Change of asset allocation getting older?

Does this rule of thumb hold true: the older you get, the less allocation to stocks (and more to bonds)? If so, what allocation at what age? Should it be a linear or rather exponential change of allocation to bonds over time?

The reason for this strategy, as far as I’ve understood it, is to avoid retiring right before a stock market crash possessing a 100% stock portfolio. Also, fixed income from bonds might play a role

@Wolverine’s already kindly provided his input to this topic:

“Common wisdom is to use age in bonds for a retirement glidepath but there are many alternatives to that common wisdom, including a more agressive path, liability matching ladders, bond tents, having different asset classes into the mix, lifecycle investing and probably other aspects I’m not thinking of right now.”

I’ll gladly admit I hardly know any of these strategies mentioned above, need to read up on it! What about the infamous dividend strategies :grin:? Of course, that’s not moving away from stocks.

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My plan is to use my savings rate around 5-7 years before retirement to only buy bonds. Also reinvest dividends from stocks only in bonds. That way my AA will slowly move from 100/0 to 70/30 where it will stay till I’m dead.

So I don’t have to worry about “is it now the right time to sell some stocks and move them into bonds?”

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Check the vanguard target retirement funds for an example glide path.

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My plan is to have so much money that I don’t need to worry about market fluctuations. I don’t want to invest in fixed income, because you are by design losing a lot of upside and the downside protection isn’t that high imho. Bonds can crash too and their non-correlation with stocks might be fine short term, but loses you a lot of money long term.

Especially if we talk tripple A CHF bonds… Investing in company bonds however is imho complete nonsense. almost the same risk, but a lot less return comparably.

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Just throwing in a quick answer, the topic is worth a more dedicated one but knowing myself, it will take… awhile… for it to get here. As a disclaimer, I’m writing mostly from memory and I am just a guy who reads the internet so this is just meant to give a few tidbits to help do your own research. All of this is an over simplification and only serves illustrative purposes.

Edit: I’ve cut it into several posts to make it easier to read.

Why bonds

Buying stocks is buying part of a business. This gives you a right to a part of the assets and profits of the company. Part of their value is derived from fundamentals (the current assets of the company and its ability to generate future profits) and part of them is speculative (supply and demand: if a stock becomes hype and people want to buy it “en masse”, its price can skyrocket regardless of any change in outlook of the company. The reverse is true too: stocks can plumet for “no reason”). If the company goes bankrupt, too bad, chances are you may loose everything.

Bonds are a different asset class. A bond is the counterparty to someone’s debt, it is money that you lend to an entity, in exchange of what they promise to pay you interest (the coupon of the bond) and reimburse the principal at the end of the agreed upon term. Unlike dividends, the interest payed for bonds is fixed to an agreed upon amount at issuance and doesn’t varry from one year to another, hence the term: fixed income.

When held to maturity, a (nominal) bond is only subject to credit risk (risk of default from the issuer) and inflation risk (the risk that the nominal value of the interests and principal loose real purchasing power). In case of bankruptcy from the issuer, bondholders are paid before stockholders, so there are more chances that you still get something back than you would have with stocks (though you can still loose everything).

Bonds can be traded on the secondary market, in which case, they are in competition with other bonds and can loose value when the newly issued bonds bear more interest, or gain value when they bear less. When traded on the secondary market, bonds are also subject to interest rate risk and their value fluctuates, much like stocks, except with usually less volatile swings. The price of a bond purchased on the secondary market most often isn’t equal to its principal value (it is not the amount you get back if held to maturity) and its yield usually isn’t equal to the coupon that is distributed (it may, but it most often doesn’t).

Bonds have 4 major characteristics:

  • the face value (the amount that will be paid at maturity)
  • the coupon rate (the rate of interest on the face value)
  • the time to maturity (how far away from the maturity date we are)
  • the credit quality of their issuer (how likely it is that the issuer will make good on their obligations)

Bond funds are yet a different beast: they are mutual funds that purchase bonds and usually roll them over (potentially selling them before maturity and buying new bonds) to maintain the duration of the fund. Bond funds are subject to market fluctuation risk, while individual bonds held to maturity do not.

Bond funds and stocks have historical different characteristics in regards to returns and volativity. I’m using only the US stock market and US intermediate term treasury, for simplicity (this is an example, it doesn’t apply directly to an investor with expenses in CHF) but, from 1972 to April 2022, Portfolio Visualizer gives the following characteristics: Backtest Portfolio Asset Class Allocation

Portfolio CAGR(USD nominal) Stdev Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio
US Stock Market 10.52% 15.62% 37.82% -37.04% -50.89% 0.43 0.63
Intermediate Term Treasury 6.57% 5.76% 31.13% -7.20% -10.70% 0.37 0.57

Historicaly, over long periods of time, bonds have been less volatile while still having decent returns. Stocks have been more volatile with better returns.

Government bonds and stocks are mostly uncorrelated. Note that this means that bonds can go up when stocks go down but also that they can both go down at the same time, like they are doing now. Bond funds and bonds traded before maturity are no safe haven.

