≡ Menu

Asset allocation strategy – what we can learn from rules of thumb

am a big fan of rules of thumb when it comes to asset allocation strategy. I initially spent a long time agonising over what my ‘optimal’ asset allocation should be. I knew there had to be one, because so many learned sources talked about the ‘efficient frontier’. A fabled place, where, if I could only reach it, my blend of equities, bonds and other asset classes would function with perfect potency to give me the highest risk-adjusted return possible.

I spent a long time wandering the desert trying to find that place, seemingly getting nowhere.

Meanwhile, all around me were these little rules of thumb. Handy guidance tools that seemed to point away from asset allocation paradise and towards the quick departure lounge to ‘that will do’.

It took me a while to realise I’d actually reached my destination – the understanding that there is no right answer when it comes to asset allocation. A standpoint summed up by passive investing sensei Rick Ferri as follows:

All of this nonsense about finding the ideal allocation is nonsense. The ideal portfolio can only be known in retrospect. We can only know what we should have done, not what will happen. So, choose a few low cost index funds in different asset classes, rebalance occasionally, and forgetaboutit.

The big decision

How much of my portfolio, then, do I fill with the rocket fuel of equities versus the parachute braking capabilities of bonds?

That’s the main question that your asset allocation strategy will settle.

The answer resides in the nature of your financial goals, your needs, and your ability to take risk – a bunch of difficult questions that can only be answered with a personal examination so intimate that it’s probably best to wear rubber gloves.

However, rules of thumb can be used to set the guidelines you’ll probably be working within once you pass the exam.

No idea what your risk tolerance is? Not sure what difference a long time horizon should make to your plan? Then the following rules of thumb can grease your understanding…

The rule of thumb

(By the way, none of the authors of the rules of thumb that follow have actually named them. I’ve made the names up to hopefully make the guidance a bit more memorable.)

The ‘100 minus your age’ rule of thumb

This rule of thumb is so old it belongs in a rest home. But it’s still got legs because it helps you to work out how your age affects your pension portfolio decisions:

Subtract your age from 100. The answer is the portion of your portfolio that resides in equities.

For example, a 40-year-old would have 60% of their portfolio in equities and 40% in bonds. Next year they would have 59% in equities and 41% in bonds.

A popular spin-off of this rule is:

Subtract your age from 110 or even 120 to calculate your equity holding.

The more aggressive versions of the rule account for the fact that as lifespans increase we will need our portfolios to stick around longer, too, and that often means a stronger dose of equities is required.

Following this rule of thumb enables you to defuse your reliance on risky assets as retirement age approaches.

As time ticks away, you are less likely to be able to recover from a big stock market crash that wipes out a large chunk of your portfolio. Retuning your asset allocation strategy away from equities and into bonds is a simple and practicable response.

The Tim Hale ‘target date’ rule of thumb

What if you’re not saving for retirement? What if you’re going to need all the money on some very definite date, perhaps for a college fund or a mortgage pay-off?

We’re looking for a rule that gives us the courage to be relatively aggressive early on and then manage down our exposure to risky equities as the happy day approaches.

Tim Hale’s suggestion, in his superb UK-focused investment book Smarter Investing:

Own 4% in equities for each year you will be investing. The rest of your portfolio will be in bonds.

If your investment horizon is 10 years then you’ll hold 40% equities. When you’re T minus nine years then you’ll rebalance to 36% equities and so on.

I like this rule because it is a reminder to rein in adventurism if you want to use investing to achieve a short-term goal (say five years or less) but it takes the shackles off if your horizon is 20 years or more.

The Larry Swedroe ‘come out punching’ rule of thumb

US-based passive investing champion Larry Swedroe has come up with a similar guideline in his book The Only Guide You’ll Ever Need for the Right Financial Plan, except his recipe is far more aggressive in the early years:

Investment horizon (years) Max equity allocation
0-3 0%
4 10%
5 20%
6 30%
7 40%
8 50%
9 60%
10 70%
11-14 80%
15-19 90%
20+ 100%

This is an asset allocation strategy that is gung-ho for growth over 20 years, before embarking on a steep descent out of risky assets that turns into an equity-free glide path in the last few years.

Essentially, this rule of thumb is pointing out that market convulsions in the early years may well play to your advantage as you scoop up cheap equities, but don’t dance with the bear when time is short.

The Larry Swedroe ‘NOOOOOOOO!’ rule of thumb

So far we’ve looked at asset allocation strategy from the perspective of the need to take risk. This next rule considers how much risk you can handle.

Swedroe invites us to think about how much loss we can live with before reaching for the cyanide pills:

Max loss you’ll tolerate Max equity allocation
5% 20%
10% 30%
15% 40%
20% 50%
25% 60%
30% 70%
35% 80%
40% 90%
50% 100%

I’m always amazed by the number of people who believe that their investments should never go down. It’s a valuable exercise therefore to be confronted with the idea that you are likely to be faced with a 30% plus market bloodbath on more than one occasion over your investment lifetime.

I found it next to impossible to actually imagine what a 50% loss would feel like, even when I turned the percentages into solid numbers based on my assets.

