This lesson is going to be a little different. Instead of me going over my own point of view on asset allocation, we’re going to look at some of the most popular asset allocations.
For each of them, we’re going to dig into who they’d work best for and who might want to avoid them.
My favorite place to start her is the Vanguard Target Date Funds. Vanguard and just about every investing company offer something similar. Here’s how these funds work:
You pick a date where you’d want to retire. “Retire” in Vanguards definition means drawing down funds somewhere in your 60s, so it’s slightly different than if you were to retire at 50 or 40.
If you believe you’ll retire in 2050, then you could choose a fund like $VFIFX, Vanguard Target Retirement 2050 Fund. By investing in just one that one fund, Vanguard will create a low-fee, diversified portfolio for you in just one fund. It’ll even change over time to be before less risky as you get closer to retirement.
If we open up that fund, we can check out what it’s investing in today.
These funds should look very familiar – they’re the same funds we’ve been talking about all through this course! The one difference is that they split the bond investment between a US Total Market Bond fund and an international bond fund.
90% of the portfolio is in equities – both US and international. Of the remaining amount, it’s about 60% in the US and 40% in international funds. That’s pretty much right on target with the 3-fund portfolio we talked about earlier (anything in the 40% to 66% range for US funds seems in the sweet spot).
At 90% equities right now, this fund is very aggressive. Vanguard ranks it as a 4 out of 5 on its risk potential scale, which makes sense considering the largest holding, $VTSAX, also has a risk of 4 out of 5. The international fund is a 5 our of 5 for risk, but that doesn’t make up the majority.
The way target-date retirement funds work is that they become more aggressive as time goes on. Gradually this fund will sell it’s US and international stock holdings and move a lot more of it to bonds.
As it stands now, this would be a GREAT allocation for someone years or decades to go before they retire! It’s high risk, but also high return.
How does this differ from the Vanguard Target Date 2020 fund, $VTWNX? That would be the fund of someone who was retiring this year (if you’re watching this in the future, it’s 2020 when I’m writing this).
Here’s the portfolio composition of $VTWNX, Vanguard Target Retirement 2020 Fund.
The biggest difference between the 2020 and the 2050 target-date funds is their allocation is almost completely swapped! For someone retiring today, Vanguard recommends 50% stocks and 50% bonds.
They split the bond allocation even more into an inflation-protected securities index. This is a fund that is very conservative and aims to match or exceed inflation.
I like this portfolio for someone retiring in their mid-60s. Having somewhere between 40% and 60% of your portfolio in bonds at the time of your retirement is a great hedge against sequence of return risk.
Sequence of return risk is a mathematical concept to describe the danger to a portfolio of withdrawing funds at the wrong time. An example would be that you retire and start drawing withdrawing funds. That first year of your retirement the market crashes and goes down 50%. You continue to withdraw your funds as you were before. Even with a recovery though, your funds may not last long enough. You’ve depleted them somewhat by continuing to spend, while at the same time they weren’t growing as you hoped.
The inverse of this is that the market goes down 50% in the 20th year of your retirement. For the first 20 years, things hummed along with some OK years and some bad years. Now though, when the market goes down 50% you have years of growth in your portfolio to lean on. The balance after that is significantly higher than if it happened during your first year.
Sequence of return risks is one of the primary reasons why it’s important to include more bonds in a portfolio during the first few years of retirement.
What you do after those first few years is the question. Do you continue to add more bonds to your portfolio, or do you ease off the bonds back to more equities?
There are people who advise both routes. If you’re retiring near the traditional age of 60+, then continuing to ease more into bonds could make sense. Vanguard believes this too. Their $VTINX or Vanguard Target Retirement Income Fund fund states:
The Target Retirement Income Fund is designed for investors already in retirement. The fund seeks to provide current income and some capital appreciation by investing in 5 Vanguard index funds. The fund holds approximately 30% of assets in stocks and 70% in bonds.
Vanguard description of $VTINX.
About 5 years after the target date for a target-date fund passes, your investments would be converted into this fund (a tax-free conversion) where it would stay forever at this mix of 70% stocks and 30% bonds for the rest of the time you held it.
Again, this is decent advice for someone retiring in their 60s with a 30-year time horizon where failure isn’t an option. This is a super-safe portfolio.
