Best Portfolio Allocation: Asset Allocation By Age

Key Concepts

• Age-Based Asset Allocation: The principle of adjusting investment portfolio composition based on an individual's age, typically shifting from riskier assets to safer ones as one gets older.
• Investment Horizon: The length of time an investment is expected to be held. Longer horizons generally allow for greater risk tolerance.
• Capital Growth vs. Capital Preservation: The two primary investment objectives. Capital growth focuses on increasing the value of assets, while capital preservation aims to protect existing assets from loss.
• Risk Appetite: An individual's emotional willingness to take on investment risk.
• Risk Capacity: An individual's financial ability to withstand investment losses without significantly impacting their quality of life.
• Human Capital: An individual's future earning power.
• Financial Capital: An individual's accumulated wealth.
• Volatility: The degree of variation of a trading price series over time, typically measured by the standard deviation of logarithmic returns.
• Upward Drift: The tendency for equity markets to increase in value over the long term due to profit growth.
• Glide Path: A predetermined schedule for adjusting asset allocation over time, typically becoming more conservative as retirement approaches.
• Sequencing Risk: The risk of experiencing poor investment returns early in retirement, which can significantly deplete savings and shorten the longevity of a portfolio.
• Inflation-Linked Bonds: Bonds whose principal and/or interest payments are adjusted based on inflation rates, protecting purchasing power.
• Safe Withdrawal Rate: The percentage of a portfolio that can be withdrawn annually in retirement without depleting the principal over a specified period.
• Temporal Diversification: A strategy that involves investing money based on when it will be needed, creating "time buckets" with different asset allocations.
• Leverage: Using borrowed money to increase the potential return of an investment.
• Risk-Adjusted Return: A measure of the return on an investment relative to the amount of risk taken to achieve it.

Core Principles of Asset Allocation

The video begins by outlining the fundamental principles of age-based asset allocation, contrasting the investment strategies of a 20-year-old with someone in their 60s.

• Younger Investors (e.g., Age 20):

  • Long Investment Horizon: Funds are typically invested for retirement, meaning they won't be needed for many decades.
  • Focus on Capital Growth: The primary goal is to maximize the growth of the invested capital.
  • High Risk Appetite and Capacity: Younger individuals can afford to take on greater risk due to their long time horizon and ongoing earning potential. Market crashes are viewed as buying opportunities.
  • Portfolio Composition: Expected to have a higher allocation to risky assets like equities (stocks) and a lower allocation to safer assets like bonds and cash.
  • Human Capital: High human capital (future earning power) allows for greater risk-taking with financial capital.

• Older Investors (e.g., Age 60s):

  • Shorter Investment Horizon: Funds are closer to being needed for retirement income.
  • Focus on Capital Preservation: The primary goal shifts to protecting accumulated savings from significant losses.
  • Lower Risk Appetite and Capacity: Market crashes are a significant risk as they deplete savings that cannot be easily replenished through earnings.
  • Portfolio Composition: Expected to have a lower allocation to equities and a higher allocation to safer investments like bonds and cash.
  • Financial Capital: Accumulation of financial capital becomes more prominent as human capital diminishes.

The process of investing over a lifetime is described as converting human capital into financial capital. Understanding asset behavior, particularly the trade-off between long-term returns and short-term volatility, is crucial for effective asset allocation.

Asset Behavior: Stocks vs. Bonds

The video details the distinct behaviors of different asset classes:

• Equities (Stocks):

  • Long-Term Returns: Historically generate greater long-term returns.
  • Short-Term Volatility: Exhibit significant short-term fluctuations.
  • Data Example: The S&P 500, over one-year periods since 1988, showed considerable volatility, with approximately a 20% chance of a loss. These are total returns, not inflation-adjusted.
  • Upward Drift: Over longer periods (e.g., 20 years), the upward drift driven by profit growth outweighs short-term volatility. Since 1988, there hasn't been a single 20-year period where equity markets have fallen.
  • Implication: Suitable for long investment horizons where volatility can be weathered, allowing investors to "monetize that drift."

• Bonds:

  • Lower Volatility: Generally less volatile than stocks, particularly short-duration bonds.
  • Capital Preservation: Primarily used for safety and capital preservation.

Age-Based Rules of Thumb and Tools

A common rule of thumb for asset allocation is "100 minus your age" to determine the percentage of the portfolio to invest in stocks. This rule captures the concept of a "glide path," where the allocation to riskier assets decreases with age.

The video highlights the availability of tools on the PensionCraft website for users to backtest their portfolios, analyze historical performance, volatility, drawdowns, risk-return plots, and asset correlations. A Monte Carlo simulation tool is also available to project future portfolio performance under uncertainty.

Beyond Age: Risk Appetite and Risk Capacity

While age is a significant factor, it's not the sole determinant of asset allocation. Two other critical components are:

1. Risk Appetite: An individual's emotional tolerance for potential losses. A young person with low risk appetite might still opt for a less risky portfolio.
2. Risk Capacity: An individual's financial ability to absorb losses without impacting their lifestyle. Low risk capacity necessitates a more conservative approach, regardless of age.

The video suggests that investment horizon (driven by age) is likely the most important factor, but risk appetite and capacity must also be considered.

Vanguard Target Retirement Funds: A Case Study

The video examines Vanguard's Target Retirement Funds as a concrete example of age-based asset allocation and their associated glide path.