At the outset of my journey, my assets were piffling, so a massive hemorrhage didn’t seem all that.

Experience is a good teacher though, and it’s worth reapplying this rule when your assets amount to a more sizable wad. You may feel differently about loss when five or six figure sums are smoked instead of four.

The Oblivious Investor, Mike Piper, uses a slightly more conservative version of this rule:

Spend some time thinking about your maximum tolerable loss, then limit your stock allocation to twice that amount — with the line of thinking being that stocks can (and sometimes do) lose roughly half their value over a relatively short period.

The Harry Markowitz ‘50-50’ rule of thumb

If all that sounds a bit complicated then consider the oft-quoted approach of the Nobel-prize winning father of Modern Portfolio Theory.

When quizzed about his personal asset allocation strategy, Markowitz said:

I should have computed the historical covariance and drawn an efficient frontier. Instead I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret, so I split my [retirement pot] 50/50 between bonds and equities.

The Accumulator’s ‘rule of thumb’ rule of thumb

Here’s my contribution:

Rules of thumb should not be confused with rules.

I have to say this, of course, lest the pedant cops shoot me down in flames, but it’s true that rules of thumb are not fire-and-forget missiles of truth.

They are exceedingly generalised applications of principle that can help us better understand the personal decisions we face.

The foundations of a proper asset allocation strategy are a considered understanding of your financial goals, the time horizon you’ve got, the contributions you can make, the likely growth rates of the asset classes at your disposal, and your ability to withstand the pain it will take to get there. Amongst other things!

Rules of thumb can help us get moving and, as long as they’re tailored, can help us answer questions to which there are no real answers like: “What is my optimal asset allocation strategy if I wish to be sitting on a boatload of retirement wonga 20 years from now?”

Take it steady,

The Accumulator

Receive my articles for free in your inbox. Type your email and press submit:

{ 51 comments… add one }
  • 1 Elizabeth June 26, 2012, 12:18 pm

    What about the % tied up in one’s home or other real estate?

  • 2 Simon June 26, 2012, 12:20 pm

    Thanks, useful stuff, and very well timed for me.

    I’d love to see similar guidance regarding geographical diversification within one’s equities, especially for those of us in the little old UK, surrounded by the giant economies of North America and the East, along with the turbulent uncertainty of the Eurozone.

  • 3 mm June 26, 2012, 12:28 pm

    very nicely summarised and explained – thanks

  • 4 Paul Claireaux June 26, 2012, 12:44 pm

    This is all interesting stuff but it misses a couple of very big questions.
    Firstly how do you invest the safe (bond) proportion given the horrendously low yield (high risk) of UK bond markets right now.
    A 70 year with 70% in Bonds would be taking a very high risk with their capital.
    Answer. Don’t use rules of thumb – take account of market distortions, stay short (hold a good slug in cash deposits) despite low interest rates. or let a fund manager provide the mix of bonds for you.

    The second big issue? – well that will be covered in my forthcoming book.

  • 5 The Investor June 26, 2012, 1:02 pm

    @Paul — The low yields are a big concern, but I don’t think it’s correct to say long-term investors are taking a big risk with their capital. As far as I’m aware, the yield to redemption of all but the very shortest Gilts is positive. You’ll get your money back after taking income into account unless the UK government defaults, and I can think of no circumstances in which it would be in its interest to do so.

    The real risk is that you get return of capital, but basically no return *on* capital. That’s why as a pretty active investor I hold no gilts currently. I am happy to let cash and NS&I index-linked certificates add some safety ballast to my portfolio, albeit not with the benefits you’d expect from bonds in normal times (due to bond’s already tiny yields).

    But anyway, this article is aimed at passive investors, and the whole point is with passive investing you don’t go around speculating and thinking you know better than the market. Exactly the same arguments about gilts you and I might make about bonds could have been made on January 1st 2011, and gilts returned double-digits from memory last year, and were the best performing asset class. Passive investors use rebalancing and strategic allocation as their weapons, not speculation about the market.

    Finally, as I always say we can’t include everything in every article, hence all the little blue links. 🙂 Here’s a recent article on exactly the difficulty of investing in bonds right now.

    Cheers!

  • 6 Paul June 26, 2012, 1:29 pm

    Simon,

    One of the best ways of getting geo-diversification is to invest in the little old UK (the LSE, that is). The ten biggest shares in a typical fund tracking the FTSE All-Share Index accounted for 35% of the total, it is even higher, 45%, in a FTSE100 tracker, and they are all major international players.

    These companies only derive a relatively small part of their profits from within the UK, in some cases next to nothing.
    The big ten are:
    HSBC; Vodaphone; BP; Royal Dutch Shell A; GlaxSmithKline; Royal Dutch Shell B; British American Tobacco; Rio Tinto; BG Group and Diageo.

  • 7 webnibbler June 26, 2012, 1:43 pm

    Thanks for the good post.

    It seems sometimes that the passive / managed approaches are portrayed as completely polarized, when in reality many investor follow a mixture of the two.

    I’m wondering if this could be considered in terms of an allocation, say 80% passive / 20% active, perhaps based on cost?

