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 is available from Amazon. Lars is donating all his profits from his book to medical research. Check it out now.

How can you know how much to invest without knowing what investment gains your portfolio may deliver in the future? Your portfolio’s expected return is the number you need.

Your expected return figure helps you plot a financial master plan that’s more robust than:

• Sticking your finger in the air.

• Consulting goat entrails.

• Getting your other half to pop on a veil on while staring maniacally at your palm and muttering “I see great fortune – but also much loss, my child,” in a cod Eastern European accent.

To calculate this critical number, you first need an idea of the expected returns of the asset classes you invest in. The numbers in our previous article on expected returns is a good starting point.

Especially useful are expected returns figures for individual asset classes as ventured by US passive investing champ Rick Ferri. Tim Hale has produced UK-centric figures in his superb book Smarter Investing.

Choose whichever expert’s asset class return numbers seem most sensible to you, and then apply them to the asset allocation mix of your own portfolio:

Multiply each asset class’s expected return by its percentage allocation in your portfolio.

This gives you the weighted expected return of each asset class.

Add those numbers up to discover your portfolio’s expected return.

Here’s an example for a portfolio I’ve just made up:

Asset class	Allocation (%)	Expected annual real return (%)	Weighted expected return (%)
UK equities	15	5	0.15 x 5 = 0.75
Developed world equities	35	5	0.35 x 5 = 1.75
Developed world small cap equities	10	7	0.1 x 7 = 0.7
Emerging market equities	10	7	0.1 x 7 = 0.7
Global property	10	4	0.1 x 4 = 0.4
UK government bonds	20	0.5	0.2 x 0.5 = 0.1
Portfolio expected real return	–	–	4.4%

Expected return source: Tim Hale’s Smarter Investing, 3rd edition.

Now do the same thing for your own portfolio. The figure you come up with is the real return you can expect your portfolio to deliver annually over the course of your investment time horizon.

See below for the caveats swirling like mosquitos around that breezy statement.

Using your portfolio’s expected return

Pop your portfolio’s expected return into an investment calculator along with your target income goal, time horizon and monthly saving dollop, and you’ve just thrown a rope around the task ahead.

Of course the one thing you can expect from any expected return number is that it will be wrong to some degree. But at least you’re no longer shooting in the dark, and you can correct your trajectory as you go.

Once you know how to estimate your portfolio’s expected returns, you can also start doing groovy things like customising your asset allocation to better fit your individual needs.

For example, if your portfolio’s equity allocation is higher than you’d like – because you’re nervous of volatility – then notch up the bond allocation in your calculations and see what difference it makes to your expected return.

Rerun the numbers and if you can still hit your financial goal within an acceptable time frame then you can afford to take less equity risk.

If you add riskier but higher expected return assets like emerging markets, small cap, and value equities then the expected return (and volatility) of your portfolio heads higher.

Again this may give you the headroom to increase the bond component of your portfolio and lower the equity allocation – potentially reducing risk without sacrificing the expected return you need.

Caveat city

No Monevator post would be complete without a sprinkling of snares, trip-mines, and general financial doo-doo for you to hopscotch over.

Here’s this episode’s selection.

Subtract your fund’s charges and platform’s fees from each line of your expected returns. Ditto for any investments exposed to tax. Nothing is more certain to dent your plans than the ongoing costs of investment.

Make sure you adjust your calculator, too, if it already assumes an allowance for these costs.

Remember to check if your expected returns are quoted as real returns or nominal returns.

Real returns are what you’re left with after inflation has taken its bite. If you’re using nominal returns then just subtract an estimate for inflation before you start: 2 – 3% is reasonable for UK investors.

The current UK government bond yield minus inflation is the best guide to the expected return of UK gilts. Choose the maturity that best represents the average maturity of your bond fund or ladder.

Expect (a bit of) the unexpected

They say always end on a song, but they probably don’t write personal finance articles for a laugh

So I’m going to end with a warning instead: Expected return numbers are expected because they take historical performance and recent valuations into account.

