Monthly Archives: January 2019

Why the 50%-50% ratio of stocks and bonds in retirement

Posted on by
Reply

apple-926456_640In an earlier post on asset allocation I talked about the notion of a 50/50 split of your assets between stocks and bonds at retirement.  I also mentioned the “4% rule” for calculating withdrawals from your accounts in retirement as a good number.  Where did these come from?  It’s not simply a compromise between the assets, and we can show why it makes sense.  With math!  Hurray!

Previously I showed how we can use Monte Carlo analysis to predict probabilities of certain events, by running many possible future outcomes using prior years’ mean (average return) and standard deviation (variation of a given year’s performance from the mean).  In the case of retirement, the goal is for the money to last for the rest of your life.  Let’s assume you are taking good care of yourself and you are going to have a nice, long 30 year retirement.  And because of inflation, you’re planning on increasing your withdrawals by 3% every year.  We can run Monte Carlo analysis for different asset allocations to see what is the probability you will still have some money left after living off your nest egg for these 30 years.  I did a simple analysis with only 100 cases just for illustration, most Monte Carlo analyses would use many more, but this should be reasonably close.  Also, here I’ve assumed that stock and bond means and standard deviations will mimic those of the past.  Again, not a guarantee.  Here’s what I got:

Probability of your money lasting if 100% in stocks: 83%

Probability of your money lasting if 100% in bonds: 39%

Probability of your money lasting if 50/50: 90%

These results should look weird.  So all stocks is pretty good, all bonds not so much, but if I allocate some of my stock money to these (worse performing) bonds my results get better?  Huh?  Yep.  Remember your goal for this money: last 30 years.  It is not maximize the most money I can possibly make, that would be in stocks.  What happens is the addition of the lower variable bonds help smooth out those cases where stocks get hammered, and increase your chances that your money will last.

Is 50%/50% perfect?  Not really.  Here’s my analysis for more stock bond ratios, for convenience graphed as % of assets in bonds:

This analysis shows an ideal is actually about 60% bonds, but what’s clear here is you need the growth power of stocks to help your returns, but there isn’t a lot of difference between 40%/60% to 70%/30% (bonds/stocks) in terms of probability of the money lasting.  I like to lean a little heavier toward stocks with bond yields so low lately, but I think anywhere in this range is fine in retirement.  The other thing to notice is, how comfortable are you with a 10% chance your money will run out before 30 years?  If not, the 4% rule might be more of a 3.5% rule.  Or, as I mentioned earlier, you can throttle back your spending in the years of stock/bond downturns.  Living to your means, always a good idea.

Rebalancing the Portfolio

Posted on by
Reply

In an earlier post I talked about determining a desired asset allocation based on the goal and time to get there.  Due to normal market fluctuations, your portfolio will not continue to maintain this allocation on its own.  Traditional advice is to review your allocation periodically (every 3, 6, or 12 months) and make transfers between accounts accordingly.  This is a fine approach, but does run some risk of selecting the wrong time to make large investments–making a large transfer just before a big turn-down in the asset.  Good advice for regular investments is the concept of dollar cost averaging, which is a complicated term for something very simple, regularly invest a set number of dollars, not a set number of shares, which will help even out the prices you pay for an asset.  You can take a similar approach to rebalancing.

An approach for a 401k (or any other investment where you are making regular contributions) is to ‘rebalance by contribution’ meaning use continuing contributions every 2 weeks to try to get back to the ideal allocation.  For example, lets say I have the following for my investment in the Vanguard Total Stock Fund:

For the example case, the normal contribution for the Vanguard Total Stock Fund would be 60% of the total contribution (60% of $300, or $180).  This is then offset by the fact that I’m currently overweighted in this fund by 1%, or

$180 + (-0.01 x $100,000/20) = $130

In other words, I’m adjusting my contribution down due to the fact that I currently have “too much” of this asset class.  Other underweighted funds, using the same approach would be adjusted up.  This can be updated with each contribution period (provided you keep up with your current allocation) and done for each investment.  Note, sometimes the contribution may actually be a negative number, meaning you should be transferring that amount of money out of the fund at that contribution time, to another fund that is underweighted.