  • 8 Paul June 26, 2012, 2:18 pm

    TA, From this article it sounds as though 30% plus losses are likely and even, from the NOOOOOOO! tabulation, that a 50% loss may have to be faced. The only people who have to face this are those who buy all their shares at the peak of a (massive) bubble and sell them all at the bottom of the following trough.
    It reminds me of the Great Crash of 87. In October 87 the market plunged 34%…….end of capitalism as we know it!! The only people who lost 34% were those that bought on 5th Oct and sold on 9th Nov. In fact the market rose 19% over 1987 as a whole so long term investors had a pretty good year. Market flutuations are not the same as losses.

  • 9 57Andrew June 26, 2012, 2:18 pm

    “Liked” 🙂

    I am freshly retired at 55 (part choice, part health grounds) and I manage my own pension fund. I am about 20-25% cash, about 30% bonds / bond funds and the rest is equities. The question I asked myself is how soon will I need to tap the fund. We have some investment property that covers the monthly bills, some cash in hand and a portfolio of shares that provides dividend income and so I concluded that I probably would not need to tap the fund for 10 years at least. Now rental incomes could fall, the equities could crash, cut dividends etc but I feel there is enough breadth to keep us in a reasonable but by no means extravagant lifestyle. So I am not a great believer in the rule of thumb. My guess is that on most metrics I would be over-exposed to equities. But I feel pretty happy with the allocation. My biggest mistake when I started managing my pension fund was to over-diversify. I ended up with too many modest holdings that ranged from the ultra boring to the frankly (with hindsight) frivolous and imprudent. My portfolio has been heavily rationalized. It is now part passive part active but slowly moving more to the former. I have concluded that the critical thing is to have enough liquidity for your foreseeable needs plus a fair bit more. As I get closer to drawing down I will almost certainly create my own bond ladder and reduce equity exposure but it will depend on how the world looks at the time. I don’t see a magic formula.

  • 10 Paul Claireaux June 26, 2012, 2:40 pm

    To the investor.
    As ever the answers depend upon personal circumstances.
    Someone of 60 in a pension fund drawing down income needs a stable (ish) return. Drawing down heavily on a declining fund value risks extremely rapid capital erosion.
    My point is simply that a 60/40 bond equity fund – whilst having produced lovely past performance during the last 30 years of bond bull market could well be at it’s minsky moment (turning point) . The short term value (from which withdrawals are taken) of long term bonds get’s savaged when inflation and interest rate expectations rise.
    So hang on to a good slug of short term stuff and cash.
    Don’t assume a mixed or tracking bond fund offers diversification safety relative to equities for the future.
    Remember – in a crisis only one thing goes up – correlation.

  • 11 Johnjane June 26, 2012, 3:40 pm

    57Andrew makes a good point.

    If the end point is to draw down from a HYP type portfolio then it doesn’t make sense to have significant investment in low yielding bonds on the way to the target date.

  • 12 Adrian June 26, 2012, 3:56 pm

    I really nice summary of nearly everything you really need to know about asset allocation.

    One think I learnt in 2008 was that my real appetite for risk in a plunging market was much less than I thought it would be in my imagination. I expect many investors particularly those within a decade of retirement might have found the same.

    The rules of thumb about maximum equity allocations based on maximum sums you are prepared to lose in a crash are really helpful for older investors (who have less recovery time) I think.

    Your article on the current dilemma about bond investing was also really informative. (Advice to avoid overly long bond durations and to consider cash and index-linked certificates where possible as part of the non-equity allocation)

    Thanks!

  • 13 The Investor June 26, 2012, 4:38 pm

    @Paul — Sure, I get the danger in government bonds. As I say I have none. I’m just saying that (a) passive investors are *passive* investors. Duck and dive out of that and you’re something else — history suggests an under-performer. And (b) while it might be obvious that gilts are expensive, they could stay this way for decades (see Japan — I don’t expect it, but it’s possible).

    Did you read the article I linked to? It explains that a rising rates environment isn’t as terrible as it seems even for bond funds, as they can roll into higher yielding securities as their existing holdings mature.

    From the article I linked to: “According to Vanguard, the largest annual loss that a 100% UK bond portfolio would have suffered in the last 30 years is -6.27% (in 1994).”

    That’s 100% bond portfolio — in reality, a mixed 60/40 portfolio would have equities likely to be doing a lot of heavy lifting to make up for the short-fall from the declining bond fund. Even if we assume this is the end of a 30-year bull market in bonds (still very much moot) I don’t see people’s bond funds being decimated as you’d see in an equity crash, more just extremely poor and mediocre.

    Caution is warranted, granted, for those of us of an active bent, but clear diversification and perhaps a heavier allocation towards cash and the shorter end as you suggest is probably as far as a passive investor wants to go.

    (A 60-year old drawing from a pension fund who is all-in bonds currently should probably annuitise and be done with it).

  • 14 david stuart June 26, 2012, 4:52 pm

    thx–great article

  • 15 Paul June 26, 2012, 4:53 pm

    A quote from Warren Buffet in this year’s Berkshire Hathaway letter:

    Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems
    apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

  • 16 Paul Claireaux June 26, 2012, 5:21 pm

    Bond fund performance over (or worst case period during) the last 30 year is not a very useful indicator for the future as it’s been pretty much a one way ride. Reducing interest rates and rising values of bonds.

