6 approaches to make one of your most important investment decisions

Key takeaways:

• Asset allocation is one of the very few things in your investment plan that you can actually control
• In most cases, the higher your allocation to stocks, the higher your portfolio returns will be
• But wise asset allocation does not throw caution to the winds and blindly chase higher returns. It also looks at risk and ensures a balance of risk & returns such that you can sleep peacefully
• The approaches to asset allocation are as follows:

John Bogle’s 4 quadrant approach, Dr. Bill Bernstein’s max risk tolerance approach, Bill Bengen’s age-based thumb rules, Bogle’s own personal allocation, The Talmud’s approach, Outrun longest bear

One of the few things in your control

There are only a handful of key things that a wise and mature investor should do to strike a good balance between investment returns and risk. One of those is Asset Allocation i.e. deciding what percentage of one’s investment to put into stock market linked Investments. (equity) In reality, it is also one of the very few things that you can actually control with regard to your investments.

Primary determinant of portfolio returns: Stock to Bond allocation

Why is choosing your asset allocation important?nbsp; Because lots of research based on historical data analysis of the US stock market suggests that the higher your allocation to equity, the higher will be your portfolio returns are likely to be in the long term.

In the table below, notice the clear increase in average portfolio returns as the percentage of stocks increase. This is based on US stock market data from 1926 to 2019

This article will introduce you to 6 possible ways / approaches to think about this topic so that you can arrive at an equity percentage that works for you.?

What is a “Good” asset allocation?

Based on the above research results, one might be tempted to put a high percentage of one’s money into equity. However, one needs to be careful not to get carried away and allocate too much because there is always risk associated with the higher potential gains to be had.

It's important to note that what wise Investment Gurus typically define as? “Good asset allocation” is not necessarily the one that provides the highest returns. Rather, it’s the allocation that provides diversification and therefore reasonable returns at reasonable risk in a wide variety of future possible market conditions.

Notice again in the table above how the risk i.e. the worst annual return keeps rising as the stock allocation keeps increasing. For example, with a 20% allocation the worst annual return was -10% but with an 80% stock allocation the worst year’s return was about -35%

Finally and most importantly, remember that in the end, a “Good asset allocation” is one that works for you personally: For your temperament / nature, and for your life circumstances. As Dr. William Bernstein says, it’s good if “it helps you sleep peacefully at night”

And before you get carried away with the temptation to allocate too much of your money to stocks, here’s a sobering piece of data to always keep in mind. Some countries have had periods as long as 50 years that the stock market has taken to return to their original levels

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With that healthy dose of caution, let’s dive into 6 possible approaches to arrive at a number that works for you.

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6 Possible approaches to asset allocation

John Bogle’s four quadrant asset allocation guide

The above guide is from one of the greatest luminaries in the Investment Industry, John Bogle, the founder of Vanguard. Given the extent of his wisdom, if all you do is follow this you will do just fine.

The “accumulation phase” of investment refers to the decades when you are earning and investing the savings. The “Distribution phase” referenced above refers to the decades when you are living off or withdrawing income from your investments.

Bogle also believes that most people typically need to increase the percentage of bonds they hold in their portfolio as they age because of the following 3 reasons:

1.?? You have more wealth to protect

2.?? Less time to recoup severe losses

3.?? A greater need for income

Since the above matrix gives ball park numbers or ranges only, in order to get the exact number, John Bogle suggests you could use “your age in bonds” as a good rule of thumb. So if you’re 60 years old you would have 60% in bonds and 40% in stocks / equity.

Dr. William Bernstein recommended Max loss tolerance approach

This is an approach advocated by yet another Guru of personal Finance & investing, Dr. William Bernstein. Bill has authored over 10 books on investing, is regularly sought after by CNBC for his views and only handles portfolios upwards of $25 Million

This approach needs you to make an educated guess about what is the maximum fall in your overall portfolio you think you can stomach. Once you’ve assessed that, use Dr. Bernstein’s table below to decide your equity allocation.

Note however, that the key point to bear in mind is not only how much you think you can tolerate financially but how much of a fall you can tolerate emotionally.

Dr. Bernstein’s recommended asset allocation table

Bill Bengen’s asset allocation approach

Bill Bengen is the father of the famous 4% rule and one of the most respected names in personal finance & investment in the world.

