How To Develop A Broad Asset Allocation Plan (Asset Allocation 101)

February 19, 2014

Old Fashioned Investor

"Opportunity is missed by most people because it is dressed in overalls and looks like work." - Thomas Edison

How To Develop An Asset Allocation Plan

This is one of my favorite quotes of all time. While investing can be very interesting and fun, anything worth doing is going to feel like hard work at times. But there are always rewards for hard work. Developing an asset allocation plan is not straightforward or easy. No one can simply lay out the answers for you. It requires some thought and effort on the part of the individual for which the plan is being made. At the same time, it is a topic that, like most others, can be often be made to be unnecessarily complex. Wealth management professionals put a massive amount of thought and analysis into coming up with specific plans for people. Often they run some type of analytical software that uses historical returns, volatility, valuation, and correlation data to come up with optimal weightings. These have limitations, but they can be useful and interesting. Interesting or not, at the end of the day, the ongoing annual fees charged by advisors can often outweigh any benefit they provide, assuming we have the ability and willingness to learn about these topics on our own.

Reminder: If, throughout this lesson, you run into a financial term with which you are unfamiliar, look it up on's comprehensive financial dictionary. If you are just starting at zero knowledge, you may want to review some of our other investment management lessons.

So, a little self-education and effort is a good strategy. It’s probably best to keep things simple. There are different layers of asset allocation. This lesson only addresses the highest layer possible, which is how to allocate between bonds, stocks, and cash (short term reserves such as money market funds or FDIC insured deposits). I see no need to break out cash as a separate asset class because I can't think of any reason that it should ever be more than 5%. No matter what stage you're in, you will always have some level of cash hitting your account and you will always be thinking about how you can either put it to work, or take it out and spend it.

There are a lot of things that factor into an asset allocation decision, such as income level, income sources, variability in income, financial goals, time horizon, and risk tolerance. The most important factor, in my mind, is time horizon. For the purposes of this lesson, we will start with a simple example based on the retirement portfolio for an average worker. Commonly, you will see asset allocation suggestions such as these:

30-40 years until retirement:

90-100% Equity

0-10% Fixed Income

20-30 years until retirement:

80-90% Equity

10-20% Fixed Income

10-20 years until retirement:

60-80% Equity

20-40% Fixed Income

5-10 years until retirement:

40-60% Equity

40-60% Fixed Income

0-5 years until retirement:

25-40% Equity

60-75% Fixed Income


0-25% Equity

75-100% Fixed Income


Now, these are very broad categories. In regard to equity, I am only thinking of common stocks, REITs, and MLPs. Wealthy people may think in terms of commodities, precious metals, private equity, direct real estate holdings, etc. But, most of us, especially beginning investors, have no need of including those categories for a broad asset allocation plan. If you want to include those categories, just realize that they probably should fall somewhere within the Equity category I've outlined. In other words, they can be thought of as subsets of that category.

We can further categorize common equity (stock) investments according to company size (micro, small, mid, and large cap are commonly used categories), sector, industry, value/growth characteristics, international/U.S., etc. These kinds of choices normally get labeled with terms such as sector allocation or country allocation, but we’re discussing a similar principle here, no matter what specific label we put on it.

Understanding certain categories of assets, and using them as part of an overall plan and strategy will increase your likelihood of success. For example, small caps generally are higher risk, higher reward than mid and large cap stocks. Therefore, it generally makes sense to have a larger allocation to small cap stocks, the further away from retirement you are. These topics are discussed in depth in an upcoming lesson called How To Manage Your Stock Portfolio.

For now, let’s continue to focus on broad asset allocation. It’s important that readers understand why the suggested allocations make sense. As a general rule, overall volatility is lower for fixed income than it is for equities. Further, once you are at or near retirement age, it makes sense to have a reliable income stream derived from securities with a set terminal value, e.g. corporate, sovereign, and municipal bonds. The other point to be made, is that if you have an adequate amount of assets, and interest rates are cooperating, you won’t have to concern yourself with market value fluctuations at all. Freedom from concern over market value fluctuations will leave you with peace of mind, and it’s difficult to put a price on that.