    A look back to the last big turning point upwards on bond yields – using Barclays Gilt Equity study – might be useful. Will do so when i have some time.

    And watch out for Annuitisation idea – it’s is also a one way ride. Once it’s done it’s done. No reversing off that decision so be very careful it’s the right one before jumping especially right now as the rates are on the floor. (and buy the right type – if your health is bad get an enhanced annuity quote – take some advice)

    Can the yield floor go for long UK bonds go lower?- e.g. Japan – Well I guess so I guess so but the risk must be that it jumps up from here. I’m just concerned that folk don’t view bonds and funds as safe havens as this turning point.
    Things can get very messy when bond markets turn. Witness several European countries that used to have bond yields similar to Germany’s

  • 17 ermine June 26, 2012, 6:06 pm

    > I found it next to impossible to actually imagine what a 50% loss would feel like,

    It feels like a bastard. No fun at all. Been there, in the dot-com crash. With the benefit of hindsight, the training was worth every penny. It didn’t feel like it at the time, and it took nearly a decade to return to the fray.

    Now I can tolerate the odd nearly 30% hit on occasional shares with equanimity, as long as they stay paying dividends, and I have seen the benefits of sitting tight and the 30% hit melts away over time.

    It has to be said that some of the education on here has reduced the overall volatility of my portfolio to a lot less than the 30% 😉

  • 18 Paul Claireaux June 26, 2012, 6:20 pm

    I just had to look up that data on the UK bond index. Data from the world renowned Equity Gilt Study.
    Worst 5 year period in last 50 years?
    Not surprisingly – was 1971 to 1976.
    Real (total return i.e. gross income reinvested a la pension or ISA) returns on the medium term bond index was . . . wait for it . . . .
    Minus 10.7% per annum.
    That’s a 43% real terms loss over the period.

    The worst year ?
    Yep you guessed it again – 1974 – the same year that the stock-market tanked. The bond index lost 40% in real terms.
    Mind you back then there’s was loads of yield on gilts to soften the blow. So the loss was reduced to a modest 30% after income reinvested.

    And the moral is?
    Watch out about making any assumptions that UK or USA bonds are safe. Havens.
    Short term individual gilts held to maturity fine
    But managed funds of them – with loads of long duration bonds inside – Not on your nelly – not now.

    Trust this helps

  • 19 The Investor June 26, 2012, 6:28 pm

    @Paul — Good stuff going back beyond 30 years; interesting. We agree much more than we disagree; I am just very wary of encouraging passive investors to start become active asset allocators as I think most people will do much worse once they begin playing that game. Maybe this bond call will prove sound or maybe not, but they then have to keep up their right calls for 30 to 40 years… The data suggests they can’t.

  • 20 Paul Claireaux June 26, 2012, 6:53 pm

    Hi,
    I think you need to strip out the concepts of passive investing for low costs – which is fine – from asset allocation.

    Even within both asset classes (equities and bonds) and whilst I accept perfect market timing is not possible – I do think it’s quite easy to avoid the “big tops” –and assume Mr Ermine would have liked to have known about this in 1999?

    It’s also reasonably easy to guage when we’re somewhere close to a bottom – if not precisely at one.
    Being close to a bottom should be nice experience – not a horrific one! But recognising a bottom is only possible once it’s walked past!!
    “Boom Boom”

    To keep things simple – when we have very little invested (compared to our lifelong goal) and we’re a long way from wanting our funds then a simple drip feed strategy is fine. And long only equities is better still. Ride the bumps because they just don’t matter – falls are all good news in the world of pound cost averaging.
    But once we’ve accumulated a reasonable chunk of our goal (and whilst continuing to drip feed any new money – without much thought- into risky assets is fine) it also becomes paramount to consider how to protect what you’ve got.
    Reverse pound cost averaging is ruddy dangerous.

    Maybe we’ll have to agree to disagree on this but I hope you’ll add my book to your recommended list later this year.

    Probably best that I get back to writing it now.

    Paul

  • 21 Arch Sceptic June 26, 2012, 8:22 pm

    Some very interesting comments. Paul’s point about 30 years not being long enough to view potential bond volatility and his data from the Equity Gilt Study on the 1970’s are highly relevant. I’m old enough to remember that inflation as measured by RPI topped out at 26% in 1974 and there were rumours at that time of plans for a government take-over by ex-army officers to address the economic and political chaos!

    Index-linked gilts were not available until the 1980’s: one can presumably assume that index-linked gilts would hold up comparatively well in a 1974 scenario. For people of retirement age where capital preservation and preservation of purchasing power are paramount, indexed-linked NSI certificates (when available) and index-linked gilts seem to me to be good core holdings. However, since neither pay commission to intermediaries and are therefore not aggressively sold, they have to be actively sought rather than acquired via “financial advisers”.

  • 22 The Accumulator June 26, 2012, 8:44 pm

    @ Elizabeth – I don’t think of my home as an investment – I’m always going to need somewhere to live. Other real estate holdings should be sliced out of your equity allocation.