The Bond Tent Portfolio
The other option is to use a bond tent approach as Michael Kitces’ advises. In this approach, you increase your bond allocation in the years right around your retirement but edge them back up in the years after. This helps to fend off the sequence of return risk, while also taking advantage of the stock market long-term.
In this example, Kitces mentions starting with a 90% equity exposure just like Vanguard did. Each year the portfolio got a little more conservative. About 10 years before retirement it started accelerating even more into bonds, such that by the time of retirement you have 70% in bonds and only 30% in equities.
What’s different is that in this model it doesn’t stay there. Instead, the amount of equities doubles from 30% to 60% over the next 15 years. This could potentially be done by setting all of the bond funds in the portfolio to reinvest some of their dividends in US and international equities.
The difference between these approaches comes down to potential growth after retirement. A stock portfolio has historically performed better, so by shifting more in that direction the end value of a portfolio would usually be higher with the bond tent approach than with the Vanguard approach.
Betterment Allocation
Roboadvisors like Betterment and Wealthfront have been getting a lot of attention lately. They behave a lot like target-date funds do – moving from aggressive to conservative strategies as the investor gets older. They also talk about other benefits like tax-loss harvesting which can save the investor money over time.
Luckily for us Betterment releases their example portfolio for us to check out!
This chart is a little harder to understand than Vanguards chart of just 4 funds, but it’s effectively doing the same thing just with a lot more funds – 13 to be exact. One of the reasons why Betterment holds so many more funds is so that it can wait for one to go down below what you paid for it, then sell it and rebuy a similar fund. It does this to try to take advantage of tax-loss harvesting. Betterment might also sell another fund that’s appreciated and use the tax-loss to balance things out – allowing you to make some trades without paying taxes.
At the 90% equities level, Betterment invests in:
- 37% International Equities
- 14% Emerging Markets
- 23% International Developed Markets
- 53% US Equities
- 5.8% Small-cap fund
- 6.9% Mid-cap fund
- 8.5% Large-cap fund
- 31.8% Total US Stock Market Fund
- 10% Bonds
- 1.5% Emerging Markets Bonds
- 2.9% International Bonds
- 1.1% US Bonds
- 3.8% US Municipal Bonds
- 0.6% Inflation-Protected Bonds
Although there are a lot more funds here, the high-level concepts are about the same. This portfolio invests 10% in bonds, 37% in international funds and 53% in US funds. Equities are split 59% US / 41% International – another example of the 60/40 split between US and International funds.
Unless you’re a robot, or you want to reallocate your funds constantly, managing this many funds would be a nightmare. As soon as one of them jumps in value you suddenly have 12 funds that are out of proportion for your target asset allocation. You can achieve this same portfolio with far fewer funds – 3 for the basics, or 5 funds if you tilt your portfolio towards small-cap and emerging markets.
The Mid-cap and large-cap funds aren’t something I’d invest in manually myself since they’re covered by the Total US Stock Market Fund already.
Warren Buffett’s Allocation
Legendary investor Warren Buffett gets asked constantly what to invest in. His answer is simple:
90% in a low-cost S&P 500 index fund, the last 10% in a short-term government bond fund.
Warren Buffet’s Legacy Allocation
That’s it – just two funds. With that, we yet again see 90% equities and 10% bonds too!
So why this allocation? This is the allocation he’s laid out in his will. You can hear it from him:
What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. My advice to the trustee could not be more simple. Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. And the reason for the 10% in short-term governments is that if there’s a terrible period in the market and she’s withdrawing 3% or 4% a year, you take it out of that instead of selling stocks at the wrong time. She’ll do fine with that. It’s low-cost, it’s in a bunch of wonderful businesses, and it takes care of itself.
Warren Buffett on why he advises a 90%/10% portfolio.
The idea here is to keep money in this portfolio at this asset allocation forever. Given that this is Warren Buffett, I’d assume this would be enough money that living off just the dividends from the 10% bonds would be enough to fund most people’s lifestyles. For most people, however, you’d probably want to add more bonds over time as we’ve talked about before.
If we were to recreate this portfolio on Vanguard, that would mean 90% in Vanguard 500 Index Fund Admiral Shares ($VFIAX) and 10% in Vanguard Short-Term Federal Fund Admiral Shares ($VSGDX).
From there, you would receive some dividends to live off of and could re-allocate every year or so.
