Losing your shirt, and getting it back

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yorkshire-terrier-2705770_640Every investor in stocks should know, there will be days, months, even years where you lose money.  It is part of the deal, higher average return in exchange for larger uncertainty of that return.  We invest in stocks because generally over the long term they make more money than other available investments.  But there is another concept to keep in mind on those down days; usually what is really driving the price on a short term basis is speculation about where a stock price is going, not investing in the company’s long term prospects of making profits and growing the company.  Here’s an example.  Suppose you have a bunch of small stuffed animals that your child likes.  They have some intrinsic value–they entertain your little one for a few seconds.  Parents, treasuring those few moments a day are willing to fork over $10 for them.  Then something odd happens, for whatever reason there is a growing momentum among the population that these little stuffed toys are extremely valuable!  People start bidding them up on eBay and some sell for $1000’s.  (Note these reasons are extremely hard to predict, and you could argue its exactly what many financial professionals are trying to do).  Suddenly, you’re rich!  Junior’s toys are going to put him through college!  Then later, people start to realize, wait, these are just toys.  Their intrinsic value is simply their ability to entertain a child.  Granted, on the right day a parent might pay $1000’s, but usually that’s a $10 value.  Their value plummets right back down to what you paid for them, and you have lost $1000’s.  But have you really?  You never really had that money.  All that happened is you owned something that a bunch of people were willing to pay insane amounts to get, but in the end you never “made” or “lost” any money at all.  The intrinsic value of what you own (in the case of a stuffed animal, its ability to entertain or in the case of a stock, the company’s ability to generate profits) is exactly the same.  You haven’t “gained” or “lost” anything!

Speculation, like in the above case, drives short-term prices out of touch with the asset’s long-term value.  Keep this in mind on those days where a stock or fund you own drops by 5% or more in a day.  Is the value of this company really 5% less than it was yesterday?  Is it’s ability to generate profits now and into the future really 5% less?  Generally, no.  The company is largely the same, but speculators are reacting to some news to drive its stock price lower (note the same holds in reverse, the company usually doesn’t gain intrinsic value that much in a day either).  If it’s still a good company, it’s still worth owning.

Also remember there are only two times where the price of something matters, when you buy it and when you sell it.  Everything in between is noise.

Note, the example is true by the way, checkout the Beanie Baby craze of the 1990’s.

Gain or Pain

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For many people, any time they are deciding on a big ticket item like a vacation or some luxury item, the calculation simply comes down to “Can I afford the monthly payments?” A little better question is “Have we saved up enough money?”, but I’d argue even this is the wrong approach when making a decision.

I don’t want to tell anyone where they should or shouldn’t spend their money. OK, I sometimes do, but really that is an individual decision based on what every person values, and everyone needs to make that decision for themselves. However, I think everyone needs to have the right information when making purchasing decisions, and that comes down to my common theme of using time, not money, as your limited resource.

Instead of asking “Can I afford the payments for that dream vacation?” or even “Do I have the $10,000 in my account for it?” a better question to ask is “How much longer will I need to work to offset this purchase?”. Instead of paying in dollars, you are really paying in “Pain Dollars” or working time. This is key, because the conversion of dollars to Pain Dollars is different for everyone. For example, let’s say that vacation meant you’d have to work 4 more months (more on this calculation in a moment) at your job. Is that worth it? For some, yes, the reward is worth the pain, and for some no. It depends on how painful your job is and how much you value the item you are about to purchase.

To figure out what your Pain Dollars conversion is, I use my early retirement “Crossing the Streams” approach, and compare my original asset curves with one set back by the purchase of the item ($10,000 in the case of this vacation). I suggest you read this blog post to understand this a little better if you haven’t already.