    @ Simon – You could look at the holdings of a developed world or all-world ETF or index fund as a good proxy for a global portfolio.

    @ Webnibbler – Yep, plenty of people do this. Personally I use investment trusts to access the small-value equity sub-class because I can’t access it with passive funds. In this case, I use a low-cost IT and feed in a percentage of funds in line with my small-value allocation.

    @ Paul – check out Ermine’s comment.

    @ Paul C – Don’t think anyone in their right mind would declare any asset safe. Point is, if you’re long on equities and you want a low correlation asset that will reduce your risk if things get even worse (perfectly possible) then bonds are a reasonable bet. Is any strategy guaranteed? No. Will it work every time? No. Should you take into account the risks that affect your particular circumstances? Yep.

    If I’m a 70-year old then I’m particularly vulnerable to inflation risk and duration risk. I absolutely agree with you that short-term maturities and plenty of cash to take care of living expenses would be high on my agenda. But if I’m 30 with 30 – 40 years to go and a high equity allocation, then no. I’d happily use long-term bonds to offset the possibility of deflation, knowing that reinvested income and rising yields will ‘smooth out the bumps’ as and when interest rates rise.

    Agree though that rules of thumb are guidelines only, not think-free, get-out-of-jail free cards. As for ease of market timing, the bulk of the evidence suggests that most investors damage their returns by trying to market time.

  • 23 Adrian June 26, 2012, 9:10 pm

    As a strict passive investor I would normally be with the Investor on this. But the choice between short and long duration bonds at the moment is for me a question of risk management regarding wealth preservation, so I am with Paul. Elsewhere the current dilemma about bond duration in the context of historically low bond yields has been described in terms of Pascal’s wager. (An argument about the existence of God where the downside for the non-believer who is wrong is far worse than for the believer who is wrong!)

    http://en.wikipedia.org/wiki/Pascal's_Wager

    In the current context the investor who goes for short duration bonds and gets it wrong (when yields fall) has lost a few points of yield . The investor who goes for long bonds and gets it wrong (when yields rise) will suffer much greater losses.

    By the way there is a recent interesting conversation with William Bernstein on the bogleheads forum about this subject.

  • 24 Adrian June 26, 2012, 9:15 pm

    PS Previously missed the Accumulator’s comments and agree that investment horizon is relevant to appetite for longer duration bonds

  • 25 The Accumulator June 26, 2012, 9:18 pm

    @ Arch and Adrian – interesting points both and well worth thinking about. The Boglehead rule of thumb for allocating between nominal and index-linked bonds is to go 50:50.

    Pascal’s wager is much beloved of Bernstein, as I recall, and he’s definitely in favour of short-term bonds. Do you have a link to that forum discussion?

  • 26 Adrian June 26, 2012, 10:20 pm

    Here is the link

    http://www.bogleheads.org/forum/viewtopic.php?t=75060

    The relevant comments are quite a long wasy down around 20-21 May.

    I have always liked his definition of bond duration as the ‘point of indifference’ by which I think he means the time by which the sum originally invested in a bond / bond fund will have been returned to the investor as yield.

  • 27 FenMan June 27, 2012, 7:37 am

    I don’t have any bonds and I don’t understand them! Practically everything is in equities paying good dividends. There’s a few bob scattered around bank accounts in fixed rate accounts but that’s only to de-lumpify the drip feed into more equities.

    I’ve become a bit of an equities believer (and it is faith rather than knowledge) and I simply see it hard to find other asset classes which will, over the long run, deliver an income directly coupled to economic growth[1]. (Property is too much like hard work to own – though I am investigating REITs).

    [1] possible dangerous assumption of continued growth in that sentence.

  • 28 The Accumulator June 27, 2012, 7:49 am

    @ Adrain – thanks for the link. Will take a look at that tonight.

    @ Paul – re Warren Buffet letter – it’s a great quote that highlights as much as anything the wrong-headed notion that an asset can be defined as risk-free. Even the cash in my bank account is being silently nibbled away by the moths of inflation. The Sage also mentions in that letter that Berkshire Hathaway maintain large liquid positions.

  • 29 The Investor June 27, 2012, 7:59 am

    @Adrian — Interesting thread. The comments from ‘Matt’ are relevant, I feel. If we enter a deflationary period, long-term bond yields will very likely fall further — yields in Japan fell from 3% to 1%. That’s a huge capital gain for long-term bond yields, and anyone only holding short stuff would face either rolling it into lower long-term bond yields or staying in short duration / cash for the foreseeable, which has turned out to be decades in Japan.

    Worse, deflation is bad for equities, so you’d see that part of your portfolio fall, perhaps precipitously, too, in that scenario. In contrast, in an environment where long-term bond yields start to reverse, bond funds with longer-duration will likely fall (though as discussed if you hold individual long bonds to maturity you *will* see return of capital) but that will very likely be dwarfed by a steep rally in equities, since it would presumably coincide with economic recovery and a resolution of the fear and dread (Europe, government debt etc) that has taken long-term bond yields down to these low levels.