I like this portfolio for someone with either a LOT of money in retirement or someone who’s continuing to work. The 90%/10% ratio of equities to bonds is a common thread through our examples and a great place to start if you have working years ahead of you.
Dynamic Bond Tent Portfolio
The last portfolio we’re going to look at is one that adapts and changes over time based on the date relative to retirement. It has three rules:
- Bonds: 50 – absolute value(years until retirement x 2) in bonds
- Note: Minimum of 10% before retirement, 30% after
- US Stocks: 60% of what’s left after bonds
- Intl Stocks: 40% of what’s left after bonds
For someone retiring at age 50, this would look something like this:
- Age 20: 10% bonds, 54% US, 36% Intl
- Age 30: 10% bonds, 54% US, 36% Intl
- Age 40: 30% bonds, 42% US, 28% Intl
- Age 50: 50% bonds, 30% US, 20% Intl
- Age 60: 30% bonds, 42% US, 28% Intl
- Age 70: 30% bonds, 42% US, 28% Intl
- Age 70: 30% bonds, 42% US, 28% Intl
- Age 70: 30% bonds, 42% US, 28% Intl
This matches up with the bond tent idea in a way, but doesn’t get quite as safe (remember, it used 70% bonds at retirement).
Going into retirement, or when the market is doing well, you’re going to think “man, I have way too much invested in bonds! I’m missing out on all the stock market gains!”.
If you think that then take a step back. Even in the most conservative year, you’re still invested 50% in the stock market. On top of that, your bonds are also growing! You’re not cutting your max investment gains in half, instead, it’s somewhere in the middle.
On even top of that though, you’re getting a lot of upside from the bonds. Remember this table?
| Asset Allocation % (Stock/Bond) | Worst Year | Best Year | Avg |
| 0/100 | -8.1% | 32.6% | 5.3% |
| 10/90 | ~-9.1% | ~31.3% | ~6% |
| 20/80 | -10.1% | 29.8% | 6.6% |
| 30/70 | -14.2% | 28.4% | 7.1% |
| 40/60 | -18.4% | 27.9% | 7.7% |
| 50/50 | -22.5% | 32.3% | 8.2% |
| 60/40 | -26.6% | 36.7% | 8.6% |
| 70/30 | -30.7% | 41.4% | 9.1% |
| 80/20 | -34.9% | 45.4% | 9.4% |
| 90/10 | ~-39% | ~49.8% | ~9.7% |
| 100/0 | -43.1% | 54.2% | 10.1% |
The 50/50 portfolio still returns on average 8.2% according to Vanguard. That’s way more than half of what a 100% US stock allocation would return.
Ok, let’s review the top 3 points from this lesson.
#1, target-date portfolios like Vanguards start mostly in equities when you’re decades away from retirement. From there they get more conservative as time goes on, switching more and more to bonds.
#2, if you have a few decades to invest before you start withdrawing funds, 90% equities and 10% bonds is a common asset allocation. It’s what Vanguard recommends, Betterment recommends and even Warren Buffett. It will have some serious swings and down years. It’s hard to know what your risk tolerance is until you experience something like that. If you anticipate reacting suddenly and selling if the market drops by 39%, then you might want to add more to bonds and think about 80/20 or 70/30 allocation.
#3, asset allocations change over time. They also are a lot different if you have 25x times your income saved up versus 2500x times your income. You want an allocation that will change over time, that’s maximizing your risk vs reward, that limits your downsides due to sequence of return risk and that will (theoretically) provide you with enough income for your future.
That’s a lot of things to get right What’s great is that if you’re going with a 3-fund portfolio you can get most of this down right away! After that, it’s just a matter of staying in the market for a few more decades.
We’ve looked at a lot of historic numbers so far in this course. If you base your investments 100% on historic returns than the choice would be easy – just invest 100% in a US index fund.
There’s a lot we don’t know though, and we want our portfolio to last a long time. Billionaire investor Ray Dalio touched on this in an interview:
You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.
Ray Dalio
A good asset allocation should be able to get you to your goals regardless of what the market does (well, within reason). It’s easy to skew too aggressive or too conservative.
Take a step back and look at your risk tolerance again. If your portfolio dropped by 30% or 50%, would that cause you to make a change? If it would, why not make that change now?
In the next and last lesson in this course, we’re going to do an activity for you to choose your actual portfolio. See you then.