This approach makes you buy less of the assets that have grown in value and more of what has fallen, hopefully leading to buying at a lower cost, similar to the wisdom of dollar cost averaging.  Admittedly, this is a bunch of work that you might not want to do, I’m a bit of an obsessive on this, and if you’d rather just do the periodic rebalancing (lump sum transfers back to your ideal allocation) every 6 months or so, that is OK too.

No guarantees in life, a quick lesson in probabilities

Posted on by
Reply

cube-1655118_640Don’t panic, I’m not going to get into too much math here.  But it is very important to understand that all of personal finance is about making projections, which are far from certain.  I will repeatedly emphasize that no one has a good crystal ball on exactly what the future holds, but we can use the past and a little probability to help us determine our chances.  For example, would you retire if you had a 80% chance of outliving your assets?  50% chance?  10% chance?  near zero?  That answer is different for everyone, but no one can make that decision without getting an estimate of those probabilities, here is an approach you can use.

Although I don’t believe anyone can precisely tell you what will happen tomorrow or next month or next year, it is reasonable to look at stock and bond price histories for any given time period, going back 100 years if you want, to make estimates of the general trend of those assets.    Let’s look at the past 10 years, the longer term numbers actually aren’t too different.  The average return of the S&P 500 (which we’ll use as our metric for stocks) is 10.4%, with a standard deviation of 18.3.  For the Vanguard Total Bond fund (which we’ll use as the metric for bonds) the average is 4.0% with a standard deviation of 2.8.  Don’t worry if you skipped that lesson on standard deviation in math class, just understand that a big number relative to the average means that the return fluctuates a lot year to year, and a small number less so.  We can then use something called Monte Carlo analysis which is a complicated term for a simple concept, run a whole bunch of sample “futures” and see how they all turn out.  Think of it like throwing dice 1000s of times and recording what numbers you get.  You can make some inferences on those future possibilities based on the results.

Using a little magic in Excel with random number generation for the return on a given year, and the means and standard deviations above, we can see what is the probability of getting to our retirement goal.  Recall in an earlier post we showed we would get to our retirement savings goal of $1.2M.  Hurray!  Guaranteed? Uh, no.  Crud.  Going back to our 30 year old with $50k in her 401k, using our asset allocation, adjusting each year, and diligently saving, the chances of having at least $1.2M in the account at retirement? 78%.  Good, but maybe you don’t want to bet your whole livelihood on it.  Before getting completely bummed, the chance of at least $2.0M?  38%.  Not bad, probability works both ways!  Also, remember you aren’t doing this in the dark!  If things happen to not be working out the way you planned, you can adjust.  Maybe your house is a little smaller, or you work another year, or find cheaper hobbies; you have the ability to live to your means, no matter what the future holds.

If you are a weirdo like me and interested in the gory details of the excel calculations, here is a link.  It’s really not that bad!

The Upside of Down

Posted on by
Reply

natural-2728146_1920No, not about Stranger Things.  Sorry for the false advertising.  What I want to talk about is why you should be happy about drops in the stock market.  I know, stick with me here.  Just a short time ago the stock market experienced a sharp downturn, and many people “lost” tons of money (I’ll have another post on this fallacy).  People are understandably sad when their portfolio loses value, I don’t like to see those numbers go down either, but we shouldn’t be.  Let’s think about the alternative.  Stocks always go up.  Everyday.  Nearly guaranteed.  No need to worry, right?  Great!  But remember my discussion on the investment “flea market”.  If stocks had a near guarantee of going up every day, they wouldn’t need to pay you nearly the same return.  People (correctly) are willing to take less money on their investments in exchange for lower probability that they will decrease in value.  This is why stocks have a greater return than corporate bonds, which have a greater return than US Gov bonds, which have a greater return than CD’s.  Return follows risk in an open market.  So if stocks went up every day without a worry, they’d yield much less!  That’s bad!  We already have lower-yielding safer investments available to us, the beauty of stocks is for those of us with long time horizons to invest, they offer a great return in exchange for riding those ups and downs.  The downs are not an unfortunate part of investing in stocks, they’re necessary.  And, if that day, week, month or even year downturn hurts you financially because you were planning on selling right away, you shouldn’t be in stocks in the first place.  So, go ahead and cheer those hits to your portfolio.  Maybe privately so everyone else doesn’t think you’re crazy.