Former hedge fund manager Lars Kroijer now advocates passive index investing as the best approach for most people. You can read more in his book, Investing Demystified
How you should allocate your portfolio across the main asset classes – shares, bonds, cash?
Like most things in investing (and in life) it depends on your circumstances and your tolerance for risk.
Age is a big factor for nearly everyone, though.
The following diagram shows how your portfolio allocation may shift between equities (shares) and the minimal risk asset (government bonds for UK and US readers) over the course of your lifetime.
(Note: To keep things simple I’m ignoring the complications of riskier foreign government bonds and also of corporate bonds.)
As you can see, most people should start off with a relatively heavy allocation to shares. Over their lifetime this is gradually tapered and replaced with a growing allocation to government bonds.
The rest of this post explains why this is usually a good idea.
How should younger savers invest?
Generally speaking, young savers should allocate a greater portion of their portfolio to riskier assets.
Young people are in the early stages of saving, and the cumulative benefits of even a small outperformance from a riskier allocation can add up to a large amount of extra money over the coming years.
If the markets turn south, young savers have decades before they need the money. They have more time for their investments to recover and make up the shortfall, or for them to adapt their lifestyles or increase their saving rate to fix the problem.
The best time to learn about the markets and how to deal with its risks is when you’re young. Getting into the habit of saving money and sticking with it will serve you very well over your lifetime, particularly as you begin to see the cumulative gains from being a saver due to compound interest.
My advice if you’re young is that you take a risk with your savings and put a lot in the equity markets. Be ready to see it rise and fall in value – perhaps dramatically – and keep enough cash in the bank so that you can afford to ride out a big fall in the stock market (known as a “drawdown” in investing circles).
You should also familiarize yourself with all the tax benefits that might arise from pensions or other savings vehicles, such as ISAs in the UK, in order to ensure you keep as much of the return as possible.
How should you invest in middle age?
Once you’re into your 30s and 40s, you’ve passed into the ranks of the mid-life savers.
You could well be at your prime in terms of earnings power and you’re probably getting a sense for how things are going to turn out for you career-wise, too.
You might also be starting to get a feel for what your expenses in retirement will look like. And maybe how many income-earning years you have left before retiring.
Often you’ll want to allocate a greater fraction of your portfolio to your minimal risk asset, perhaps in longer-term bonds, than you did a couple of decades earlier.
But whilst you could already have accumulated a fair amount of money in your portfolio by this age, in most cases the potential extra return from keeping a continuing allocation to equities will be important to reaching your financial goals in retirement.
Should the equity markets be bad going forward, you still have some working years to address the losses on your investments, either by saving up more and reducing your current spending, planning to work longer, or reducing your expected spending power in retirement.
For many mid-life savers, tax considerations should again play a major role in the execution of their portfolio.
Make sure you’re thinking with a multi-decade time horizon when deciding where to shelter your assets, and keep up-to-date with the latest government legislation.
Asset allocation for retirees
At the other end of the spectrum we have someone already in retirement – perhaps without a huge excess of savings to get them through their remaining years.
This group of savers should have a far lower tolerance for risk. That’s because they have fewer options to make up for a shortfall if the stock market turns against them.
At the risk of over-simplifying, if you are not going to benefit very much from the upside of having more money (with limited years left to enjoy it) because you already have enough – but you would experience the painful downside of having to eat beans on toast in your old age if your investments go down – then don’t gamble with your retirement and stay with minimal risk bonds.
Of course estate planning and passing on assets to the next generation could well play a major role here, in terms of the exact structuring of your portfolio.
Also consider what non-investment income you can expect – company pensions, social security, and so on – and compare that to your expected outgoings.
The difference between the two will need to come from investment income, or by liquidating part of your portfolio for cash or a guaranteed income such as an annuity.
While rules of thumb don’t apply universally, if you retire at the typical age and stick to only spending 4% of your portfolio per year, you will probably be fine. (You can increase that percentage as you grow older – we’re all living finite lives and you can’t take it with you!)
A realistic and slightly morbid point – I would also encourage you to get ready for the day when you can no longer handle your savings yourself, or even plan to pass it on.