Let me give you a simple example. Say that I have $1,000,000 saved and I’m retiring tomorrow. I could invest 80% of it, or $800,000 into a well-diversified basket of long term, investment grade, fixed coupon corporate bonds and get a roughly 5% yield as of February 2014. The average time to maturity on those bonds would be in the 20-30 year range. The market value will probably fluctuate all over the place over the next 25 years, but the terminal value of each bond is set at the face amount of the bonds (assuming I bought at par, that amount will be $800,000), and the annual coupon payments don't fluctuate. So, market value fluctuations won’t matter to me, because my plan as a retiree is to live on the $40,000 annual income generated by my bonds. I can lock in that income amount for the next 25 years or so, at which point I will have reinvestment risk due to the potential for changes in yields (the bonds won't all mature at the exact same time... I have to make some simplifications in order to create readable lessons).

Obviously, some retirees will have other sources of income on top of that, but this is a simplified example. The other $200,000 can be invested into equities to act as an inflation hedge. After 10 years, the equities will hopefully be worth a great deal more than $200,000. Based on the historical market average return, they will be worth roughly $498,000. In 10 years’ time, I can take half of that money to invest in more bonds, thus increasing my income. If corporate bond yields were still at 5%, this would increase my income by $12,375 annually (a bump of 31% after 10 years – nice!). This cycle can continue until I pass onto that wonderful place where such trivial things as money will no longer matter!

Another type of risk that still matters greatly under this scenario would be credit risk. However, based on historical data, a basket of well-diversified investment grade corporate bonds is unlikely to experience heavy credit losses. Click on this link and look at Table 13. That table is telling us that a passive portfolio made up entirely of the lowest rated investment grade corporate bonds (BBB) would, after 15 years, experience a default rate of 8.07%. That assumes that you buy bonds and never sell them even as the ratings drop to below investment grade. Further, the historical recovery rate is around 40%. So, with one of each of the lowest rated investment grade corporate bonds, and no ongoing management, you should expect to lose about 4.84% every 15 years to credit events. But, diversification is still of primary importance since you won't know going in which bonds will end up in default. Bonds are sold in increments as small as $1,000. So, it is possible, at least in theory, to have a basket of 800 different bonds under the scenario described above. In reality, you probably wouldn't want or need quite that many.

When you are younger, it generally makes sense to have a much higher allocation to stocks. That’s because stocks typically outperform bonds over long periods. The long term average return of the stock market (S&P 500 from 1928-2013) is 9.55%. By comparison, the best bond market proxy we have shows 5.5% average annual returns from 1926-2012. So, why not just always invest in 100% stocks, since they offer higher returns? First, those are long term averages. The stock market return in any given year rarely comes close to the average. Further, there is no guarantee that stocks will offer higher returns than bonds over any given future time period. Last, given the high volatility of stocks, and the risk of losing up to 20, 30, even 40% in a single year, it’s prudent to reduce our exposure as we get closer to retirement. When we are further away from retirement, we have plenty of time to recover losses. So, we are in a situation where it makes sense to follow a higher risk, higher reward strategy. Being afraid of market value fluctuations when you have a long time to retirement is an easy mistake to make, but it’s crucial that you don’t make it. The Bible instructs us that we can't act out of fear. Just remember that you’ve got plenty of time, and you’re still buying. If the market drops significantly, be glad that you’ve got a chance to buy some stocks on the cheap. In the long run, history tells us you’re going to be fine anyway… and the Bible teaches us that we shouldn’t ignore history.

To some degree, these target ranges can’t be based only on historical averages. Instead, they have to take current conditions into account. With corporate bonds earning in the neighborhood of only 3-5%, many of us probably won’t achieve our goals by investing heavily in long term bonds right now. That’s why there is currently often identified, a need and desire to have as high an allocation to equities as possible when we have plenty of time to recover any potential losses in market value. Also, when interest rates are incredibly low, bonds themselves are subject to higher potential losses in market value. Further, they are guaranteed to offer low returns when interest rates are low. Even though market value can fluctuate up or down for bonds, I tend to think of the current yield as the maximum I’m going to earn on bond investments. Hoping for a return above the current yield offered means, in effect, that you are betting (hoping) that interest rates will fall. But I don’t want to go too far into that topic. Just realize that current market conditions factor into your decision, whether financial advisors want to admit that or not. If corporate bonds were offering yields in the 8-12% range, I promise you they would (at least, they should be) all be showing clients much higher target allocations to corporate bonds, across the entire spectrum of time horizons.

