In Part 2 of our Allocation Strategies series we’re covering one of the most important topics relating to portfolio allocation, picking your equity to bond ratio.

What is portfolio allocation and why does it matter? Basically it’s about finding the right mix of investments, deciding which account buckets to put those investments in, and deciding when to tap into each of those buckets during your life. And like everything else in the world of investing, portfolio allocation is about balancing risk and growth.

Allocation strategies aren’t just for early retirees, or retirement in general. They’re useful concepts for anyone who invests. The goal is to make sure the success of your portfolio doesn’t depend on a single investment or even a single investing plan. Your portfolio allocation strategy should be designed to earn the total return you need over time for your entire life expectancy. And your strategy shouldn’t be a one-time decision either. You’ll want to revisit your allocation strategy annually as the market fluctuates and you make withdrawals or deposits so you can make sure it’s meeting your needs as well as your hopes and dreams.

We are not certified financial professionals. For more information please read our Disclaimer.

---

Everyone, Meet Jane Roe!

We need an example scenario for this post so in honor of the incredible importance of making abortion legal, safe, and accessible for every woman in the USA, we’ll call our example person Jane Roe. Because after all, having the right to choose for yourself is paramount to financial independence.

As we write this post Jane is in the process of figuring out her comfort level with risk so she can create her equity/bond allocation strategy. Of course Jane has already built her Money Job system to help her budget for annual expenses, but if you missed that first post in our Allocation Strategies series you can find that Money Job post here.

Here are a few more details about Jane…

• She is 45 years old, has no children, and single by choice
• She was a high income earner during her career
• She reached financial independence in 2020, and plans to start early retirement in 2022
• Her post-retirement budget for annual living expenses (including taxes and health insurance) is $55,000
• She has $126,800 set aside in cash and cash equivalents to cover all of her Surprise and Experience Money Jobs for her first few retirement years
• Her total portfolio value is currently $1,500,000
• Her safe withdrawal rate (SWR) is 3.67%
• She saved 27.27 times her annual expenses before retiring

The following graphic gives us an overview of Jane’s portfolio and her SWR on the left, then a table for her budget in the middle, followed by a table for her additional Money Jobs on the right. The goal with this part of our spreadsheet is to keep an eye on the big picture of your finances.

What’s Your Risk Tolerance?

Anyone who invests in the market needs a baseline strategy that fits their age and risk tolerance. You need to know when you might start drawing down on your portfolio and you also need to know how freaked out you would be during normal (or unusual) market volatility. If you’re young and won’t need your money for decades, having all equities or a high percentage of equities in your portfolio will expose your money to the historical direction of the market… which is good because that historical direction is UP!! But if you’re retired and withdrawing from your portfolio now, or planning to retire very soon, it might make sense to reduce your equities somewhat for less exposure to near term unpredictability.

In other words, if you don’t need to withdraw from your portfolio anytime soon that volatility is probably a good thing since that upwards volatility helps create longterm compounding growth. But during retirement if you’re making regular withdrawals like we are, that volatility can create adverse sequence of returns risk and cause a portfolio to run out of money before you run out of time.

Do You Have (a) PMS?

We all have unique plans, goals, and dreams so we all need a financial plan that considers our goals and circumstances. And we all deserve better than the silly old rules of thumb that weren’t designed for us in the first place. From our perspective, every investor is a special unicorn.

If you’re thinking about what your allocation should be, pause to fill out a Personal Money Statement (PMS) or any other style of document that lets you outline your unique plans and put target dates on them. What are your hopes and dreams for your life now? And for your life after retirement? How would you feel during normal market fluctuations? How would you feel during a Black Swan event? What kinds of changes would you see as appropriate for you and your portfolio during normal market volatility, and during Black Swan events?

At the end of February in 2020 when the Coronavirus Crash first started we definitely had a moment of surprise and anxiety when we saw that crash keep crashing. I remember turning to Ali and asking, “What are we going to do?” In that moment we didn’t do anything other than refer back to our PMS document. Our PMS stated very clearly: “We will not panic as a result of the ups and downs of the market. And we will especially not panic if there is a major Black Swan event or a prolonged downturn. We will not sell securities due to market corrections. And we will not invest the cash set aside for our living expenses as a reaction to a downturn in the market.” Since we had our guidelines set before the crash we did not panic. We responded to the crash by doing nothing! Well nothing other than to go for a walk and focus on what we wanted to have for lunch.

What would you do if you experienced a market crash in retirement? Before that happens lay out your plan in a PMS!

What’s Your Equity to Bond Ratio?

When we filled out our PMS a year before we retired we talked a lot about what our equity to bond ratio should be as we approached early retirement, knowing our real goal was to make sure our portfolio could last for 60 years. We wanted enough bonds to give us some stability and we wanted enough equities to allow for growth. We talked about options like a more risk averse 60/40 ratio, as well as a more risk tolerant 80/20 ratio, and then we settled on an equity to bond ratio of 75/25. We can’t control much but we can control our equity to bond ratio and that means we have at least a little control over the long term reliability of our portfolio.