Keep things simple in your older years. Have only a couple of accounts and not too many investments, and make clear to whoever is going to take over the management of your assets how you think they should be managed and why.
You can look at Warren Buffett’s estate planning for his wife for inspiration to keep things simple. Buffett’s instructions are merely to divide his wife’s money between a Vanguard equity tracker and short-term US government bonds.
What about if you’re rich and old?
You should note though that Buffett has instructed his executors to keep a far higher proportion of his wife’s assets in equities than would be sensible for most retirees.
We can presume that’s because the sums involved are relatively massive, and thus a fall in the stock market would not be a big threat to his wife’s standard of living!
If you retire with much more money then you need, then the risk profile of your portfolio may be different, too.
Rich retirees are often no longer investing only for their own needs, but also for the longer term needs of their descendants or whoever the assets will be going to, such as a charity or a bequest.
Since the time horizon for those descendants can be much longer term and since their own needs for day-to-day living for the rest of their lives are already covered, their portfolio could well include more equities and a generally riskier profile than if it was just for the retirees themselves.
How to shift from one allocation to another
As for the practical matter of reducing your investment in equities and raising your allocation to lower risk assets as you age, it’s usually best to do this as part of your normal investing activity.
For instance, if you’re regularly saving into a SIPP each month, do some sums and over time start to direct a greater portion of the savings towards your bond holdings.
Similarly, if you’re paid income from your share portfolio as a dividend, as you get older you could reinvest that money into bonds rather than buying more shares.
The idea here is to reduce trading costs, and in some case taxes.
Another option is to use a so-called life-styling product that gradually shifts from equities to shares as you age. These are already very popular in the US, but watch out for high charges and hidden fees.
You could use something like Vanguard’s cheap LifeStrategy fund. This automatically splits your assets between global equities, bonds, and other assets, with a fixed allocation to equities.
Monevator has previously discussed how to gradually transition your money across two such funds to create your own simple DIY life-styling strategy.
Lars Kroijer’s Investing Demystified
Im 26 and currently set to auto-invest each month into a Vanguard Lifestrategy 80 Acc. Would you suggest this is too safe?
If I retire at 55 as planned, with the intention of remaining invested rather than taking an annuity, and sticking roughly to the 4% rule of thumb (slightly more pre-SP and slightly less post) then why wouldn’t I stick with a 70%-80% equity allocation?
@gadgetmind, the argument is that on retirement, you lose your ‘human capital’ i.e. your income generating capacity, and that has huge implications for your capacity for loss – hence, you should reduce risk exposure.
Personally, I’m quite drawn to the concept of a liability matching ‘floor’ of ‘safe’ assets/annuities/pensions, to guarantee a basic income, and then taking risk with the remainder. The asset allocation and % equities you’d end up with using this approach would obviously depend on the total size of your assets relative to your desired guaranteed income (and your access to other guaranteed income such as state or defined benefit pension).
So, the only thing I have to decide is what level of income I want to guarantee, and how much risk I want to take with the rest of it. Simples :-/
My capacity for loss relates only to the index linked 4% that I want to withdraw. I’ve modeled my plan with firecalc (showing SP turning up 12 years after retirement, no DB in our house) and I’ve got a 98% chance of the pot lasting 30+ years. If I increase my bond allocation, this probability drops, which causes me to question the use of the word “safe”!
BTW, the new “Freedom and Choice” announced in the budget took me from 95% to 98% because it lets me “profile” my drawdown to match my SP/tax situation far better.
@Dunk
I’d hardly say this fund is *safe*!
I suppose it depends on whether this is for your pension, or ISA. If it’s your ISA (and you have a pension elsewhere), you could always go for LS100 if you’re feeling confident. If it’s for your pension, I’m not sure that I’d feel confident investing 100% in equities.
@Luke
This is for my ISA only. Pension is invested in a mixed fund weighted about 60% equities through the company scheme.
@gadgetmind, I’d be interested to hear more about how you have used Firecalc to model your outcomes – did you customise anticipated future returns (rather than using the historical US data) and if so what returns did you anticipate?