Looking back at that original scenario, we had a 32 year-old doing well, with a projected early retirement in March 2043 (age 56). What if she decides to take that vacation? Her current bucket one assets decrease by $10k and her crossover point shifts by 4 months:

I know what you’re thinking, if I make more than $10K in 4 months, how can the impact be this great? And, the impact above looks like a lot more than $10k! The answer is a) not all of your money you make goes to savings (in fact most doesn’t) and b) we are looking at the impact of a purchase today compounded over time. Is that dream vacation worth it? Some would say yes, some would say no, but I think everyone should be informed of its impact in his or her working time.

This is also part of the power of working in a job you really enjoy. For those lucky enough to love their job, the conversion rate of Dollars to Pain is very advantageous, meaning your able to exchange very little pain for a great deal of dollars. By thinking about “paying in Pain” everything just became cheaper! Four months for you might be pennies—doing your job everyday is a pleasure—four months to someone else might be a fortune.

Punching Out Early Part II: Crossing the Streams

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When I was a kid, I went to see the original GhostBusters in the movie theater. Looking back, it’s a combination utterly ridiculous and great movie. One thing you learned is never cross the streams:

“Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.”
–Dr. Egon Spangler

“That’s bad. Okay. Alright, important safety tip, thanks Egon.”
–Dr. Peter Venkman

Here, we’re going to talk about crossing the streams, and much like the ultimate destruction of Gozer the Destructor (another geeky Ghostbusters reference), it’s good. In the last post we created curves for how much we might need to punch out of our jobs, and have enough to support our chosen lifestyle. Now for the fun part, figuring out when we can get there. We’ll look back at Bucket 1 first, life up to age 59.5.

Bucket 1. Again, this consists of three parts:

  • Home Equity. This is the current value of your home (you can use zillow if you need an estimate) less your current mortgage. This will go up every year as you pay down the principal on your mortgage. Since we did not adjust our retirement home for inflation, do not adjust your home value either.
  • College Savings. Hopefully in a 529 savings plan where it earns returns tax-free
  • Regular Savings. All of your other accounts that are not specific retirement accounts (401k and IRAs are not part of this bucket)

We can project each of these out with time based on the amortization schedule of our mortgage, and an assumed rate of return of the college and other savings accounts. We then add them all together, this might look like the following:

Bucket 2 is addressed in a similar way, and includes 401k, IRA or other retirement only assets, yielding a rate of return appropriate for your asset allocation.

Once we have an idea of our asset growth with time, we can compare that to the needs curves and look at where we cross the streams:

In order to retire, we need to be above both curves. For this example, the most restrictive case is our Bucket 1 money, and indicates an expected early retirement at age 56. This is not guaranteed, in fact there is a LOT that will happen between age 32 and 56 that will change both curves as you get older and life happens. Also, we had to make reasonable guesses for things like rate of return of our investments. But I find this a really useful exercise to compare my current and future lifestyle choices with my current and future savings to see where these choices project. Don’t like the answer? Save more! Or learn to be happy with less in the future! Conversely, maybe the curves are showing a projected retirement well before when you’d like to stop working, possibly indicating that you are not living it up enough in your present. That is sub-optimal use of your assets allocated to your time also–but note, almost no one falls into this group. (Oh no, too much money! Gah!)

Punching Out Early: Part I: What do I need?

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I’ve had some earlier posts on figuring out when you’ll be able to retire, taking the traditional route to 65. However, for many people, myself included, that seems like an awfully long time to spend doing something that isn’t first on your wish list when you get up in the morning. If your job does fit this category, fantastic, and the wish to retire early isn’t nearly as strong. But for most people, they’d really rather do something else, which is the allure of early retirement. People in the FIRE movement endorse the idea of retiring at 30 or even sooner! While I think much of this message gets confused and oversold, early retirement is a laudable and achievable goal. Let’s look at a strategy.

One magic number is 59.5. That’s the earliest you can start drawing on tax-deferred 401k and IRA savings. So, it makes sense to break up your assets into two buckets, 1) Money in taxable accounts for retirement life before 59.5–assuming a goal to retire before this age–and 2) Money for life after 59.5 (in tax advantaged accounts). Think of the first bucket as a bridge account since it bridges your retirement date to 59.5 when your true retirement assets become available. For simplicity, I assume Bucket 1 has to contain everything to get me started in retirement, meaning it covers my retirement (preferably without a mortgage), my kids college, and the money I need to live on until Bucket 2 kicks in at 59.5.

