I 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…
(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|
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|
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,