Firecalc is a good model (and very interesting to look at the range of outcomes – basically if you withdraw little enough to minimise the risk of running out, you are much more likely to end up with more than you can cope with!) but my feeling is that models based on history can only go so far in predicting how things might pan out over what could be a 50 year retirement. I fully acknowledge that I am somewhat risk averse though – I wouldn’t sleep easy with my entire future so heavily exposed to the stock market (unless I had so much that I had a good measure of comfort in my withdrawal rate and could reduce my spending as necessary in a downturn.).
I just used the standard models and then plugged in SP trickling in later. Yes, lots more to tweak, but serious risk of garbage in, garbage out.
I know it’s all a bit rough and ready, but I’m really only after a high-level sanity check. If things head south, we can reduce income (I’m being very ambitious regards what we’d like post tax!) and we can also downsize house to something of 1/3rd the value and still be in an average house.
Of course, I’d love the reliability of a DB pension but we’re 100% private pensions, ISAs, etc.
@Dunk.
I’d expect at your age you’d come in the ‘early saver’ camp, which the chart above shows a 20%/80% split between safer assets/equities. This pretty much mirrors the Vanguard LS 80% fund *
* with the caveat that the chart was just an example of how a portfolio may shift over time.
I’d say it depends entirely on your appetite for risk. I’m a few years older than you (just a few 😉 ) and recently received some excellent advice from the Accumulator here, in response to one of my comments here (http://monevator.com/asset-allocation-types/#comment-619978) about allocation to equities. I’d recommend reading the Accumulator’s response a few posts down – it certainly helped me put things in perspective.
Whilst under slightly different circumstances, the Accumulator said:
** slightly paraphrased to be more generic
Am I, at 29, about to enter mid-life? 🙁
I’m all-out in equities at the moment, apart from my rainy day fund!
Future employment income is like having a bond. Younger people, with a lot of employment in front of them don’t need to hold many bonds in their potfolio, because they have a lot of likely income from the bondlike sale of their future labour.
Older people have fewer working years ahead (sometime none), so they can’t accept the riskiness of too much equity — they need to replace the bondiness of future employment with some real bonds.
I was going to carry on and say something crazy about it making sense for very young workers to gear themselves with debt, in order to make even larger equity investments when they haven’t got any capital yet, since future income streams will repay the debt. Then I realized that this is what they do already, sort of, by taking mortgages to buy real estate.
Once one factors in the decreasing pseudobond of future employment, it becomes clear why one needs to modify the portfolio asset allocation in order match the change in future labour-related income.
@Dunk & @Jonny
I’m a couple and a few years younger than the two of you, 24 and I’m currently 90 / 10.
25% UK equities, 59% Dev world, 6% property & 10% UK Gilt, all index trackers to put it as a simple breakdown. Now this is within an ISA and although it’s a relatively small amount I don’t think my risk profile would change if my holdings were larger because I have it stamped into my brain that this is a 30 year operation (I ‘hope’ to retire at 55), so I know that if there is a drop 20%, 50%, or what ever that I’m not going to get scared and pull the plug as I’m in it for the long term.
Table 1 suggests that 3% p.a. might be a wiser choice in the UK
http://advisorperspectives.com/newsletters14/Does_International_Diversification_Improve_Safe_Withdrawal_Rates.php
Table 2 suggests that the use of international diversification would push that up to 3.25%.
In both cases you’d then have to subtract charges and taxes.
My figures (which are actually 4.42% for 12 years pre-SP and 3.85% afterwards) do include all income taxes but not my 0.45% pa fees. Fortunately, under the new rules, my wife can empty her SIPP tax free over 5-6 years so there will be no more fees there, which helps.
As for safe withdrawal rate, I’d love to get well under 4% pre-SP, but most knobs are already set to 11 as it is!
I suppose if you have a generous income for your 4% withdrawal rate, maybe your basic ‘floor’ income would only be a 2% withdrawal rate, which even to my hypercautious nature should be enough…(though, I’d probably annuitise half and use the investment income as discretionary top up income). I realise that annuitising is anathema to many private investors, but longevity insurance has a place imo.
