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DIVERSIFICATION

 

The way to cushion against stock market volatility is by owning not just stocks but bonds too. Don't expect to be educated about the basic principal of bond / stock diversification by product pushing salesman who sell annuities, non-traded REITS, gold, market timing services, etc.

 

By 2009 many retiree investors who were both over-allocated into stocks and drawing money from their savings saw their portfolios drop dangerously low and had to go back to work. But it wasn't the stock market's fault. It was their fault for putting too many eggs in the stock market "basket"!

 

2000s

Above rate of withdrawal for each year: Jan 2000: $4,000, 2001: $4,136, 2002: $4,251.81, 2003: $4,319.84, 2004: $4,419.19, 2005: $4,538.51, 2006: $4,692.82, 2007: $4,842.99, 2008: $4,978.59, 2009: $5,167.78, 2010: $5,147.11, 2011: $5,229.46, 2012: $5,396.81, 2013: $5,510.14, 2014: $5,592.79, 2015: $5,682.28, 2016: $5,687.96

 

Historical performance of a 28% S&P 500 index / 72% 10-Year Treasury bond portfolio

 

28

 

 

How did a 75 / 25 portfolio hold up during the great depression?

This question is also covered in the annuity discussion.

 

A stock market crash of 90% is highly unrealistic today. The stock market today is not what it used to be back then. But just for fun let's take a look at how diversification into bonds protected you back then. From 1929 to 1946 your portfolio was never in danger of running down to zero. Unlike the charts above in which we took out about 5.5% per year, in this example the money is allowed to compound and dividends are reinvested. The lowest the 75/25 portfolio ever dropped to was $85,524 at the end of 1931, however when adjusting for deflation of the 1930's you were actually even at that low point in time! Not bad considering that you were 3 years into the great depression!

 

 

 

 

Now let's look at what would happen if we were in retirement, drawing out 4% per year from our savings, and with that 4% pegged to the annual rate of inflation / deflation. This chart below also accounts for annual rebalancing on Jan 1 of eavery year. Even while living off of the nest egg, you did not out of money. Keep in mind that portfolio values below are not adjusted for inflation / deflationi. There was double digit deflation in the early 1930's.

 

1929-c

Above rate of withdrawal for each year: $4,000, $3,893.60, $3,545.51, $3,180.32, $3,018.45, $3,124.39, $3,204.38, $3,237.70, $3,358.47, $3,290.96, $3,248.18, $3,271.89, $3,649.37, $3,868.34, $3,931.78, $4,021.03, $4,360.00, $4,998.74, $5,385.64, $5,334.48, $5,403.83, $5,830.73, $5,941.51, $5,989.05, $6,030.97, $6,006.85, $6,096.95, $6,298.15, $6,474.50, $6,519.82

 

What has been the lowest risk asset allocation?

 

According to a study, from 1970 until 2010 a portfolio of 28% stocks and 72% bonds was the lowest risk allocation ratio. Notice in the chart below that by investing in 100% bonds alone you were taking on more risk than by adding a position of 28% in stocks. While past performance does not guarantee future results, this study does provide some general guidelines for those who seek low risk. In fact Bill Gross, the biggest fixed income manager in the world, has warned that the three-decade bond bull market is likely over. Accordingly at this point in time, advisers seem to be recommending a little more exposure to stocks than 28%. They are certainly not recommending getting all out out of bonds either because when stocks fall, money runs to the safety of bonds. If stocks crash you will be happy that you put some of your money in bonds and this will also offer you the opportunity to rebalance. Additionally some argue that the bond bubble is over stated. DISCLAIMER: This is not to say that a 28/72 portfolio will turn out to be the lowest risk allocation moving forward or that taking the lowest risk is the best strategy for you right now.

