Nowadays I am a big fan of rules of thumb when it comes to asset allocation strategy – although initially I 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.

It’s 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 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. Re-tuning your asset allocation strategy away from equities and into bonds is a simple and practicable response.

This is the strategy we employ in our model Slow & Steady passive portfolio.

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 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’s 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:

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:

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.

(Hopefully our long grapple with the 4% rule seared that into our brains!)

The foundations of a proper financial plan are a realistic 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!

But 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

What caught my eye this week.

I stuck my oar into a Twitter debate this week, after economist Julian Jessop produced a graph purporting to show that the UK has not grown much more unequal post-Thatcher:

I responded that if we assume the data is right, then it’s still interesting that things don’t feel that way. So why the disconnect?

I am sure one reason is house prices. Those who have been on the housing ladder for decades – especially those who can help their own kids on – don’t seem to understand how un-affordable prices for the young have fractured society.

Perhaps that doesn’t show up in overall statistics of inequality because older would-be poorer citizens were made richer by rising house prices? I don’t know.

The other reason I put forward was Instagram. The fabulous lives of celebrities, influencers, and the several thousand photogenic cats and dogs made famous by social media cast a pall over our realities.

In the old days the Jones’ lived next-door, or perhaps across the street. Now they’re in your pocket, for many people day and night.

On the spectrum

It all points to new, technology-enabled (or perhaps enfeebled) ways of feeling rich or poor, which reminded me of an excellent blog post by US writer Morgan Housel.

Commenting on how the super-rich can’t help but make even the ordinarily rich feel poor, Housel writes:

Past a certain income the most difficult financial skill is getting the goalpost to stop moving.

And today’s level of global wealth has moved it a town over.

Housel then proposed a new spectrum of financial wealth, described by words, not numbers – because numbers don’t seem to tell us the whole story anymore.

While there are categories on the list I’d feel prouder to belong to, I plumped for ‘Health Wealth’ as my current status:

You can go to bed and wake up when you want to. You have time to exercise, eat well, learn, think slowly, and clear your calendar when you want it to be clear.

…which is gratifying, because I’ve been reading Why We Sleep? by Matthew Walker, and it’s life-changing enough to have seen me buy some new blackout curtains!

Where would you place yourself on Housel’s spectrum? And are there any categories he’s missing?

Have a great weekend!

p.s. Monevator has been ranked as the #1 UK personal finance blog by Vuelio. Several other good blogs on that list, too.

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When we asked you for questions to put to passive investing guru Lars Kroijer, we were inundated. So we’re doing something a bit different – a collaboration between Monevator and Lars’ popular YouTube channel.

Every month Lars will pick a few of your questions and then answer them individually, in video and transcript form, as below. We’ve already got enough questions to last us a year or two, so sit back and enjoy!

Note: embedded videos are not always displayed by email browsers. If you’re a subscriber over email and you can’t see the three videos below, head to the Monevator website to view this Q&A with Lars Kroijer.

Should I invest in passive products that mimic hedge funds?

First up this time, Tony asks about ETFs that seek to mimic hedge fund exposure. Do they make sense for a passive investor?

Lars replies:

In short, I don’t think you should invest in these sorts of products. There are a couple of reasons.

First of all, it’s incredibly hard to mimic hedge fund exposure. There are perhaps 10,000 hedge funds in existence. They are doing all sorts of things. But it’s really really hard to get access to a lot of them – they’re closed for new investments. Besides, it would be impossible to create investments in the proportions or the sizes of these hedge funds.

So the exposure you’ll end up having is probably quite far from the actual hedge funds’ exposure.

I think what a lot of these ETF providers try to do is not to replicate an investment in hedge funds, but to say synthetically what does hedge fund exposure look like? So they would say that hedge fund exposure is like having point two of S&P, point one of oil, point two of gold, and so on. But like this you’re creating a lot of tracking error versus the actual hedge fund industry.

To me, a passive investor is someone who doesn’t think that through active security selection they can outperform the market. I think there are a lot of benefits from coming to that realization. But a hedge fund is almost opposite of that. And by picking the people that we think can outperform the market – the hedge fund managers – we are indirectly being the pickers ourselves, too, by picking the funds.