Annuities are grim value at age 55. Add on escalation and 100% spouse and you might as well not bother.
Quite right. I was thinking more of around 65-70. (but 100% spouse? Even the most gold plated DB pensions don’t go that far!)
Doing less than 100% spouse at age 55 could create an unhappy spouse if I go under the number 28. Plus drawdown effectively gives 100% spouse (and escalation if done right) so we need to look at an annuity with these for apples versus apples.
I thought this was a good article, butI was quite surprised to see people in their 30-40s labelled as “mid-life accumulators”
In the modern UK these are the very same people taking on huge mortgages on family homes and paying for kids
There isn’t much accumilaion going on for most of those families
I suspect it was copied from an older book…
@Edward you can rest easy. Taking this calculator and assuming you are reasonably clean-living you are a third of the way through life with a life expectancy of 86. Enjoy!
I am 36 years old. I am fortunate to be in a public sector pension scheme so I am 100% in equities in my ISA. About 50% of this is in a blue chip high yield portfolio and the other 5o in emerging markets, junior miners (ouch – at least I know I can stomach the 50% falls mentioned above).
For cash savings I using premium bonds. Will soon be able to keep 50,000 in these from 2015. As I am fully invested in my ISA I see the premium bonds as a fund to use outside of ISA in event of a market crash.
Hello,
For the bond allocation, I am having much difficulty in deciding the balance between various types. Do you think that the Vanguard Lifestrategy 20% is a good option for this? It seems to have a good mixture of gilts, IL-gilts, international government bonds and corporate bonds.
Hence I was thinking a good midlife SIPP profile for me would be as follows:
30% – Vanguard All world index ETF (VWRL)
20% – FTSE All-share tracker (e.g. SWIP growth D)
50% – Vanguard Lifestrategy 20%
The 0.29% TER for the Lifestrategy is ~ 0.15% increase on the individual bond funds, but maybe Vanguards ‘skill’ in assigning the right allocation would negate this difference ? (I’ve no idea how they decide the allocation)
@algernond
This isn’t a dig, but I can’t understand why so many people see the need to tinker with the LS funds. They’re diversified, have low costs (they’ve actually reduced since inception) and automatically rebalance without any intervention.
Isn’t your choice of funds roughly equivalent to just buying LS80 in the first place? 🙂
It’s a fair point Luke. I was only thinking that I could give more ‘home bias’ by segmenting the equity bit from Lifestrategy 100%
Still, my main question is whether the Lifestratgey 20% is a good one-stop solution for bond diversification part of a portfolio.
@Neverland – I’m with you on this, I’m 38 with a mortgage and family to pay for. No accumilation for me yet, outside of some ex company pensions (now work for myself). Maybe in 5 or so years time, I’ll fill mine and the mrs ISA’s but for me now it’s all about paying the mortgage off while I’m earning.
This one always brings me out of the woodwork….I’ll apologize in advance.
The idea that equities can drop by 50% without warning has no backing in history barring crushing defeat in war or a total breakdown of social order…..Russian revolution, Weimar Republic etc. In these situations bonds are no defence either.
The following is from Shiller’s US data based on annual averages of total stock market returns. It is also real (corrected for inflation).
In the past 140 years there have only been 5 occasions when falls exceeded 30% and only one of those was greater than 50%. These are:
1) 1916/17 (WW1). The fall was -35%. Returned to 1916 level in 1924
2) 1929/32 The fall was -55%. Returned to 1929 level in 1936.
3) 1937/42 (pre US WW2). The fall was -34%. Returned to 1937 level in 1944.
4) 1972/75 (the Great Inflation) The fall was -33%. This did not return to 1972 levels until 1983. The Great Inflation hurt equities…..it destroyed cash and bonds.
5) 2000/2009 (the dot.com bust followed by the financial crisis). The fall was -37%. The 2000 level was not reached again until 2013.
Big falls are painful but they should be kept in perspective. They are rare and happen for a reason…..of the five, two coincided with World Wars and three at the end of periods of wild financial excess, the 1920’s, the 1960’s and the 1990’s. They also repair themselves surprisingly quickly.