Another important point to consider is the reason for having target ranges, as opposed to more strictly defined target percentages. First, even if you have well defined goals, predictable income, exact time horizon, understand very well your own risk tolerance, etc., you still want to allow yourself some flexibility to make what are commonly referred to as tactical calls. Your strategy might be to hold 60-80% equities when you are 10-20 years from retirement (this is known as a strategic allocation). So, how do you choose your allocation within that range? You could choose to have a hard target somewhere within that range, based on your personal financial plan. Alternatively, you may decide to set a target range for yourself. You may decide that you will seek to enhance returns by holding onto more fixed income (up to 40%) when stocks appear to be overvalued, and less (as low as 20%) when stocks appear cheap. Conversely, when bonds start to look more attractive relative to stocks, you may want to increase your allocation to them. Giving yourself a range to operate in will afford you some small level of freedom to capitalize on your knowledge, while also ensuring that you do not become overly convinced of particular outcomes, make large bets, and potentially ruin your long term investment plan.

So, that is one reason for having a range. The other is that you can’t rebalance daily. Market value is going to fluctuate for both stocks and bonds. The allocations to each class will naturally drift with market value fluctuations. However, sticking to the plan probably means rebalancing once they fall outside of the ranges, or at a pre-set schedule (quarterly, semi-annually, or annually).

You need to explore these topics and determine how they might apply to your individual situation. The above example may work fine for the average worker who is planning to work for 30-40 years, and putting aside 10-20% of their income each year into retirement accounts. They may not be suitable for a 20 year old who just inherited $100,000, wants to invest it for an undecided future purpose, and can’t stand the thought of watching the assets their relative worked so hard to earn, lose a significant amount of market value in any given year. When I ran this lesson by a friend who is a financial advisor, he pointed out the wisdom in working backward from your goals in order to develop your plan. For example, if I want to have $40,000 per year in retirement income, how might I go about achieving that goal? If I'm already well on my way to achieving that goal, do I really need to have a high percentage of my wealth in the stock market?

As I mentioned many times before, it all comes back to having a well thought out, individualized plan and sticking to the plan. Planning is a biblical instruction. What I normally give in my lessons are extremely simplified examples. It may very well pay, even if you are a do-it-yourself investor, to sit down with a financial planner who will charge you an hourly fee to go over your situation and help you develop a long term financial plan. Just educate yourself as much as possible before doing so, and realize that many of them are still going to try to sell you on investment products while going over your plan with you. That’s what they’re incentivized to do and we’re all trying to make a living. Just be aware of it when going in. Some of them are going to sit down and give you a well thought out plan free of sales pitches, and some of them are going to give you extremely biased “advice”. That’s why this is an area where it pays tremendously to educate yourself as much as possible.

Maybe you can get started exploring the right questions on your own. Here are the kinds of questions that must be explored in order to come up with a detailed financial plan:

1)  What does my balance sheet look like? In other words, what assets do I own, and what liabilities do I carry?

2)  What are my “operating expenses”? What are the ongoing expenses necessary to keep my current lifestyle? To have my desired (realistic) lifestyle?

3)  What is the bare minimum income I can accept?

4)  What are my sources of income?

5)  Are those sources reliable? Are they steady/predictable?

6)  What risks do I face with those income sources? (e.g. if I have a job, how secure is it? Are people in my industry facing layoffs?)

7)  What are the goals of my investing? Retirement? Do I want to have a target amount in X years in order to start a business? Fund a charity?

8)  If retirement, how much do I need to have the retirement that I want?

9)  When do I want to have it?

10)  When do I need to have it? In other words, when is the absolute latest I can retire in case things don’t go so well with my investments?

11)  What is my personal level of risk tolerance? Can I emotionally handle watching the market value of my investments drop 10% in one year? 20%? 30%? 40%?

12)  Do I have a high level of self-control when it comes to finances?

13)  If the markets experience a worst-case scenario, how will that affect my plan and my personal situation?

14)  Is it important to me to leave an inheritance to my children and grandchildren? Or do I want the last check I write to bounce?

If you can answer these types of questions, you have at least started down the path of creating an asset allocation plan that makes sense for you, in light of your situation. Thank you so much for reading! Keep checking back... there are many more lessons to come!


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