So I think investing in hedge funds is almost the opposite of what a passive investor should do. Generally, the huge fees and expenses associated with the funds put you so far behind that unless you have some special angle, it’s worth staying away from them.

There’s probably been some value created in hedge funds over the last couple decades, but there’s also been tons and tons of fees. There’s also selection bias – we tend to hear from only the successful funds, much like in the mutual fund industry, and we don’t hear about the huge failures because they tend to die and disappear. That’s another reason I think just to stay away from this type of investment.

I would say that if you’re really interested in hedge funds (and if you’re able to invest in them, because they often have minimum investment sizes) I would do the work and find a few funds that perhaps offer unique investment opportunities, and invest in those.

That can be an incredibly exciting thing to do and but it’s also something that’s hard for regular investors. In any case, I think it is slightly outside the scope of this question.

Checking up on your portfolio

Rick asks how often he should monitor the funds in his portfolio:

Lars replies:

First of all, there’s no firm rule for this whatsoever.

Just to take a step back, one of the major benefits of a passive portfolio – on top of probably making you wealthier in the long run – is that you spend very little time on it.

You don’t have to spend a ton of time reading the Financial Times, the Wall Street Journal, or research reports. You don’t have to understand whether Facebook is a better investment than Apple. No, you just buy the broadest cheapest index tracker and let the market do all that for you. That saves you a ton of time.

Incidentally, let’s say you invest in a market that’s up 10% – say Europe. [With a tracker] you make that investment with zero time spent and almost no cost.

Let’s say instead you’re up 12% [from investing actively] in the market. That’s only 2% that you spent all that time to achieve – because 10% you got via the market!

I’d even question whether you can reliably make 2%. But even if you did, it’s only the 2% extra you spent all that time achieving.

Coming back to the question, I would say definitely have a look at your portfolio when there’s money flowing in and out. Also have a look when something in your personal circumstances has changed that could impact your risk profile.

This could be a personal thing such as – to start with the positive – a bonus at work. Or it could be you lost your job. Perhaps you got a windfall through an inheritance, which is often obviously not entirely a good thing. Or perhaps there’s an external issue, such as an economic crisis where you live.

I would definitely have a look in those circumstances – and perhaps it’s not a bad idea to get help from a local financial adviser.

But in general, I’d say have a look at it every three to four months just to make sure things are not totally out of whack and then have a more thorough review once a year, perhaps again with a financial adviser. In general, when you hear lots of financial drama in the news that could impact both the markets and currencies again, check out how that impacts your portfolio.

And of course as Rick suggests, once in a while you should think about whether there are better products out there? Has your tax situation changed?

And again, that could be worth talking to an adviser about.

What is the point of owning the minimum risk asset?

Finally for this session, Paul asks why do we need to have a minimal risk asset – that is, the lowest-risk asset we can get our hands on – in our portfolios?

Lars replies:

The short answer is you don’t always need this asset, but you’re very likely to.

Just taking a step back, it’s my view that most people are very unlikely to be able to outperform the financial markets. As a result, they should put together a very robust two product portfolio.

Firstly, they should invest in the global equity markets, through an index tracker typically.

Second, they invest in the lowest risk asset they can possibly get their hands on. For most people, this is typically government bonds that are highly rated in your local currency, with a maturity that suits your investment horizons.

You combine these two to match your investment risk profile, and you’re done! Investing can be more complex than that, but in my view, it doesn’t really have to be for most people.

So why do you need this minimum risk asset? Well, if your risk profile is such that the risk of the global equity market suits you, then you don’t need it. For most people though, that’s just too risky. So they temper the risk of the global equity markets by also investing in a very low-risk asset and then combining the two so that they optimize for their own risk.

Let’s say you want a 50/50 allocation – you’d need to put 50% of your portfolio in the minimal risk asset.

In some people’s cases, they want all their assets to have no risk at all! In that case they’d invest only in the minimal risk asset.

Until next time

Right, we’re out for this month. Please do feel free to add to or follow-up Lars’ answers in the comments below.

Watch more videos in this series. You can also check out Lars’ previous Monevator pieces and his book, Investing Demystified.