The large percentages recommended to be held in “safe” assets is questionable.
Wheether the
@Paul — You’re talking to someone who was selling his surplus possessions in 2009 to invest in the market! 😉
So clearly I am basically in agreement in terms of *my* risk tolerance.
However whether we like it or not most people are allergic to loss. They go to a financial adviser and say they want “about 10%, risk free”. I regularly discuss investing with university educated 30-40-somethings who will not put any money in the market because “it can go down”. Not “it can go down 50%”.
They/we can work on those attitudes (this blog is part of that) but telling risk allergic people to pony up to the hilt in equities is not the way to do it. They will sell their shares when the market falls and be worse off than when they started.
I’m suspicious of the utility of your data, at least in UK terms. Peak to trough the UK had two crashes in 2000 and 2008 which were over 40%, so I’ve got to think in real terms they were very close to 50%.
And why 50%? A 30% fall if sustained for years will do plenty of damage to a 65 year old.
These things do happen, we aren’t really a generation who needs reminding (as say a retiree in 1999 could have been forgiven).
Yes, volatility can be mitigated against — cash buffers, invest for income and ignore capital etc (though both required correspondingly larger pots). It cannot be mitigated by saying you personally don’t care about it. The fact that you and I have high risk tolerances does not mean that 100 years of financial A,B,C goes out the window. 🙂
The weird thing about now is that bond yields are so low and the outlook so poor. But that wasn’t the case for much of history, and it won’t be in the future.
It is what it is though. In reply to the comment about living off fixed income, the 10-year gilt is yielding just under 3%. That’ll keep up with inflation. You’d usually combine it with some equities. And remember the average person will be selling down capital. So your pot is getting smaller over time — but so is your lifespan.
It’s a different mentality to the accumulation phase we’re all more familiar with.
@neverland and @elbow — The article is about what people *should* be doing, not what they are doing. 🙂 Most people who retire in relative comfort put away a fair bit of money. If people live beyond their means or pump excess wealth into inflated UK housing, then no, it likely won’t be possible.
And that’s okay, if say having a big family with a modest income or doing a low paid job you love or living in a particular place is what you want to do. All valid choices, but we can’t rewrite the laws of finance, or pin our hopes on lottery tickets at 60.
Has anyone noticed that Vanguard LS 20% has massively shifted the bond allocation to international over the last month ? It now only seems to be <30% UK bonds. Is that a more stable strategy than most UK bonds ?
I’m 20 and currently invest £100/month into Vanguard LS 60% Acc (started Nov 2013). It might be seen as a little conservative given my age but I think of it as the ‘core’ holding in my portfolio and look to add more equity exposure – perhaps through an emerging markets tracker. Any suggestions on what I can add to complement the LS 60?
TI,
Hi, thanks for your considered reply. I do rant on. I appreciate that many 65 year-olds have to be cautious because their pots aren’t big enough to tolerate volatility. Often the main reason for that is they have been scared out of “risky” investments when they still had thirty years of earnings and investments ahead of them. To me idea that an employed 35 year-old puts his pension in bonds seems extraordinary.
On annual averages the fall in the FTSE100 from 2000 to 2003 was 40% (real) although dividends over that period probably pegged that back to nearer 30%.
If we all agreed it would be a boring place. Keep putting the provocative stuff up there.
@PaulS
Here is the FTSE versus the FTSE Total Return on a few dates.
Dec20 1999, FTSE 100=6930, FTSE 100 TR=3141
Jan30 2006, FTSE 100=5780, FTSE 100 TR=3141
Aug17 2012, FTSE 100=5852, FTSE 100 TR=4077
Dec19 2012, FTSE 100=5972, FTSE 100 TR=4198
Feb3 2013, FTSE 100=6347, FTSE 100 TR=4466
Apr10 2013, FTSE 100=6387, FTSE 100 TR=4539
The TR dipped just below 2000 in 2003, so yes, a 30% drop.
If I wasn’t so lazy, I’d lookup some 2014 figures to stick in there! However, the message is that reinvested dividends do a great job of smoothing returns over longer timescales.