    I stress again, on a personal level deflation/long gilts is *not* my bet. I’m a pretty active investor, and I have no long-term government bonds as I type. I am with that camp when it comes to where I place my chips. Thus it’s a bit ironic to be defending asset allocation that has a long-term bond component.

    But I stand by my comments that passive investors following a portfolio approach are probably best off sticking with their allocations, and not trying to call markets that are *not* obvious or one way bets, whatever any of us think is likeliest.

    If the bond component falls in value a bit over a few years (which as I say I happen to agree is the most likely outcome), that has to be seen in context of how the overall passive portfolio performs — the idea is *not* to punt on the best asset class every year, it’s to get an overall satisfactory return.

  • 30 Greg June 27, 2012, 9:49 am

    I would point out what sort of job you have matters a lot:

    University lecturer = bond-like job: have more equities
    Salesman on commission = equities-like job: have more bonds

  • 31 Adrian June 27, 2012, 9:51 am

    http://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/

    @investor. I completely agree with you that it is dangerous and wealth destroying to take try to predict or to take bets on the market. I also agree that a deflationary environment is possible, as of course is a few years of high inflation (Like you I know I can’t know the direction of the market). For anyone with a long investment horizon, on this basis, I would agree that the best strategy, even now, is to buy bond index ETF / mutual fund (current weighted duration of the UK gilts market is around 9.6).

    The link above which you may have seen is reassuring and contains some interesting data on historical returns on US & Canadian long-term bonds (see ‘And the bond played on’ – where it seems that an annual double digit fall has been a very rare event).

    For all that if I was a newly retired investor with only a medium-term investment horizon I would argue (on risk management / Pascal’s wager grounds) that it currently makes sense to keep your bond duration shorter than the market average of 9.6. You could use iShares 0-5 year gilts ETF (although current YTM is only around 0.5%) or as I would you could mainly follow the recent discussions / advice to use cash as a substantial part of the non-equity portfolio.

    Incidentally, I think the dictinction between making decisions on a risk management basis vs ‘knowing better than the market’ approach is crucial. Although both involve adopting a non-market average portfolio the justification for doing this is very different and they are pretty much opposites. In the latter an investor claims (foolishly nearly always) to have better knowledge than the market. In the former the logic is ‘I know I can’t time or predict the market, but what I do know is that for my personal circumstances the risks of changes in the market are asymmetrical’. ie the downside risk of the market moving sharply in one direction (in the case of the current discussion regarding bonds if yields rise) is much worse than a market move in the other direction.

  • 32 Neverland June 27, 2012, 1:37 pm

    @ Greg

    The point you make about job security being a factor is very good one, but….

    Are there really many “bond like” jobs in the UK at the moment?

    The public sector headcount will shrink c. 20% in the next 5 years under current government plans (and out of date optimistic government revenue forecasts)…

    …the only real “bond like” job I can think of are under-takers 🙂

  • 33 Paul June 27, 2012, 2:32 pm

    @TA. Buffet’s liquidity is, as he says, mostly in Treasurty Bills which are, essentially 1yr bonds.

  • 34 the other Nathan June 27, 2012, 4:26 pm

    Although not to many people’s taste the Permanent Portfolio asset allocation;
    http://monevator.com/9-lazy-portfolios-for-uk-passive-investors-2010/
    is worth picking apart to see how a portfolio containing very volatile but uncorrelated assets perform to give fairly steady growth through different conditions.

    A couple of things that I picked up from Harry Browne’s thinking are that
    * you’re not holding long term Gilts for their yield
    * cash is an important asset, not just an “opportunity cost”
    * you need tight, concise rebalancing rules

    There’s also a whole load of thinking about how to hold your assets that’s worth consideration whatever your chosen allocation.

    When I was floundering about trying find out about asset allocation I found this comparison of the major (US I’m afraid) asset allocation strategies quite useful.
    http://madmoneymachine.com/2012/02/28/lazy-portfolio-analysis/

    By far the most illuminating experience wrt. asset allocation I had was holding an advisor managed, equity heavy, “balanced” portfolio, with cash in an Icelandic bank in 2008. Happy days 🙂

  • 35 The Accumulator June 27, 2012, 9:39 pm

    @ Adrian – thanks for drawing attention to this thread:
    http://www.bogleheads.org/forum/viewtopic.php?t=75060

    Fantastic stuff. I’ve even ignored Spain v Portugal to get through it. I thoroughly recommend this thread to anyone who’s interested in how to handle their bond allocation in these extraordinary financial times.

  • 36 Moneyman June 28, 2012, 6:00 pm

    Great topic & comment thread.

    Perhaps I can offer a different perspective? My own financial enlightenment was to realise that ultimately I was saving/investing primarily to provide an income in retirement – so therefore why not develop a portfolio that provides an income? I also realised that there are several ‘layers’ of income that can be bought, with different risk characteristics. So the equities/bonds allocation is too simplistic.

    My main asset classes are: property (family home – avoiding housing costs in later life), pension fund (through work) and financial assets – in the ratio of approximately 1/3 each. The financial assets include 3 main asset classes: cash/cash deposits, dividend shares, and fixed-income assets (such as gilts/government bonds, corporate bonds, PIBS and others) – in a ratio of around 1/3 each.