 

 

RUN AWAY FROM ANY "ADVISER" WHO IGNORES DIVERSIFICATION in order to sell you a high commission product like an annuity! Ignoring diversification is a deceptive, dishonest technique by which commission-based and even fee-based" advisers" try to sell high commission products like annuities, life settlement investments, indexed universal life insurance, and other commission-based financial products that are touted as "not being tied to stock market ups and downs" or what they call not tied to "the Wall Street Casino". They'll say "Look what happened to the stock market from 2000 to 2009", when in reality, as illustrated at the top of this page, history has demonstrated that bonds and stocks are generally safe.

 

The flip side: Taking on too little risk may

result in you missing out on huge gains

 

Just as a conservative bond heavy portfolio will protect you from stock market crashes, it can also result in you missing out on huge gains if the stock market decides to make big advances such as it did during the 80's and 90's. During the 80's decade alone, your money grew 46% more if you were allocated 100% in stocks versus just 28% in stocks / 72% bonds. During the 90's decade you money grew about 118% more. Or during this entire 20 year stretch, a $100,000 nest egg grew to $507,809 with 28% in stocks and 72% in bonds, but with 100% in stocks grew to $1,587,429 or a 212% greater return. Each of the models below uses calendar rebalancing on January 1st of every year.

 

1980 1990

 

The bottom line

 

At the end of the day you need to decide how much risk you want / need to take and live with that decision. Generally speaking you want to take as much risk as is necessary to meet your retirement goals, but no more. If you are young and not drawing on your money money then generally speaking you want to take more risk by investing more in stocks because stocks have historically been the best performing asset class. If you are in or near retirement when you will be living off of your nest egg then you want to take less risk because if stocks crash 50%, all of a sudden what used to be 4% withdrawals are now 8%. Taking out 8% with a 30 year time horizon could easily leave you broke.

 

Still unsure? A good start is Blackrock's portfolio builder or Vanguard's free portfolio creation tool. These sites will spit out a simple portfolio based on your information. Another is Ric Edelman's free portfolio creation tool which spits out a more complex diversification of bonds and stocks.

 

Mark Hulbert makes a good argument for why there's not that much upside in taking the risk of being 100% in stocks. He suggests that 60% stocks and 40% bonds is a good allocation ratio.

 

Check out Vanguard's study of allocation ratio historical returns.

 

As of 2014, Warren Buffet recommends that for long-term results the average investor put 90% of their money in the S & P 500 index and the other 10% in short-term government bonds.

 

Article about diversification - Recommends SPY and VFICX. Subtract your age from 120 to determine how much percentage to allocate to the stock asset class.

 

Jim Cramer on Bonds

 

On 11-28-2014 Jim Cramer said on his MSNBC show Mad Money that in this era of low interest rates you can sometimes be too prudent and too risk averse. If you cling too much to bonds in your early years this is more likely to jeopardize your retirement (than if you were to invest more in stocks). Either you cling to safety and then when it's time to retire you don't have enough cash or you take some risk in stocks, typically when you're younger, and go for the higher returns that will enable you to retire wealthier. The bottom line is this is Cramer's general bond allocation ratio recommendation:

 

Younger than 30 - No reason to own bonds

In your 30's - 10% - 20% bonds

In your 40's - 20% - 30% bonds

In your 50's - 30% - 40% bonds

60 to retirement - 40% - 50% bonds

After retirement: Own some stocks, approximately one-third of your portfolio. Focus on high yielding stocks that can generate more income with less risk. Although Bob Brinker recommends more exposure to stocks with a 50/50 allocation for a 70 year old.

 

How important is rebalancing?

 

According to Vanguard rebalancing (to retain your bond/stock allocation ratio) can increase your returns at a rate of up to 0.35% annually. From 2000 - 2013, when returns, dividends and interest were left to compound, and when rebalancing on January 1st of every year, a 75/25 portfolio provided a 7% average annual return on investment. Not bad considering that this period included a recession with sluggish stock market.

 

Related links:

Stock and bond returns from 1980 - 2013

New York University stock and bond returns since 1928

ROI calculator

Compounding Return on Investment Calculator

Simple Return on Investment Calculator

 

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