There are some generic retirement rules of thumb that traditional investment managers still recommend, such as the old idea that your percentage of stocks should equal 100 years less your age. According to that old rule of thumb Jane should hold only 55% equities and 45% bonds in her portfolio — we object to that! This is 2021 and people are living longer and retiring earlier than they were when that old rule of thumb was created. Today’s retirees need more growth oriented equity to bond ratios to make sure their portfolios last. 

There actually is a new version of that old rule of thumb that says that your percentage of stocks should equal 120 years less your age. According to this new rule of thumb Jane should hold 75% equities and 25% bonds in her portfolio since she’s 45 years old. That sounds much better to us, but we still think it’s a bad idea to simply follow a standardized rule of thumb without taking everything unique about your situation into consideration.

Know Your Variables!

There are important variables to consider when trying to pick your portfolio’s equity to bond ratio. We each have circumstances, plans, and goals that compound to give us unique financial needs. We can control some variables to some degree, like how much we spend. But there are also some variables we can’t control at all, like inflation.

Variables you can hopefully control:

• How much you save
• How much you spend
• Your risk tolerance
• Your investment fees

Variables you can’t control:

• Inflation 
• Market fluctuations
• Market return
• Your life expectancy

All of these variables are worth understanding and tracking, whether you can control them or not. For all of those things we can’t control we just do our best to make informed assumptions. We gather data, make plans, and stay open to making changes when we learn new things that give us a deeper understanding of our finances.

The chart below shows some of Jane’s basic portfolio data including her estimated real return and expenses. This gives her a baseline to start with when testing her portfolio.

Estimate Your Portfolio Longevity!

When estimating portfolio longevity we like to start very conservatively with a lower range of annual market growth and dividend yields. We also like to reduce nominal growth by estimated inflation and known fees to calculate a real return rate and finally target an allocated return rate. 

Without a crystal ball it’s impossible to predict exactly how long a portfolio might last. But coming up with a baseline prediction is still an important part of the process. If you want to run your own estimate check out the spreadsheet we share, our Simpli-FI-ed Calculator.

75% Equities with a 3.67% SWR

Calculating real allocated return rates when estimating portfolio growth helps us clarify how our expenses (with annual inflation) impact our long term projections. It also helps us start to project how long our portfolio might last.

Based on the assumptions Jane started with such as 2% inflation and a 4.77% allocated real return, we can see in the example below that her portfolio is projected to run out of money in 47 years. And that initial example doesn’t even factor in things like major one time expenses or health care costs. That baseline starting point also excludes retirement income sources like pensions, Social Security, or rental property income. As shown in the graph below, Jane’s portfolio will continue to grow until her annually inflated expenses overtake her retained compounding growth.

The chart below shows how Jane’s growth and buying power with a nominal return of 7.8%, reduced by 2% inflation, leaves her with a real return of 5.77%. Jane’s 75% equity allocation further reduces her return rate down to an allocated return rate of 4.77%. When we subtracted Jane’s annual withdrawal rate we saw her 4.77% allocated return, less her 3.67% SWR, results in a 1.1% retained return. Having a retained return of only 1.1% may not seem like much but with the power of compounding growth it is still pretty magical.

80% Equities with a 3.67% SWR

After running that initial baseline calculation above, Jane was a bit concerned that her portfolio would run out of money in only 47 years since she has projected her life expectancy at 95 years. And Jane knows those last years before her end of life could include costly medical expenses and health care needs so she’s definitely not comfortable with a 47 year portfolio. As a next step Jane wanted to move her equity allocation up to 80% to see how that would change things in the calculator.

You might not think a 5% change in equities would have that much of an impact, but incremental changes can have a big impact over the life of a portfolio. By increasing Jane’s equity allocation to 80% the calculator showed her portfolio would last an extra three years. That helps but it doesn’t get her to her full life expectancy. Jane might need to consider other variables that could extend the life of the portfolio even further like working for another one or two years to build a bigger portfolio and/or dropping her annual expenses by a few thousand dollars. All of the variables impacting your portfolio have either a negative or positive effect on growth so knowing what you can control is powerful.

Changing her equity allocation up to 80% extends the life of Jane’s portfolio to 50 years. The chart below shows how Jane’s growth and buying power with a nominal return of 7.8%, reduced by 2% inflation, leaves her with a real return of 5.77%. This time we see that Jane’s allocation of 80% equities further reduces her allocated return rate to 4.97%. Jane’s 4.97% allocated return, less her 3.67% SWR, results in a stronger 1.3% retained return.

Living with Volatility 

One of the biggest factors for investors to consider is the higher your equity exposure the more your portfolio will be subject to the natural ups and downs of the market. Of course we don’t want volatility in our personal lives. But as longterm investors market volatility seems fairly normal in the same way that the overall longterm upward trend of the market seems normal. But even if you understand that reality, it can still be hard for lots of people to trust that what goes down must eventually come up again.