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Total returns vs interests/dividends

Bonds have long been liked for the interest they distribute, allowing a retiree to derive a fixed and regular income from their holding. This held value when trading was complicated, involved calling real people to have them execute the trade and involved big fees. Selling your assets wasn’t a very winning strategy.

This has changed. Nowadays, most investors get access to cheap brokerages with near instantaneous transmission of the order. Selling is easy which means deriving income from interests and dividends no longer has a real advantage against just selling assets to derive the same amount of money from the portfolio. If anything, selling is often more tax efficient (it is the case for swiss investors who don’t incur capital gains taxes but are taxed on interests and dividend income). This is why modern theories are that total returns (capital gains + interests/dividends) is what matters rather than interest/dividends. This actually takes some edge from bonds and makes the relative safety of their principal, when held to maturity, the more interesting part of them in my opinion.

The Trinity Study (4% Rule)

The Trinity Study was a study conducted in the University of Trinity (tadaa!) and published in 1998.

It was conducted using historical backtesting on a set of allocations of stocks (S&P500) and bonds (20y US treasuries) and tested the results of varying starting withdrawal rates, subsequently adjusted to inflation to evaluate the chances of success of each starting withdrawal rate on 15 and 30 years periods.

Note that for the purposes of this study, success was defined as the portfolio not being depleted after the studied period. A balance of USD 0.01 after 30 years was a success, as was a balance of USD 1,000,000. A lack of USD 0.01 after 29.9 years was a failure, as was total bankruptcy after 10 years.

The results of the study are summarized by retirementresearcher.com: Safe Withdrawal Rates for Retirement and the Trinity Study

In short:
For a 30 years period of inflation adjusted withdrawals, a 4% starting rate of withdrawals had been successful:
93% of the time for a 100% stocks allocation.
98% of the time for a 75/25 (%stocks/%bonds) allocation.
100% of the time for a 50/50 allocation.
87% of the time for a 25/75 allocation.
42% of the time for a 0/100 allocation.

We already see that more agressive allocations take a hedge versus too conservative ones, while some kind of balance seems to be optimal. But a 30 years period of retirement doesn’t help much when it comes to FIRE, since we plan to retire earlier than the normal age and live longer out of the fruits of our investments…

Enters Big Ern

Big Ern is a legend of the FIRE community. His blog is a wealth of resources and I highly recommand browsing it for anybody interested in FIRE or investing for retirement in general.

He has a serie on the 4% SWR where he expands the withdrawing period to 60 years. Of particular interest is the table of his results using different allocations and different SWR:

We see that more agressive allocations have better chances of surviving a 60 year retirement using the 4% rule than too conservative ones. We also see that for longer retirement periods, the 4% rule should rather be a 3.5% rule or somewhat lower.

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So what of the gliding path toward retirement?

Past results are no guarantee for the future, and while Big Ern studies show that a 100% allocation to stocks should be perfectly acceptable for a retirement strategy using a 3.5% SWR (though 75/25 seems to be better overall), this is math. The results assume someone applying mechanically the 4% SWR rules, but we are human beings: watching our portfolio get depleted with no more additional capital to compensate for it can be gruesome and give way to behavioral errors, or simply very, very bad nights (with potential health consequences… silver lining: having a fatal stroke before the portfolio gets depleted means it actually did suffice to fund retirement, if you’re into that kind of thinking. That’s not the outcome I’m aiming for myself and I intend to sleep well and enjoy life for as long as I will be able to).

Psychology trumps math, hence risk tolerance assessment, hence the search for a balance between return and volatility of the portfolio, hence bonds (and other asset classes).

As we start our professional career, human capital is all we have. Since we have close to no financial capital to loose, taking risks is a very attractive option and loosing it all only means we would start again. Winning brings big rewards, loosing only means you’re back at the start, as a still young person with a lot of human capital. At this point, the new contributions trump the variations in the market and big markets downturns have lesser psychological impact on us. Investing in riskier assets is easier.

As we age, we gather financial assets and loose human capital. At some point, our invested assets are largely more important than new contributions and the variations of the portfolio value start to have more of an impact. On top of that, retirement gets closer and we think more about the money we’ll have to withdraw from the portfolio then. At this point, it is very likely that our risk tolerance changes and that a more conservative allocation starts making more sense.

Finally, at the door of retirement and afterwards, we suddenly cease getting any new contribution coming from our work. Whatever we have is all we have to endure until our death, knowing that less healthy days and bigger medical and elder care expenses are probably coming further down the road. Some people can take it, most probably need more safety to be able to enjoy life without getting anxious every time the market gets a hiccup, or even worse, a real crash.

At that point, bonds serve 2 purposes:

  • they hopefully reduce the portfolio volatility (yes, I know, 2022 doesn’t quite follow that path, more on that in a future post).

  • they hopefully provide a stable reserve of funds able to finance future expenses for an acceptable amount of time (make it 10-15 years, for example). And yes, I know, hello 2022 again!

Which brings us to the actual question of the OP: how to craft our gliding path?

First, there are other ways to consider retirement funding than the 4% rule. I’ll keep it for another post but keep in mind that the 4% rule is more guidance than rule, nobody follows it to a T anyway.