    However, within each of the financial asset classes there is clearly a spectrum of risk: again, for dividend shares and fixed-income assets I aim for a split between low/medium/high risk holdings.

    Obviously, you can’t start with this overall portfolio but I suggest it as a potential target allocation – in other words, the end-game of your investing career.

  • 37 The Accumulator June 28, 2012, 8:31 pm

    @ Moneyman – thanks for your contribution. You’re right that discussion of an equities / bonds split is quite a low-res view of asset allocation. You can certainly zoom in for more detail.

    For me that would mean:

    Equities – broad market index, small-cap and value. Property and commodities allocations would also be carved out of equities although not my house. That’s not an investment, that’s a roof over my head.

    Fixed income / defensive assets – gilts, NS&I Certs and cash. Gilts break down into short-term bonds, long-term, intermediates and index-linked (i.e. anti-inflation).

    These are the assets that I both understand and have a useful function to perform in my portfolio. I try to consider all investment sources as part of one portfolio i.e. ISA holdings, pension holdings and regular holdings are all considered part of the same whole – at least as far as my retirement plans are concerned. Rainy day fund and mortgage fund are considered separately as time horizon is different.

  • 38 SemiPassive June 28, 2012, 10:37 pm

    The point The Accumulator makes about viewing ISAs and pension/ SIPP as part of one portfolio is interesting, my tax situation makes SIPP contributions much more efficient, but wanting to maintain a large cash position (earning 0%) is difficult in a SIPP. Hence while I continue to drip feed into equity funds in my SIPP I may gradually liquidate my stocks and shares ISA and shift that money into Cash ISAs instead.
    My current SIPP positioning is 50% cash, 25% index linked gilts and 25% cash that is waiting for a correction before topping up equity index funds.
    I’d feel happier about having 75% in equities within my SIPP if my Cash ISA pot was bigger.
    I’m with Paul C on conventional gilts, although they may have one last hurrah if we have a sharp correction in the next 6 months or so.

  • 39 SemiPassive June 28, 2012, 10:40 pm

    Oops, that should have read “My current SIPP positioning is 50% equities”.

  • 40 The Investor June 28, 2012, 11:37 pm

    @SemiPassive — Our recent guest article in praise of cash by Pete Comely had a link to some interesting SIPP-able deposit accounts:

    http://www.investmentsense.co.uk/free-services/best-buy-savings-accounts/accounts-for-pensions/

    I’m not sure of the mechanics of using them, having never done so myself, but the rates there are seemingly much better than the 0% you’re getting so worth investigating perhaps if you’re keen on holding a big slug of cash in your pension.

  • 41 SemiPassive June 29, 2012, 11:20 am

    Thanks for the link, once you can get 3.5%-4% (eg keep up with inflation or the dividend yield of the FTSE100) it becomes more viable to hold cash. Although my SIPP provider doesn’t offer access to those accounts and I wonder whether there is tax to pay on the interest or are those gross figures like Cash ISAs where you get to keep the lot regardless of your oncome tax band.

    On the ‘traditional’ age related move to increasing bond allocation, as with another poster my current aim to beat inflation (avoiding level or inflation linked annuities which are appalling value)
    will be to use income drawdown based on a SIPP full of higher than average yield shares.

  • 42 Paul Claireaux June 30, 2012, 3:50 pm

    To Semi Passive
    You could well be right about the last hurrah on mid and longer term gilts but I wouldn’t place money on it myself. A shift up in inflation expectation or a shift down in the UK’s rating could knock these securities for six.
    Interesting to see you hold a fair % in linkers and I’d be careful there too. In his book – “The Trouble with markets” Roger Bootle (one of the more intelligent economic forecasters) offers well reasoned argument of the risks with these assets in the event that we do flip into the dreaded deflation. I’ll try to summarise:
    Gilts and Linkers are priced according to a discount rate for valuing future cash flows. That rate is normally linked to inflation at say RPI plus 1% pa which makes linkers fairly stable in price during most “normal range” periods of inflation.
    However, if we slide into deflation the discount rate for pricing these securities is forced up. Why? Because it cannot go below zero at the short end where cash gives a minimum zero return.
    So, if the expected rate of inflation (deflation) fell to say -3% on a 5 year outlook we might have a discount rate of +3% pa over that period. Giving a nominal expected return of 0%.
    The rising discount rate – which might be less prominent further down the yield curve – would nonetheless rise at most durations reducing the present value of future cash flows. In other words prices would fall.
    To quote Bootle – “this quirk complicates indexed bonds. Many people expect them to be safe and predictable instruments throughout their life and not only if held to maturity. This they are NOT – if the economy flips into deflation.
    I wouldn’t say hold none as we all need to hedge against inflation (as well as deflation) but I hope this helps.

  • 43 Paul Claireaux June 30, 2012, 3:52 pm

    Should have read
    “if the expected rate of inflation (deflation) fell to say -3% on a 5 year outlook we might have a discount rate of RPI +3% pa over that period. Giving a nominal expected return of 0%”

  • 44 Adrian June 30, 2012, 8:21 pm

    @semipassive

    I am not sure if this is right but another way of explaining price movements of index-linked gilts is I think as follows.