His research suggests a slight tweak on the “Age in bonds” approach that John Bogle also recommended. Bill says you could do 3 types of asset allocation:

·?????? Conservative asset allocation

·?????? Moderate asset allocation

·?????? Aggressive asset allocation

Here’s what Bill’s asset allocation formulas are:

Bogle’s own personal asset allocation

Lots of historical data does indeed seem to suggest that in the long run (15 years or more) stocks tend to do better than bonds. But the more I look at historical data on returns from stock and bonds in different countries around the world, the more I get the feeling that you truly cannot predict whether stocks or bond will do better over the long term in the future.

The more I look at historical data, the more I am convinced that I know nothing and that actually no one can predict anything of the future in terms of stock market returns.

So if you agree and are of the strong belief (like myself) that despite lots of historical data suggesting stocks do better than bonds, you cannot predict whether the same will hold true in the long term future, one philosophy is to put an equal amount in stocks and bonds. If stocks do well in the future, well you have 50% in stocks. If bonds do better in the future, well you have 50% in bonds.

But don’t be fooled into thinking this a dumb portfolio. This 50:50 allocation is backed up by none other than the legendary John Bogle, the founder of Vanguard. John Bogle’s own personal wealth is allocated 50:50 ! And John Bogle is nothing short of one of the biggest names in Finance in the world !

This is also the basis of the famous Couch Potato Portfolio by Scott Burns More on this here: https://www.optimizedportfolio.com/couch-potato-portfolio/ .

The Talmud’s asset allocation

Here’s a good asset allocation approach for those who like investing in real estate.

More than 14 centuries ago the Talmud (an ancient work of Jewish wisdom literature) advised the following asset allocation: "Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve."

The modern day equivalent would be to have 33% in real estate, 33% in Stocks or Equity Mutual Funds and 33% in debt funds, bonds or FDs.

Outrun longest bear market

This one, while logical sounds risky to me personally but I’ll put it out there because it is a way of thinking that seems to appeal to many.

Here’s the approach:

·?????? You research historical data on the longest bear market. Say the longest it’s taken for the Nifty or Sensex to recover their original levels is 10 years

·?????? Now you set aside 10 years of expenses and put that into bonds. The rest goes into equity

Here’s a chart showing one of the longest periods it took for Indices in India to regain their original levels. It took almost 10 years from 1992 to 2002 to recover.

The risk with this approach is that you can’t predict how long a bear market you might face during your retirement

A few additional key points to note:

1.?? Never decide how much to invest in equity based on your “need” / desperation or desire to generate higher returns. Always base it instead on how much “risk” you can tolerate or sleep well with.

2.?? Always remember that there are countries where equity has taken multiple decades (50+ years in some cases) to recover to original levels. It could happen here in India also. See Financial advisor Avinash Luthria’s article on this here

3.?? A lot of Gurus of investing suggest that allocating less than 50% to equity could be risky if you want to beat inflation. So please do bear that in mind as you come up with your own figure.

4.?? Young people should start with low stock exposure & see how well they can manage crashes, and only then increase their exposure to a volatile asset class like equity

5.?? Don’t pick an asset class based on returns needed. Include an asset class like equity in your portfolio based on your risk tolerance

6.?? Full credits to Darrow Kirkpatrick the Co-founder of CanIRetireYet.com for beautifully summarizing these diverse approaches to asset allocation

Summary

Clearly, asset allocation is a highly subjective topic (like everything in personal finance amp; in life actually) and there are no real rules set in stone. Above, I’ve presented some of the approaches or ways of thinking advocated by wise investment Gurus and luminaries in the field of personal finance amp; investing. In the end though, you will need to make your own judgement call and arrive at an asset allocation number that works for you. See which approach resonates best with you and go with that or even just go with your gut feel finally.

My gut feel though is that if you settle on an equity allocation between 50% and 80% most people will be rather safe. Good luck with thinking through this important decision !

Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I am merely someone like millions of other common folk who have been investing in Mutual Funds. I’ve invested in Mutual funds for approx. 22 years. I’ve also been a diligent student of the subject of investing over the past 22 years. In these articles I’m merely sharing my experience & learning from that journey in the hope that it might help others in some way. Neither am I in any way directly or indirectly claiming to be a hot shot investor who has generated exceptional or above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes and don’t repeat them, you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments.

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