Second, several bits of guidance have been given:

Jack Bogle, the father of Index investing, suggest that “age in bonds” is a good starting point to ponder on the gliding path toward retirement.

Benjamin Graham, Warren Buffet’s inspirational figure, states that “the investor should never have less than 25% or more than 75% of his funds in common stocks.”

There are advocates that say that given our longer life expectancy than our ancestors, a change to the “age in bonds” guideline, toward a 110-age in stocks or 120-age in stocks makes sense.

As suggested by nabahlzbhf, checking the Vanguard target retirement funds gives an example. They seem to start off more agressively (11% bonds for a fund aimed at people of age 19-25), then trend toward age in bonds, with a cap (71% bonds for people age 75 and older).

That being said, I’d pay attention to recency bia when reading on the recent advice geared toward more agressive allocations. While some of it is rooted in truth (Big Ern studies, for example), we’re getting out of a period of incredible returns for stocks and until very recently, bonds yielded close to nothing (when not negative), so it’s easy to diss out bonds and think that stocks is all you need.

As stated above, there are several different ways to look at funding retirement spending and there are a slew of strategies to address it, I’ll get more into it in a further post but for now, I’ll simply mention:

  • liability matching ladder of bonds: since, baring bankruptcy, the amount of principal paid back by bonds at maturity is known in advance, we can purchase our bonds to make it that an amount matching our expected expenses achieves maturity every year, only drawing on stocks to build more year ladders.

  • risk parity portfolios: there is more to the investing world than just total market stocks and bonds. By mixing a broader set of assets, mixed with factor investing and mixing bonds durations, one can aim to achieve a “permanent” portfolio, that should maximize risk adjusted returns and terminate the need for a bonds glidepath. Harry Brown’s Permanent Portfolio, Ray Dalio’s All Weather Portfolio (though it’s interesting to note that Ray Dalio currently thinks that bonds, which make up 55% of the All Weather, are trash and that investing in EM is the future…) and the Golden Butterfly are among those.

  • some people like to increase their bond allocation before retirement, then live off it for the first years, gradually decreasing it until reaching their target retirement allocation (bond tent).

Also to note and maybe the most important part of this post: retirement planning is very personal. There is no “one-size fits all”. Only you know yourself, your needs, your wants, the people you want to support and those who can support you, etc. Guidelines are nice to take a quick decision and buy time for more in depth considerations and to help give directions to said considerations but you are unique and should do what works for you.

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Just a short feedback from my side, got to digest the wealth of info a little first: Wow, this was incredibly helpful, thanks!

Discussions have been so much focussed on stocks I find it refreshing to hear about bonds again. Also, the strategies around retiring are super interesting, I’d love to hear more!

There seems to be quite a lot of uncertainty involved, namely around the date of our death: everyone of us could suddenly die of a cardiac arrest, a stroke, cancer, or simply a traffic accident. Which, for me, again brings up the topic of working part time before retirement. Does it actually make sense to abruptly retire 100% at a late age, or is gliding into retirement from an earlier age the better choice (“hedging the early death risk” :sweat_smile:)? Part-time partially enables the “RE” of FIRE, but decreases income. Wondering if there’s a sweet spot in this tradeoff? But clearly, that’s a different topic.

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This is actually not a risk in FIRE. The main risk is that you live a very long but miserable life with lots of heavy medical complications that requires many expensive medical treatments and expensive care. We are not in US, so we don’t have to come up for these costs completely by ourselves, but it still matters.

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That is the “ah-ha” point that answers the question at the start of the thread: If you are planning on a long retirement period it is safer to have a high equity allocation. Pivoting to bonds does not make sense.

Kitchen logic explanation is that over a long period the risk of holding equities relative to bonds dissipates meaning that we benefit from their higher return, with low risk (someone can correct me if I got this wrong)

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My understanding is that the ideal approach is @Cortana’s one: invest in 100% stocks while you are working and switch to something of a 75/25 allocation once you reach your number. The risk is hitting a big and prolonged crash right before hitting your number, which could delay your retirement by years, which is why, I guess, one might find value in a more conservative allocation nearing retirement.

The other reason for more bonds is pyschological: the perfect plan doesn’t matter if one can’t stick with it. As we become richer and get closer to retirement, it’s likely (for many of us, though there are exceptions. If you are one of them, all the more power to you) that our tolerance to market fluctuations diminishes, which would warrant a bigger allocation to bonds. Better an imperfect plan that we can implement fully than a perfect one we fail to follow at the worst possible time.

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The conventional advice on asset allocation makes sense if you stop working at normal retirement age. For example look in the table above: 4% WR and 30 year period. It is safer to have 75% stocks than 100% stocks

However in this community we are different and for someone with a 60 years’ retirement the risk flips the other way around.

I agree the biggest risk to a successful outcome is a bear market in the first 2-3 years. I think the point is not to be too aggressive with the WR - for example I saw an analysis that the WR assumed should be lower when CAPE is high, and could be higher after a bear market

Also search for “bond tent” and “sequence of returns risk”.

Right around the retirement time (-5/+5 years or alike) it makes sense to become more defensive.
Then going further down the line you can shift back towards stocks again.

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