Money Matters, Simplified.
Investing Strategies: Retirement Investing and Asset Allocation
But first, we're going to play a little game called "Pick a Portfolio!" Let's imagine that you have five portfolios in front of you, and you have to choose one to invest in for the next 35 years. First, we'll ask how they performed over the past 35 years -- particularly, how much they grew (measured by compound average annual return). Next, how risky are these portfolios? This can be measured by standard deviation (the higher the number, the more volatile). Finally, let's check out the portfolios' worst one-, three-, and five-year returns to see what declines investors endured. Where would you bet your financial future?
Pick a Portfolio!
1972-2007
Portfolio A
Portfolio B
Portfolio C
Portfolio D
Portfolio E
Annual return
11.2%
14.3%
12.9%
11.7%
13.1%
Standard deviation
17.0
22.5
17.4
21.6
15.7
Worst 1-year return
(26.5%)
(30.9%)
(21.4%)
(22.2%)
(22.5%)
Worst 3-year return
(14.6%)
(16.7%)
(10.5%)
(17%)
(9.5%)
Worst 5-year return
(2.3%)
0.6%
3.3%
(2.6%)
4.8%
Picked one? Great. By the show of hands, I can see that most of you picked Portfolio B or E, and no one picked Portfolio A, C, or D. (OK, so I can't really see you -- or can I?) Let's pull back the curtain to reveal the investments in each portfolio:
Portfolio A
Portfolio B
Portfolio C
Portfolio D
Portfolio E
Large-cap U.S. stocks
Small-cap U.S. stocks
Real estate investment trusts
International stocks
Equal parts A, B, C, D, occasionally rebalanced
Large caps and small caps from Ibbotson Associates; REITs from NAREIT Index; International from MSCI EAFE Index.
Surprised? First, consider that the average investor's portfolio is dominated by large-cap U.S. stocks (individual stocks or large-cap mutual or index funds). Yet I'm pretty confident that you didn't choose Portfolio A. So there may be a disconnect between what you want from a portfolio and what's actually in it.
The second point -- and the most important one -- is that a well-diversified portfolio has historically provided very respectable returns with much lower risk. Portfolio E had the second-best return of the five portfolios -- beaten only by small-cap stocks -- but had by far the least volatility, and its worst years weren't nearly as bad as those of small caps.
This game actually comes from Roger Gibson (though he used commodities rather than small caps), president of Gibson Capital Management, author of Asset Allocation: Balancing Financial Risk, and one dang smart dude. He also developed charts similar to the one below to show which assets were the best and the worst (1 is best; 5 is worst) for each of the past four decades:
Decade
Large Caps
Small Caps
REITs
International
Four-Asset Portfolio
1972-1979
5
1
3
4
2
1980-1989
3
4
5
1
2
1990-1999
1
2
4
5
3
2000-2007
5
2
1
4
3
The well-diversified portfolio is neither the best nor worst during any one decade -- in fact, it's often smack-dab in the middle. Driving in the middle of the road from 1972 to 2007 provided the second-best return. That's the real benefit of lower volatility; we all have to accept some, but too much has a cost. After all, if you lose 50% on an investment, you then have to earn 100% just to get back to breakeven. (Go ahead, do the math if you don't believe me.) Furthermore, if history's any guide, holding a bunch of assets that don't always move in the same direction will provide quite a nice return without the need to place a bet on a single asset -- no fortune-telling powers required!
A portfolio for the future
Is Portfolio E the type of portfolio you should actually own? It's not a bad start for those who won't need to touch their money for 20 years or more. But different asset classes are like fashions -- for one period, an asset will be "in," and the next period, it's "out." These periods usually last longer than a year -- which is why annual rebalancing is too much. (By the way, Portfolio E was rebalanced only when an asset dropped below 20% or grew beyond 30% of the portfolio.)
As the previous chart shows, the hottest asset in one decade can drop to the bottom in the next. If that pattern continues, large-cap stocks can prepare to take the throne, while small caps and REITs are due for a breather. Plus, in rocky markets like we're in now, U.S. blue chips tend to hold up best -- so a bigger chunk in large-cap stocks is wise.
How does all this fit with different styles of investing? Tilt your portfolio toward value-oriented, dividend-paying blue-chip investments. But your portfolio should also have a growth component so you can profit if today's up-and-comers become tomorrow's on-top dominators. These would mostly fall into the small-cap category, though there are plenty of large growth companies that will get larger. The younger and more risk-tolerant you are, the more your portfolio should contain growth-oriented investments.
Putting it all together
So how do you create the right balance of assets? We'll get you started with three model portfolios based on your mile marker along the road to retirement. Choose the one that's right for you and implement it with low-cost mutual funds or individual stocks (if you've demonstrated an ability to pick good ones).
Just remember that for a well-diversified portfolio to really pay off, you have to stick with it for a long time -- decades, ideally. In any given year, one investment in your portfolio will be up ... and another will be down. That's the way it's supposed to work, and it's how reduced volatility and rebalancing pays off. But if you get scared out of volatile assets that can be down 30% in a year, stick to bonds and an S&P 500 index fund.
If you decide to own some of the more volatile assets that have had a good run lately (ignoring the past several months), such as small caps, emerging markets, and REITs, there's no rush to buy all at once. Dollar-cost average into these investments gradually with new contributions to your retirement accounts.
How to allocate at any age
Young and Crazy
(15 years or more from retirement)
Asset Class
% of Portfolio
Large-cap blend/growth
20
Large-cap value
20
Small-cap blend/growth
15
Small-cap value
15
Real estate
5
International large blend/growth
8
International value
8
International small
5
Emerging markets
4
Intermediate-term bonds
0
Inflation-protected bonds
0
Young at Heart and Responsible
(10 to 15 years from retirement)
Asset Class
% of Portfolio
Large-cap blend/growth
15
Large-cap value
15
Small-cap blend/growth
8
Small-cap value
8
Real estate
5
International large blend/growth
7
International value
7
International small
3
Emerging markets
2
Intermediate-term bonds
15
Inflation-protected bonds
15
Getting Golden
(5 years from retirement and retirees)
Asset Class
% of Portfolio
Large-cap blend/growth
15
Large-cap value
15
Small-cap blend/growth
6
Small-cap value
5
Real estate
5
International large blend/growth
5
International value
5
International small
2
Emerging markets
2
Intermediate-term bonds
20
Inflation-protected bonds
20
Copyright © 2008 Universal Press Syndicate.