Asset Allocation in Retirement [Retiree Portfolios] July 10, 2000

Retiree Portfolio Asset Allocation in Retirement

Asset allocation assuredly plays a role in overall portfolio returns. How big of a role is a matter of dispute within the financial community. Nevertheless, asset allocation is a discipline worthy of practice by retirees. While the allocation each of us should use is an individual choice, its use will make the inevitable stock market decline less painful by ensuring any loss in portfolio values is kept to a minimum.

By David Braze (TMF Pixy)
July 10, 2000

A poster on our boards recently wrote, "Like a lot of other new retirees who have managed their own 401(k)s, IRAs, and other investments for years, I feel that I can pick appropriate funds and stocks to generate the needed return. My concern boils down to two words -- ASSET ALLOCATION! They say that your long-term returns are affected almost exclusively, at least up to 90%, not by what funds or stocks you pick, but by the particular allocation of the assets."

In other words, 90% of your total return over time depends on your investment mix between stocks, bonds, and cash rather than the actual selection of the individual stock, bond, and cash instruments for your portfolio. I'm sure you, like me, have seen that sentiment expressed before in various investment media. Is it true? Maybe it is, but then again maybe it isn't. The topic has been widely argued in the financial planning community of late.

In their 1986 landmark study, Determinants of Portfolio Performance, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation explained more than 93% of the variation in an investment manager's average returns over time. Brinson, Beebower, and Brian D. Singer largely reaffirmed these conclusions in 1991 in a similar study.

Still, some financial analysts challenged both study results because the conclusions implied that actual security selections played a small role in returns, whereas asset class was all-important. William Jahnke made the most notable of these challenges in his article The Asset Allocation Hoax, published in 1997.

In their 1999 paper Does Asset Allocation Explain 40%, 90%, or 100% of Performance?, Roger Ibbotson and Paul Kaplan reported the results of their study, which concluded that asset allocation, on average, explains 100% of returns over time, 90% of the variability of returns over time, and 40% of the variability of returns between investment managers.

In a point/counterpoint rebuttal to the Ibbotson piece, Jahnke asserts that asset allocation explains nearly 100% of portfolio performance only in the absence of active security selections and the conscious timing of trades. If one does not index, but instead makes individual security selections and also attempts to time market moves, then asset allocation accounts for far less of the overall portfolio performance.

All I've written so far is pretty clear, right? Yeah, I thought so. Your guess is as good as mine regarding how much of your return will be explained by asset allocation. In fact, the arguments are so clear, a whole industry has been built around them. Do a Google search on the phrase "asset allocation model" and you will get more than 1,000 hits. Many will take you to sites that, for a fee (surprise, surprise), will design a customized portfolio just for you. Explore a few and see what they have to say and to offer. And then think about what the entire topic of asset allocation means and how you should apply that concept to your retirement portfolio. By doing so, my guess is you can pretty well construct an allocated portfolio yourself based on your willingness to take risk in the market.

I know what I believe, and that's fairly well expressed in the article Investing Your Nest Egg Foolishly. To me, asset allocation in retirement simply recognizes that I no longer possess the earning power to recover from an investment decline like I could in my working life. Accordingly, because the major investment vehicles -- stocks, bonds, and cash -- do not necessarily move together, prudence and my tolerance for taking a loss dictate that I spread my money across all three. By doing that, I hedge my bets and ensure I can sleep well at night. If stocks fall, my bond and cash investments help minimize that loss by providing stability to my portfolio. Conversely, during better times when inflation is likely to be higher, stocks will provide faster growth to my portfolio than bonds and cash. My trick, quite simply, is to decide what percentage of my stash I need in each of those three markets. And for that there is no magic answer. Instead, it's a decision each of us must reach on our own.

I determine my percentages in a circuitous fashion. I begin by remembering that investing is a long-term concept, and long-term investments hold money that I do not need and will not use for at least five or more years. Money I absolutely know I will use in the next five years goes into cash and bond instruments, and I think of those funds as short-term savings, not long-term investments.

Based on historical averages, I know that over the last 50 years the longest bear market in stocks -- from peak to trough to former peak -- was roughly five years and nine months. The average bear market was roughly 20 months. Thus, as a retiree, if I have five years' worth of income held in short-term savings like cash, CDs, T-bills, and short- to intermediate-term bonds, then I will avoid the worst of most bear markets. And by doing so, I'm more likely to have that money available when it's needed even if the inevitable stock market decline does occur. Therefore, I determine what percentage of my portfolio is represented by five years' worth of needed income. That percentage is invested in cash and bond instruments, and the rest of my portfolio goes into stocks.

So, we decide on our asset allocation percentages, and we invest our portfolio accordingly. As time passes, the ratio of each portfolio asset to the others changes. That means that periodically we must rebalance our holdings to return to the desired percentages. How often should we rebalance? I prefer doing so no more than once a year. Others would say a quarterly or semiannual rebalancing is in order. That's a personal choice.

However, rebalancing means trading, and trading means fees. The more trades you make, the more money you will spend (and possibly the more taxes you will incur). The more money you spend, the lower your return. And the lower your return, the lower your overall portfolio value. You get the picture; so just ask yourself how much you would like to line your broker's pockets (or pay the tax man). That should determine quite nicely how often you think you should rebalance.

That's about it on asset allocation save one more thought. Asset allocation is a discipline that works well. Unfortunately, in an era of rising stock markets such as we have enjoyed for well over a decade, we tend to lose sight of why that discipline is necessary. Just as keeping part of our money out of stocks means we won't fall as far during market slumps, it also means we won't go up as far in periods of rising markets. Missing part of those rises could cause some to abandon the discipline so more can be invested in stocks. Bear in mind, though, that stocks can and do plunge in value far and fast. Therefore, adhere to the discipline and you will be less disappointed when the drop occurs -- and it will occur at some point.

In other words, don't let Greedy Gus get the better of you. There's much to be said for a modicum of stability in retirement because, unlike a real roller coaster ride, experiencing a downward plunge in your retirement portfolio really ain't all that much fun.

See you next week. Until then, post away as usual on the Retired Fools discussion board.

Best to all... Pixy