As such, expected returns are more credible than the prophecies of the Ancient Mayans, but they can still be wildly off-beam because the dispersion of investment returns resembles a shotgun blast.

Take it steady,

The Accumulator

Missing Monevator alert: For some sinister reason, Monevator email subscribers didn’t get my article on this week’s Budget. It was a spirited old ramble followed by some good comments from readers, so go check it out if you missed it!

People have been fretting about the stock market being too frothy all year (and for long before that…) But it’s worth remembering the majority of pundits are American.

I’d agree, for what it’s worth, that the US market is looking dear, especially the small to mid-sized companies.

But personally I think that the UK and Europe still look fair-to-good value. And some emerging countries like China and Russia are now in a bear market.

Supporting my feeling about the UK market is this interesting graph from John Kingham, posted on his UK Value Investor blog:

The graph suggests the FTSE 100 is still in the green ‘safety’ zone, when comparing its longer-run earnings to valuation.

John writes:

While a slightly cheap market isn’t particularly exciting, it does imply slightly better future returns than normal.

If we have 2% inflation and 2% real growth from the underlying companies, plus 3.5% or so from the dividend and a little bit more if the market mean reverts upwards towards fair value, then over the next 7 years we may get something like a 10% annualised return over that time.

At the end of that period in 2021, the FTSE 100 would be at 10,700.

Note the sensible use of the word “imply”. There’s nothing in this sort of valuation work that guarantees anything, and indeed the market could halve this year – or double.

But as an antidote to doom brought on by a few good years of decent returns, I think it is reassuring.

Keep on keeping on

Of course, passive investors know better than to try to time markets. Keeping your allocations, rebalancing, and ideally adding new money every month or year is how that strategy wins.

Barron’s has a short and interesting post on how those who save steadily over time can afford to ignore valuation:

For three decades, two investors put an annual $1,000 into Vanguard 500 Index starting in 1983.

One of them is Disciplined Dave. Dave invests his money on the last trading day of each year. He doesn’t try to time the market.

The second investor is Hapless Harry. Harry wants to time his annual contribution, but he has “the worst timing in modern Wall Street history.” He invests his $1,000 at the market peak every single year.

The result from 1983 to 2013?

• Dave’s $31,000 grew to $177,176. That’s 9.9% a year.

• The same money from Harry hit $169,153, for 9.5% a year.

There wasn’t too much difference between picking the worst days to invest and picking a regular day – just $8,000 or so.

It was time in the market that counted.

Of course you could argue that Harry would have done better to sit out the bear markets, if he’d somehow been able to see them coming in advance.

But The Brooklyn Investor warned this week that even the great value investors owe very little of their success – if any – to trying to time the market:

All of this is not to say that valuations don’t matter. They matter a lot. We are “value” investors, so of course “valuations” matter.

When we say don’t worry about warnings about overvalued stocks, bears will call us perma-bulls; that we bulls think markets always go up.

Well, they don’t. They will go up and down as they always have.

My argument is that it’s going to be hard to predict the market based on it. Higher valuations will mean lower prospective returns but higher valuations don’t necessarily lead to an imminent bear market or correction.

A bear market or correction will always be inevitable, but it’s hard to say when it will happen. And if you don’t know when it’s going to happen, it’s going to be very hard to capitalize on it

A lot of stupid comments that people leave on websites annoy me – I’m sensitive soul, in truth.

But the most annoying of all are glib comments about the market being obviously expensive and certain to crash, and so me or anyone else being muppets to write about shares.

The worse thing isn’t that these people are misleading everyone who reads their comments by giving some specious illusion of prescience – though that’s annoying and potentially costly enough.

But it’s that some tiny percentage of them will be right, by luck, every few years when the market does crash, as all long-term investors know it will now and then.

By all means follow valuation and have a sense of whether you think it’s time to add more of your funds to cash, bonds, or shares.

But run screaming from anyone who claims to know what’s going to happen.

They don’t. Nobody knows.
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