Bucket 1. Similarly to the earlier post on retirement, we first need figure out how much we need. This is a curve that represents our needs starting in the present (Retire Today!) and extends into the future, and is the sum of 3 elements:

  • Retirement Home Cost. You can use today’s dollars if you are a current home owner since later in the calculation you’ll be offsetting this with your current home equity in today’s dollars. If you don’t currently own a home, you’ll have to calculate this using today’s dollars and inflation, I suggest 2.5%. If you want to rent in retirement, this number is zero, but remember you’ll have to figure the rent into your needed monthly income
  • College Funds Needed. My earlier post had a rough calculation you can use for each of your kids, assuming you want to pay their way through school.
  • Living costs, from now until 59.5. If retiring after 59.5, this is zero, but otherwise is a little more tricky than the other two. You’ll want to devise a retirement budget to your desired lifestyle, similar to the approach we took earlier. But remember, early retirement means you’ll be paying your own medical insurance without Medicare, not a low cost item. Also, I suggest tweaking this number up based on inflation to the rough date where you think you’ll actually retire. There are a number of ways to calculate the lump sum you need to support this budget, you can simply multiply your budget by 25 (the 4% rule we used earlier, assuming living off interest only) but that is probably a little too conservative for this bucket, knowing you have another bucket behind it. I use the Present Value equation in Excel, so my needs decrease with each year I get closer to 59.5. In total, your Bucket 1 curve will look something like this:

You can always play with the assumptions, but the curve in general gets lower as you age, simply because the time is decreasing from now until age 59.5, so you need less money to live.

Bucket 2. Bucket 2 is simpler, it only takes into account what you need live on, from age 59.5 until….whenever. Here I’m going back to the conservative rule of 4% withdrawal and assuming I have to live off the interest only. This is conservative, but if I don’t adjust my yearly budget for inflation, it kind of balances out. You can also use the Present Value approach used above in Bucket 1. The question we need to ask is how much do we need as a lump sum for any given year of retirement, such that the money will grow to the minimum amount we need at age 59.5? This is the amount saved at any moment in time that we assume will grow to our need at age 59.5 without the need for further contributions (which we aren’t making when retired!). This will increase each year, since each year there are fewer years to age 59.5 (and thus less time) for our money to grow. The bucket 2 curve will look something like this, this assumed an 8% return on assets:

When can you retire? If your Bucket 1 assets are above the needs line and Bucket 2 assets are above the needs line, you are in-line for retirement. (Ha! See what I did there? Graphing humor. Always kills).

But wait, those are some pretty big numbers, you mean if I want to retire at 40 I need nearly $2M in Bucket 1 and half a mil in Bucket 2? For the scenario above, yes, per our assumptions, at least that much. Are the FIRE people accumulating millions by the time they’re 40? Well, no, probably not. The FIRE people are (hopefully) doing these same kinds of calculations and saying “Whoa, those are some pretty big numbers!” and altering their needs way down to get them more reasonable. Maybe their kiddos will go to community college, maybe they’ll live on $30K a year (though I really don’t know how that would work with health insurance), maybe a $100K condo will do just fine. You can do the same if you like, its all about what kind of lifestyle you value, and what kind of time you’re willing to put in for it. That’s different for everyone, but I do have some future advice on how to strike that balance. (FYI, to give you an idea of this impact, changing to the assumptions I just listed is a need of ~$500K in Bucket 1 and ~$200K in Bucket 2, still a big nugget, but a little more reasonable for age 40).

In my next post, we’ll look at where we stand and projecting out when we’ll meet both criteria.