@Sean
The LS funds are intended to be “all in one” portfolios. If you want to add more equity exposure then go for LS80 or LS100 because 40% in bonds is very high given your age. Maybe the LS100 as a core with a strategic bond fund alongside, perhaps some commercial property, and a “racy” IT or two for EM or smaller companies?
You’ve got lots of options, but do consider winding back on fixed interest as long as you won’t do anything silly if capital values drop 40% rather quickly.
@ Paul S – For a broader view on major stock market crashes around the world, check this out: http://wpfau.blogspot.co.uk/2014/01/greatest-hits.html?m=1
Data for real terms stock market crashes of 50%+ (including reinvested dividends) for 20 developed world countries.
A disconcerting number did not involve world war or a breakdown in the social order. The worst for the UK was -71% in 1973-74.
@ Gadgetmind – I remember Firecalc giving me a surprisingly high equity allocation for post-retirement too. Here’s a piece on why you might want to reduce equity allocation at the start of retirement when you’re most exposed to sequence of returns risk:
http://monevator.com/buy-shares-in-retirement/
The underlying research suggests raising equity allocation as you get older. One interesting point is that while high equity allocations in retirement mean that you’re more likely to not run out of money (using historical returns), if things don’t go your way then you’re more likely to miss your income goal by a wide margin than with a higher bond allocation. Essentially you’re taking a punt on a favourable sequence of equity returns when you’re in the danger zone.
TA,
Thanks interesting data and it appears to be based on the same basis as my own…….annual real data with dividends reinvested. That said I cannot understand why my calculation for the US 1972-74 is -33% and this table has -52%.
You will note that by far the most common date set in the table is 1972-74. However it is also worth noting that this was the Great Inflation. Equities were bad but they were just about the best place to be. Bonds were flattened and, unlike equities, they did not bounce back.
Just wanted to say that I’m with Gadget when it comes to equity %. Husband and I are 60 and 58 respectively and winding down with respect to earnings. We each have approx. 100k invested, mostly in VGLS. I’ve set our equity percentage at 70%. But we do have a chunk of cash to smooth any big stock market drops, plus a few bits and pieces of FS pension income. We’ll normally take 4% as income from the investments, but will forego this in ‘bad’ years, and take the income from the cash buffer instead. As to annuities: wouldn’t consider one now (we’re too young and providing a spouse income means the annuity income would be ridiculously small. HOWEVER, on first death the survivor might do worse than sink entire portfolio into an annuity, and dispense with the work and unpredictability. A single life annuity taken at, say 75, with a pot of 200k would probably give a higher income than taking 4% per year off the investments.
Good advice Valkyrie. There’s a strong case for simplifying your affairs when you’re very deep into retirement and I recently read an article that identified the magic inflection point for annuities at some point in your 70s. It might well have been 75, can’t quite remember and the article was American so may not apply directly here. Wade Pfau has also recommended deferred annuities as a good deal but again, that’s US market orientated and I’m not even sure if we can get deferred annuities in the UK yet?
Wade Pfau has also demonstrated that 4% is not absolutely safe for the UK (historically) but of course it depends on the length of your retirement and the returns you actually get. Moreover, I suspect you and Gadgetmind are more than savvy enough to see trouble brewing and will cut your cloth to suit.
@ Paul S – greatest bond losses http://wpfau.blogspot.co.uk/2014/01/greatest-hits-part-2-bond-market.html?m=1
I am 31 with c. £50k in my private & work pensions. Asset allocation is approx 60% developed world equities and 40% small caps, emerging markets & asia pacific. There will come a point when I want to start preserving capital (bonds/cash) but I can’t find much useful information to help me decide on this (Tim Hales book was good). If my retirement horizon is greater than 10-15yrs away I don’t see any reason not to be 100% in equities other than to smooth annual returns. There will have to be an element of market timing i.e. don’t convert to cash/bonds post dot-com crash or credit crunch, wait 5yrs or so. Does anyone know of a formula or tool based on current assets, projected rates of return for different assets, expected retirement and life expectancy etc to help derive a target asset allocation for a given age?