It’s also interesting to test your portfolio with real market activity. One example we’ve been using from our very recent history is the 2020 Coronavirus Crash, a Black Swan event that caused the Dow to lose 37% of its value and the S&P 500 to lose 34% of its value between February and March of last year. We decided to test Jane’s portfolio using a 75% equity allocation and a 30% market drop. Even though her portfolio showed a large drop along with the market she was relieved to see that her drop was less dramatic because her portfolio was only exposed to 75% of that total market crash. Jane’s portfolio only experienced a 22.5% drop in value compared to a 30% drop in the market. But that protection is a tradeoff against growth since Jane’s portfolio would have an allocated real growth rate of only 4.77%.

Conversely, if Jane’s portfolio was allocated to hold 80% equities her portfolio would be exposed to a larger drop as well as a potentially faster recovery. With 80% equities her portfolio would drop 24% in value during a 30% drop in the market, and then would hopefully recover faster with a larger allocated real growth rate of 4.97%. Allocation really is a balancing act between reducing risk and reaching for growth.

Growth is Key!

Picking an allocation rate that helps manage your reaction to volatility has value, but picking an allocation that keeps your portfolio growing for the amount of time you need is essential. Jane wants to do as much portfolio testing as possible now that she’s locked in a retirement SWR of 3.67%. Since we already tested Jane’s portfolio with 75% equities and then a more aggressive 80% equities rate, it’s time to see what a more conservative 60% equities rate looks like.

60% Equities with a 3.67% SWR

In this test Jane’s equity ratio has been reduced to 60%. The chart below shows the same nominal return of 7.8%, less 2% inflation, with her a real return of 5.77%, which gives her a 4.17% allocated return. Again we subtract Jane’s withdrawal rate to see how much growth she would retain. This time her 4.17% allocated return, less her 3.67% SWR, gives her only a 0.5% retained return.

Dropping the equities in Jane’s portfolio to only 60% doesn’t do her or her money any favors. The chart below shows that 60% equities with a 0.5% retained growth rate means her portfolio will only last 39 years. With these numbers rate Jane would run out of money by age 84, long before her projected life expectancy. The numbers in this test might keep her calm during a market drop but they won’t give Jane the annual growth rate she needs to make her portfolio last through a long retirement.

The only bright side to this test is shown below. Jane saw that 60% equities means her portfolio would only be exposed to an 18% drop during a 30% market drop, and of course she liked realizing her portfolio would take much less of a hit with this allocation if there was a market crash like the Coronavirus Crash today. That was a great reminder that having a lower exposure to risk can do a lot to protect your portfolio in a down market.

Fees Can Cause Problems!

One of the most overlooked variables in this complicated puzzle is investment fees. Some of us are DIY investors, but we’ve heard from plenty of people who don’t have the confidence to manage their own money and so prefer to work with CFA’s who actively manage their portfolios. We like to invest in more passively traded index funds that are designed to track a benchmark like the total US broad market. But others want to invest in funds that are more actively managed with the idea that they might bring in a home run hit that sets them apart from the pack. Regardless, we all pay some level of fees.

In the above examples Jane has been investing in passively managed index funds as much as possible with a net expense ratio of 0.03%. That’s a really, really low fee percentage and we’re using that number because it’s the same fee percentage we paid in 2020. In an effort to help Jane understand how her 0.03% fees are working in her favor, we’re going to test her portfolio with slightly higher fees. The example below shows what her portfolio would do over time if we increased her fee percentage to 0.5%. You might think those fees are still low, but that increase has a huge impact on Jane’s portfolio.

With this one seemingly small change in Jane’s variables her portfolio would only last 36 years compared to the 47 years we saw with 0.03% in fees. We’ve found that many people don’t realize paying 0.5% in fees (or even higher fee percentages) across their portfolio is extremely consequential. It’s really important to understand that fees can make a BIG difference, and not a good one, in the life of a portfolio.

Choose Your Equity to Bond Ratio Wisely!

Your final equity allocation ratio is very personal. Maybe yours is one part rule of thumb (120 – age = equities), plus one part emotional needs (check your PMS), and one part life expectancy (portfolio longevity). Some people might copy another person’s plan or follow standard advice, both of which are a bit like throwing a dart at a dart board to see what you randomly get. In the end you need to pick an equity to bond ratio that’s right for you, both emotionally and financially. Be mindful of your investment strategy and you will sleep better at night.

As an investor you can’t capitalize on long term compounding growth without exposing your portfolio to some risk. Your time horizon and temperament will help you find your equity to bond ratio, and you can document your strategy in your PMS with a description of WHY you picked your equity ratio. Then you can rebalance according to plan and on schedule, regardless of what the market is doing. There will be times when you need a reminder of what your goals are and why you picked your numbers, and there might also be reasons to adjust your equity ratio at some point. If you do make any changes, be sure to document your reasoning for those changes in your PMS. The goal is to make sure you don’t make adjustments on a whim or have knee jerk reactions based on fear or greed. And since I love sports analogies I’ll share my current favorite — Remember to go for base hits and don’t get caught up in the fervor of swinging to the fences.

The next post in this Portfolio Allocation series will focus on bucket strategies as a way to make sure we have money positioned in accounts that are accessible when we need them, as well as tucked away for long term growth.

Now check out Part 3 in this series!