogle, has always suggested implementing his rule-of-thumb to manage this risk—and that is your age. Your tolerance for risk and your age are closely related when putting the final touches on your portfolio. As a general rule, as you get closer to retirement age or if you’re already retired, your tolerance for risk goes down. By definition, we retirees have fewer livable years for our portfolios to recover after a massive stock market sell off. Thus, in our 70s and 80s, we should restrict our stock allocation to 20-25%. The remainder (75%-80%) should be in bonds (or fixed accounts). The stock/bond allocation split is a crucial decision, often overlooked by many investors in 2008. Many elderly were exposed to 80%, 90% and sometimes 100% in stocks when the 2008 stock market crashed. This misfortune could have been prevented by simply including bonds approximately equal to one’s age.

Dan and I followed this rule of matching our fixed accounts with our age. We painfully learned the stock/bond split lesson (and diversification) as a result of the 2000-2002 technology bubble crash. At that time we had a foolish and a dangerously naivé 100% stock allocation, obviously stock exposure gone awry. Not surprisingly, we paid the price with a 70% decline in our portfolio.

Our Crucial Decision: An Appropriate Stock/Bond Split?

 

The Vanguard portfolio allocation models helped us decide on the 30%/70% stock/bond split. After looking at all of the choices from 100% bond allocation to 100% stock allocation, we were torn between two choices illustrated in Table 4. Our first choice was to select the bond allocation that matches our ages, which is a no-brainer. The 40% stock/60% bond split was the closest fit as both of us were in our 60s. However, we choose the slightly more conservative 30%/70% stock/bond split when we compared the risk and average return to the slightly more aggressive 40%/60% stock/bond split.

 

 

 

The “average annual return” for the slightly more aggressive allocation (40%/60%) was 7.9% over 89 years of stock market history. However, the (30%/70%) returned 7.3%. The additional risk for only a .6% higher return was not worth it. Thus, we opted for the lower stock and higher bond exposure for an average return of 7.3%. It’s a reasonable return on investment goals for retirees, which is to meet or beat the inflation rate.

Thus, we now hold to a 30% stock/70% bond split. The strategy worked to protect us from the 2008 crash — dubbed the year of the greatest stock market crash since the Great Depression. Our portfolio only decreased 11.8%. In our experience, the stock/bond split was the major strategy which protected our portfolio from another major loss. Yet, we are perplexed by some financial professionals who insist that the “bonds by age” rule is outdated and should be ignored. In our opinion, the professionals want to make this simple, yet powerful strategy, complicated so we investors have to depend on their “advice.” In our experience during the 2008, the bonds-by-age rule worked as planned to protect us from one of the biggest stock market crashes in history.

Exceptions to the Bonds-By-Age Rule

There are two exceptions:

1. Some people have special considerations such as leaving their investments to heirs or charity. Or the have a robust pension benefit and they collect social security. In these exceptional situations, investors can live comfortably from their pension and social security. So they are able to take more risk with their investments.
2. Investors in their early to mid 20s could have 100% in a diversified portfolio of both domestic and international stocks and no bonds. This group would rebalance among the stock asset classes. Having said this, all investors should have a small percent of cash handy for emergencies or planning for big ticket purchases. Young investors need to learn how bonds work and a small allocation would do the trick.

We Adhere to the Bonds-By-Age Rule for One Good Reason

We are retired and need distributions from our investments to fund our retirement. Dan has only social security and I have a modest teacher’s pension, a tiny social security payment and a small Veteran Administration compensation benefit for wounds suffered in Vietnam. Our portfolio supports our retirement lifestyle and beats inflation. Seniors generally cannot afford a major loss by having the stock/bond split that is more appropriate for a younger person or allocating 100% stocks. Thus, we follow the “bonds by age” rule.

Rebalancing

 

Rebalancing is easy to understand, but for many investors it’s sometimes difficult to employ. Vanguard has an extensive article on all aspects of this important action. From whatever action the investor takes, the primary goal of rebalancing is to get back to your original stock bond split. It’s not an exact science, of course. For example, after seven years of exploding stock market returns, our portfolio was recently out-of-balance with a 47% stock / 53% bond split. Our stock allocation grew and our bond allocation declined. To rebalance, we sold some of our equity holdings and purchase bonds to get closer to our original plan: 30% stock/ 70% bond allocation. With each of the following three actions, we increased our bond and reduced our stock holdings:

1. I sold my mother’s Minnesota Mining and Manufacturing stock that I had inherited.
2. We trimmed our Total Stock Market Index by 1/3.
3. I sold some real estate and invested this new money in bonds.

Consequently, we are back to about a 35% stock/65% bond allocation. As previously mentioned, it is not an exact science as we are looking into selling more equities and purchasing more bonds to move to our 30%/70% stock/bond split.

Target Date Funds

As previously mentioned rebalancing can be challenging. It requires advanced skill and knowledge as you are required to assess your portfolio at least once a year. You can either get help from a fee-only financial adviser, or you can invest in a fund that automatically rebalances your stock/bond split for you. A popular choice for working investors are Target-Date Funds (Click here for pros and cons of TDF). They manage the job of rebalancing for the investor. Just pick the target year closest to the name of the fund and you are all set. Most TDF are named in the year that the investor will retire, such as 2020, 2025, 2030…2050, etc. The good news is that most tax-deferred retirement plans have TDFs available.

Primary Goal of Rebalancing: Reduce Risk!

The primary reason why some investors have a difficult time rebalancing is the constant dilemma of selling the best part of their portfolio that is performing well. But that is exactly what investors need to do. Why? The answer is straightforward. The primary goal of rebalancing is to reduce risk, not to chase returns. To earn high returns one must increase the risk. It doesn’t work any other way. We must be careful of the balance between risk and return with a regular maintenance of the stock/bond split. In this high flying stock market, our portfolio performed well as it was drifting towards more risk by a gradual exposure to stocks and lesser exposure to bonds. We are bringing it back to our original stock/bond split by rebalancing.

In sum, the primary purpose of diversification, the stock/bond split and the maintenance of this allocation through rebalancing is to keep risk in check. This is not about eliminating risk; we need some risk to earn a return that meets or beats the inflation rate. And that is a big deal as so many investors fall below that threshold of earning average returns. (Click here for Dalbar’s historic and pathetic returns from investors who do not have a solid plan). It’s a mistake to think that this strategy alone will increase performance. If the stock and the bond market increase, our portfolio will follow suit (and visa versa). But not all asset classes grow and lose in perfect sync (click here for the famous Callan Table of asset class performance). Rebalancing reverses the knee-jerk reaction of buying high and selling low into your plan of selling high and buying low through rebalancing.