Freedom, not Retirement

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mountain-984277_640The Financially Independent, Retire Early (FIRE) movement has gained a decent following recently.  Generally, I’m a fan, anything that is encouraging young people to live beneath their means and save as much as possible is right up my alley.  Mr Money Mustache is probably the most popular among those promoting this effort, and I encourage you to check out his blog, there is a lot of practical advice to living a life of wealth.  But like anything, the approach can be oversold as another magic pill of the easy path to wealth.  Back to math for the answers.  Love you, math.  Love you.

Some within FIRE will shout Retire at 30!  Sounds too good to be true, and generally it is if you take it literally.  Recall the post on budgeting, the first thing you have to figure out is how much you’ll need to live, and remember if retired you are paying your own medical insurance now.  Don’t be shocked but this can be $25-$30K per family (assuming no subsidies from the Government here) and rocketing up every year.  And you HAVE to have health insurance.  Remember, your time, and indirectly your health is the one thing you absolutely have to protect.  You also have food, housing, bills, some minor entertainment.  Don’t expect to give up Netflix and be able to live on $10 a day.  Assuming all of these things, $60k per year (assuming that health insurance remember) is not an extravagant need.  Recall the post on living in retirement, a general rule of thumb is assuming you can withdraw 4% each year for living expenses (conservatively assuming you aren’t drawing down the principal), you need $1.5M, and this is pretty bare bones living.  Let’s assume you start working at 22, and you assume a solid return of 11% on your investments which is a pretty aggressive assumption.  To retire at 30, you’d need to save roughly $125,000 per year to get to $1.5M.  This is savings after tax.  You can’t count your 401k or IRAs, those aren’t eligible for withdrawal until you’re 59.5 (question, Congress people.  why the 0.5?  seems so random).  Do you have a job at 22 that allows you to live and save that much?  No?  Hmm, how about retire at 40?  With the same assumptions, it’s still $30k per year.  Every year, starting at 22, and assuming you get an 11% return every year.  This is at least possible but still really, really tough for most people.  Plus, remember that the 4% rule is no guarantee the money will last (see my post on Monte Carlo analysis).

So I’m not anti-FIRE movement, but clearly there is something else to this besides: Step 1, get a job making insane money.  Step 2, spend almost none of it.  Step 3, invest in a stock market that is consistently going up.

Instead, the movement really should be called “Free to Pursue Work Regardless of Earnings (FTPWROE)” but that doesn’t have quite the same ring to it, and the vowels are in terrible locations.  Think about “retirement” at 30 or 40.  This is not sitting on a beach with a Mai Tai.  Instead, it is saving a decent cushion, so that you can pursue work you find more meaningful and enjoyable, regardless of the income.  Recall my post on the 3 elements of a job, here you are ignoring the income element and strictly focusing on the time the job requires and your personal enjoyment, and there is a beauty to this that I respect.  Suze Ormann famously criticized the FIRE movement but I’ll bet some of that is she has a certain picture in her head of retirement because she literally retired to a private island in the Bahamas.  I understand she and her wife do insane amounts of fishing, and have to admit, sounds fantastic.  But FIRE people are still looking to achieve something (besides landing a big snapper).  So if you leave your accounting job and decide to be a youth counselor  (maybe with an outfit that offers health insurance, score!), maybe you can do it with a big enough supplement nest egg.

So take the good parts of the FIRE philosophy: live frugally, save extensively, invest wisely.  Seek joy in the free/inexpensive things instead being sucked into the materialism hole.  The power of that pile of cash you build may not be enough to sink your toes permanently in the sand at 30, but may give you the cushion you need to live the life you want.

Evaluating your Job

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When you start working you’ll likely have yearly performance reviews.  Your boss will sit down with you, explain to you the things you’ve done well, what you’ve done not so well, and what goals you should have for the future.  It’s generally a valuable exercise to make sure you are on-track to what the company wants.  But you should be doing the same thing in reverse, at least yearly, evaluating how the job is working for you.  If you feel happy, great, but if not, I’m sorry Job X, we need to let you go.  You just aren’t working out.