    The price of linkers is determined by market expectations of inflation. If the market expects high inflation the price of the linkers is high. If the market expects lower inflation or even deflation then the price of linkers falls.

    Now consider the following scenarios:

    (1) A short-term investor who invests in a single index linked gilt. The gilt is sold before maturity. The investor buys at high inflation expectations and sells at low inflation or even deflation expectations. The price is high at the time of purchase and low at the time of sale and the investor gets badly stung. This the concern in your post.

    (2) A longer term investor buys a single index linked gilt and holds it to maturity. The investor buys at a price expecting 2% inflation but over the remaining term of the gilt there is 5% deflation. The investor will clearly loses out but not necessarily by very much in REAL terms. Even if the nominal sum returned is less than the nominal sum invested, the point is that in a deflationary environment the real value of the sum returned will be to some extent protected. (Suppose the investment is £100 and £90 is returned. The £90 post-deflation will buy almost as many goods as £100 pre-deflation.)

    (3) A long term passive investor who buys different linkers at different time points and holds them to maturity. Sometimes the investor will be lucky and real inflation will be higher than the market expectation of inflation at the time of purchase. Sometimes the investor will be unlucky and real inflation will be less than the market expectation at the time of purchase. However, on the average over the medium term the investor’s luck will balance out and the investor will get protection from EXPECTED inflation.

    Most importantly though , in all three scenarios the investor gets protection from UNEXPECTED inflation. Only in scenario 1 does the investor (more a gambler than an investor in this scenario) risk a serious erosion of wealth in return for buying this protection. To my mind the point of investing in linkers is as a hedge against UNEXPECTED inflation and in sensible scenarios (ie 2 and 3 above) there is only a low risk of significant loss of purchasing power.

    I should say that I am very much an amateur self-taught investor and I would appreciate comments about scenario 2 particularly any proper quantative analysis.

    All the best

    Adrian

  • 45 Adrian June 30, 2012, 8:23 pm

    The post should have been to @paulclaireaux too!

  • 46 Adrian July 1, 2012, 6:48 pm

    @paulclaireaux @semipassive

    http://www.fixedincomeinvestor.co.uk/x/learnaboutbonds.html?id=206

    You are probably familiar with info in the above link and similar information on the debt management office site but it confirms what I thought.

    If index linked certificates are bought at par then you can’t lose purchasing power even with deflation provided they are held to maturity.

    If you buy at a price different from par then you may gain (if actual inflation is worse than the priced-in expected inflation). Or you may lose (if actual inflation is better than the priced-in expected inflation).

    However, if you buy index-linked gilts of different durations at different times (eg pound cost average with an index-linked gilt index fund) then the times you lose by buying at non-par will be balanced by the times you win.

    So, for the investor in the draw-down period (eg a retiree) index linked gilts offer guarantee of purchasing power with the added benefit of protection against high unexpected inflation. There are two main costs for these benefits. The first is to lose out on actual gains in value and purchasing power from ‘normal’ bonds during deflation . The second is to lose out on the equity risk premium.

    Anyway for me as I approach the wealth preservation / drawing down period it makes sense to have a significant proportion of my bonds in linkers. I have a small proportion of gilts but otherwise I am very close to semi-passive’s 50% equities 25 % index-linked and 25% cash.

    A

  • 47 Adrian July 1, 2012, 6:49 pm

    I meant index linked bonds not certificates!

  • 48 Paul Claireaux July 2, 2012, 1:10 pm

    To Adrian.
    I wouldnt question your arguments but I’d prefer not to buy linkers to hold to maturity. The consolation that linkers maintain purchasing in a deflationary spiral does not sound like fun.
    Protection from deflation can be had with cash and short gilts which also offer the option of selling out to buy the stuff that get’s really cheap in deflationary times – equities or property.
    Also – as Credit Suisse note in their last yearly report – Gold performs best of all during times of both high inflation and high deflation.
    I’ve reduced my Gold holdings of late but still retain a fair proportion in that assets class just in case fear of mass soverign default takes hold again. That credit risk is also something we need to factor in to pricing of Gilts and Linkers.
    Tricky business investing eh !

  • 49 Adrian July 2, 2012, 1:45 pm

    I wasn’t meaning to imply that linkers are the investment of choice in deflation just that even in the worst case deflationary scenario they should largely maintain purchasing power or real value despite showing a nominal fall. Cash and ‘normal’ nominal bonds are as you say clearly going to be better in deflation. For me the answer over the long term is too hold a bit of all three ie cash, nominal bonds and index linked bonds.

    We’ll have to disagree about gold!

  • 50 emanon September 2, 2013, 10:02 pm

    I am setting up my portfolio as well as my wifes all wrapped in an ISA, until we can hopefully meet our ISA allocation and also tuck some more into SIPPs

    We do not have the exact same asset allocation. Should these be viewed as 2 separate entities or should they be seen as a holistic portfolio in order to get a clearer idea of how close we may be to our goals. We are the same age and have the same goals (she just doesn’t know it yet) so there’s nothing too complicated there. What are the ‘rules’ about managing two or more portfolios?

Leave a Comment