• Age 25 (Early Career):

  • Allocation: 80% stocks, 20% bonds.
  • Stock Split: 60% Global ex-UK equity, 20% UK equity.
  • Bond Split: 15% Global ex-UK bonds (hedged to sterling), 5% UK nominal bonds (government and corporate).

• Age 50 (Mid-Career):

  • Allocation: 75% stocks, 25% bonds.
  • Observation: The glide path has changed minimally, leading to a question about its necessity if the changes are so gradual. A simpler approach like a Life Strategy 80/20 fund or a two-fund portfolio might suffice.

• Pre-Retirement:

  • Significance: This is a critical period due to accumulated wealth and increased sensitivity to market crashes.
  • Sequencing Risk: A crash at this stage can deplete savings, leading to faster withdrawal rates in retirement and shortening the portfolio's lifespan.
  • Allocation: 55% stocks, 45% bonds.
  • New Asset Class: Introduction of inflation-linked bonds to protect purchasing power.

• Age 75 (Retirement):

  • Glide Path Bottoms Out: The de-risking process generally concludes.
  • Allocation: Significant allocation to inflation-linked bonds (nearly 20%) due to the importance of inflation protection. Equity component remains for long-term growth and inflation beating.
  • Overall Risk: The portfolio is designed to have low risk.

Criticisms of Target Retirement Funds and Life Strategy Funds

The video raises several concerns about these types of funds:

• Not Universally Suitable: Not everyone will desire or benefit from the predetermined glide path. Some research suggests that maintaining more equity later in life can be beneficial.
• Lack of Withdrawal Flexibility: In a single fund, investors cannot choose which asset to sell during withdrawals. If selling from a Life Strategy fund, both equities and bonds are sold, even if bonds have performed better.
• UK Bias: A significant bias towards UK equities is criticized, as UK markets have historically underperformed global equities.
• Exclusion of Commodities: These funds typically do not include commodities, which can offer diversification benefits.

Alternative Portfolio Strategy: Tyler's Optimal Allocation

The video references research by Tyler, creator of Portfolio Charts, on optimal asset allocation for a 30-year retirement period, tested across various developed markets and historical worst-case scenarios.

• Worst-Case Scenario: Japan in the 1990s (property and equity market crash).
• Sustained Withdrawal Rate: A 4% initial annual withdrawal rate, inflation-adjusted thereafter, would have prevented depletion even in the Japanese scenario.
• Portfolio Composition:
  • Stocks: 40% (with a domestic bias, e.g., 10% domestic stocks).
  • Gold: 30%.
  • Bonds: 20%.
  • Broad-based Commodities: Included.
• Key Takeaway: Diversification beyond just stocks and bonds, including gold and commodities, can lead to comparable or better outcomes. Vanguard funds often lack exposure to these asset classes.

Real-World Customer Behavior and Personal Strategies

• Vanguard Customer Behavior: Vanguard's own research indicates that customers do not strictly follow age-based glide paths. Many maintain higher equity allocations even in later life, suggesting a greater willingness to accept risk. However, this data is limited to assets held on the Vanguard platform.

• Personal Investment Strategy (Presenter's Approach):

  • Core Investment: 100% in a global equity fund.
  • Pre-Retirement De-risking: Gradually shifting to hold a certain number of years of income in safe investments. This is calculated based on required income (excluding state pension and other sources) multiplied by the estimated recovery time for equity markets (e.g., 4-5 years).
  • Safe Investments: Could include a gilt ladder, money market fund, commodities, or gold.
  • Post-Retirement: Maintaining some safe assets for flexibility and to sell assets that have not crashed during market downturns.

Alternative Frameworks for Asset Allocation

Two alternative strategies are presented:

1. Bucket Approach (Temporal Diversification):

   • Concept: Investing based on when money will be needed, creating "time buckets."
   • Buckets:
     • 10+ Years: Majority in risky assets (equities).
     • Next 5 Years: Invested in safe assets (cash, money market funds, gilt ladder).
     • 5-10 Years: A mix of risky and safe assets.
   • Benefit: Works backward from future needs to current investment decisions.

2. Leverage and Temporal Diversification:

   • Concept: A more aggressive strategy that involves using leverage when young to boost early returns and reduce sensitivity to pre-retirement crashes.
   • Rationale: While young, individuals have more time to recover from potential losses.
   • Backtesting Results: Studies suggest this strategy can lead to higher returns and a more sustainable retirement pot.
   • Caveat: Requires a high risk appetite, as leveraged investments are significantly more volatile.

Cliff Asness's Two-Step Approach

The video concludes with a perspective from Cliff Asness, a prominent figure in investment:

1. Identify the Best Risk-Adjusted Return Portfolio: This involves combining assets (like stocks and bonds) to achieve more return per unit of risk. 100% equity offers high expected return but also high risk.
2. Assess Expected Return:
   • If Not High Enough: Consider leveraging the portfolio (e.g., using funds that allow for leverage).
   • If Too Risky: De-lever the portfolio or combine it with more safe assets (cash, money market funds).

Conclusion and Takeaways

The video emphasizes that asset allocation is a complex decision influenced by multiple factors beyond just age. Getting the right mix is crucial to avoid sleepless nights and regrets. The core message is to consider investment horizon, risk appetite, and risk capacity when constructing a portfolio. While age-based rules and target-date funds offer a starting point, personalized strategies that account for individual circumstances and preferences, potentially incorporating diversification into assets like commodities and gold, or employing temporal diversification, can lead to better long-term outcomes. The availability of tools for backtesting and simulation is highlighted as a valuable resource for investors.