It might be obvious if the job isn’t for you (if you’re morning commute is filled with heaving sobs on the prospect of going in the building, this might be a sign) but I like to look at 3 basic criteria for any job when determining how it fits for me.  Every person will weight these criteria differently, but regardless, I think Job X needs to have strong scores in at least 2 of the 3 for you to maintain some level of happiness.  The three questions to ask are

  1. How much do I enjoy the work on a daily basis?  This can be due to the job itself, the people, the environment, or other factors that keep you from those commute tears.
  2. How much am I compensated for my time?  This is salary and benefits naturally, but also hidden compensation, such as the ability to learn a lot in short period of time.
  3. How much of my time is required?  Some jobs pay a lot and ask for a lot of you in return.  Some jobs stress a work/life balance.

The Japanese concept of Ikigai adds the fourth element of the value of your job benefiting society in general, but I consider this part of the first element of your job satisfaction.

Getting all three of the above is tough.  Usually those job descriptions are something like “Shortstop for the Boston Red Sox”  Lots of enjoyment and cash, minimal time, but there aren’t too many of those jobs out there.  If you can find one (or can hit Major League pitching) fantastic, but really, really try to get 2 of the 3.  For example:

  • Loving the work, but being paid peanuts and having the job take all of your time leaves you with little resources or time for anything outside of work.  You better really, really love it
  • Getting a huge salary but hating the job and having it take all your time is no good either.  What good is the money if a) you don’t enjoy you’re time at work and b) there’s almost no time outside of work? For many people, the solution is I’ll Buy Stuff!  That doesn’t really work.  If you like the work, the extra money can help enhance the little time you have outside the job, and at least you’re happy at the job, or if you have lots of extra time, the extra money can help offset the time in the office you aren’t crazy about.  But note, it’s really tough to offset this if you hate the work.
  • If the job doesn’t take a lot of time but pays little and isn’t satisfying, this isn’t so good either.  You’ll likely still feel unfulfilled, and maybe stressed to meet your budget.  Without some disposable income, you might not be able to make good use of that extra time you have.

There are other little items of evaluation, but I recommend reflecting on your job in at least these three categories.  If you can only hit on 1, you are probably better off finding something else in your organization, or outside.

Psst! Secret of Investing! Gimme $5 Grand

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padlock-2739049_640There’s a common sales pitch in the financial industry, again trying to let you in on the secret to wealth.  There are radio ads that literally go on for hours, the guy has bought up the entire time slot for his ad, disguised as a financial talk show.  He talks in vague terms like “smart strategies” and how if you’re not a millionaire but only a thousandaire you need to generate massive returns on your money.  He’ll then invite you to a free seminar at a crappy Holiday Inn presumably showing you how to do this.  What an awesome, free service!

Yeah, not free.  The ‘seminar’ is really a sales pitch for their trading class, which only costs somewhere between $4000-$5000.  Oh.  And the strategies generally involve lots of trading, which requires additional commissions.  But they promise (but don’t guarantee) huge returns!  Let’s think about this.

  • They can likely present testimonials from people where their system worked.  Of course, that is true, just be random chance!   Would you play the lottery based on the testimonial of the person who won?  (That’s rhetorical, please don’t play the lottery.)  What does the average person make?  Better yet, what is the full distribution of returns of all their students?  Including your enormous fee.  Uh, they won’t have that info.
  • If their system did work, why are they telling you about it?  Even for $5K!  Remember how difficult it is to beat the market, if you find a system that works you want to keep it very quiet and make millions not sell it for thousands!  As soon as the word gets out–if the strategy they are selling was any good to begin with–the market adjusts prices accordingly and the strategy doesn’t work anymore.   Short-cuts to finding that out-sized return depend on the knowledge being tightly held.
  • The strategies generally involve something called technical analysis which involves looking at the chart of prices in the past, finding ‘support’ levels (low prices) and ‘resistance’ levels (high prices).  Some people believe in this, I think its akin to a palm reader staring at your hand to tell you your future.  You can pay money for that too (again, please don’t do this either).  There was a famous study by a University in New Zealand that basically concluded technical analysis strategies don’t work.
  • Some will offer to refund the seminar (or, more likely let you take the seminar again) if you don’t make money.  No risk!  Well, except for that money you put up for our high trading volume strategy.  We’re not covering your losses on that.  Sorry dude.
  • They are for profit companies, which need to make money, after they pay for their long infomercials and all their staffs and all their offices and all their other overhead.  Where are they getting the money to cover all this and still make profits?  You.  Again, why not just use their own awesome strategies to make money?  Because they know it really doesn’t consistently work and this complicated business selling questionable information is much more lucrative.

Fortune magazine took a look at these services, and walked away less than impressed, you can read about it here.

Let’s say you have $10K to invest.  I suggest an S&P 500 index fund.  You decide to go with these guys.  One day one I’m ahead of you by $5k because I didn’t have to give it to these guys.  Over the next 10 years of investing, you don’t have to just beat the S&P 500, you have to CRUSH IT.  Like, double it.  And that’s just to break even with me and doesn’t include all the additional commissions you’ll pay with each trade.

In 2008, Warren Buffet famously challenged any hedge fund to bet him that they could beat an S&P 500 Index fund over a 10 year period.  Think hedge funds have access to these famous ‘strategies’?  People pay them a ton of money assuming they do.  One hedge fund management company took him up on the bet.  And got crushed.  They didn’t even have to wait for the end of the 10 years (the money went to charity).  It’s also telling that more hedge funds weren’t willing to take him up on the bet…maybe they know something after all.

You know where you can make lots of money?  Selling seminars to less informed people.  Don’t be one of these.

Early Life on the Job

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I’ve spent a bunch of these posts on smart financial decisions but up to now have ignored the biggest asset you have: your ability to get paid for your time.  Life in your first job is a classic example of being tossed into the weeds with only tools, but little guidance on the environment.  School hopefully provided the basic skills to do the job, but rarely will you be given guidance on how to succeed at work.  Here are my suggestions for this new world.

  • Seek positions where you have maximum opportunity to learn.  This is extremely important early in your career.  I’ve made far more money later in my career due to knowledge gained in these early assignments vs seeking early assignments paying a slightly higher salary but without the intellectual challenge.  For your first few positions, heavily value the knowledge gained.  This is a type of hidden compensation and as a bonus, these jobs will likely be more interesting.
  • Show initiative.  In school, the structure is generally centered around some authority figure providing you a well-defined, detailed problem for you to solve.  Work structure is rarely this straight-forward.  Frequently it is your job to uncover what needs to be done, then do it.  In other words, come up with the questions and the solutions.  When uncovering a problem, try to solve it best you can without needing a lot of help from your superiors.  Don’t keep beating your head against the wall, but at least give it your best shot.  Remember your bosses also have a lot to do and greatly appreciate someone who is able to make progress on problem without a bunch of hand holding.  A key skill is knowing when you’ve hit your limit and need help, which is part of my next point.
  • Build your corporate network.  I know I just said try to do as much as you can without constant oversight, but the combined company resources will be a huge key to your success.  With every interaction, learn what that person does.  Even seemingly ‘wasted’ conversations can help you understand someone’s expertise and help you build your network of experts to lean on when you need it.  My advice to to keep a database/address book with each person and his/her expertise.  Build this network.
  • Document everything.  Have a working notebook for what you do.  Record what is said and decided in meetings relevant to you.  Write down your own thoughts as well.  This might seem tedious and will slow you down a little, but you will absolutely need to refer back to it.  Plus your attention to detail and diligence will be noted.

Remember, your number one financial asset is you. Learn. Improve. Your ability to get paid for your time is by far the biggest investment return. A job earning 10% more but going nowhere and teaching you nothing is much, much less valuable than a job teaching you skills and challenging you.  You think education is finally over when you finish school, but it is actually just beginning. The real part anyway. All your education did is get you in the door. What you do from this point forward makes your career. Dedicate yourself to constant learning, the reward (financial or otherwise) will be tremendous.

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

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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

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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.