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Early Retirement Investing 101: Figure Out Your Asset Allocation

by retirebyforty on September 25, 2013 · 21 comments

in early retirement guide, investing, retirement

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Asset allocation:  An investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.

-via Investopedia.

Whew, that was a little slice of Snoozeville. I will try my best to make the rest of this article a little more interesting… Asset allocation may sound very boring, but it is essential for long term investing. Your asset allocation is your investment road map. It will point you in the right direction and bring you back on track if you go astray.

Asset Classes

Generally, there are 3 asset classes that are included when we work on asset allocation.

  • Stocks – This could be individual company, mutual fund, and/or ETF. The stock market has the highest risk/reward out of these asset classes.
  • Fixed income – Bonds, bond funds, and Certificate of Deposit. This asset class is much safer than stocks, but historically generate less ROI.
  • Cash – Money in easily accessible accounts such as a saving account or money market.

Most of us like the gain from stock market investing, but we also can’t really handle the volatility. We can reduce volatility and risk by investing in bonds and having some cash reserve. Having some bonds and cash will also let you buy stocks during those down markets.

I think it is perfectly fine to put everything in stocks when you are just starting out and don’t have much money. As you get older and your life situation changes, you will need to adapt your asset allocation accordingly.

Asset Allocation will change as you age?

I invested all my portfolio in the stock market for many years, but now I’m much more diversified. What changed for me?

Goals – We all go through different life stages. When we first start working, our goals might be just to have fun. Later on, it might be to buy a house, to fund your kid’s education, or save for retirement. All these different goals will alter your asset allocation. For me, I’m not working a full time job anymore and I can’t save as much as previously. My goal now is growth with a big dose of capital preservation thrown in.

Risk tolerance – As you get older and build up a bigger portfolio, your risk tolerance will most likely decrease. When I was young, a 30% drop in the stock market didn’t faze me (much) because 30% of my portfolio was just $10,000. Now, I’d be physically sick if our portfolio dropped 30% because the raw dollar amount is so much bigger.

Investment horizon – As you get older, you also have less time to recover from a huge loss. If you are withdrawing living costs from your portfolio, a big down year have an equally big aftershock. All the money you withdraw during a down year will not have a chance to be a part of the economic recovery. Most older people also like more stability in their portfolio even at the cost of long term return. Our investment horizon is still about 20 years so we can be more aggressive right now.

How to dial in your asset allocation

It’s important to find the right asset allocation for yourself and stick with it through thick and thin. A lot of individual investors lost a lot of money by selling at the wrong time. If you have a personalized asset allocation plan, then you won’t have to worry about trading in and out of the market. You just need to stick with it and rebalance once in a while.

However, finding your own custom asset allocation ratio is not easy. I think it takes at least 10 years of investing to know how much risk you can tolerate. When the stock market is doing well, everyone’s risk tolerance is sky high. Who would want to miss out on the 20% gain on VB (small cap index ETF) we have seen in 2013? The real test will be when VB drops 50%. Go through a few of these down markets and you’ll see how much risk you can really handle.

Asset Allocation Calculators

Luckily, there are many online calculators to help you dial in your asset allocation. If you have been investing for less than 5 years, I would go through at least a few of these just to see what they say. You are probably overestimating your risk tolerance quite a bit.

Vanguard

Vanguard Investor Questionnaire. The Vanguard questionnaire asks you ten questions in an attempt to determine your risk tolerance. After you answer the question, Vanguard will show you the recommended asset allocation. I like this one because it’s pretty simple and it will show you Vanguard’s recommendation. Their recommendation seems a little conservative to me though.

figure out your asset allocation Vanguard questionaire

Yahoo!

This quiz from Yahoo! has 10 questions – Over 90 percent of investment returns are determined by how investors allocate their assets versus security selection, market timing and other factors.* Use this calculator to help determine your portfolio allocation based on your propensity for risk.

* Source: Brinson, Singer, and Beebower, ‘Determinants of Portfolio Performance II: An Update,’ Financial Analysts Journal, May-June 1991

Rutgers University

Investment Risk Tolerance Quiz from Rutgers - Answer 20 questions in an effort to determine your risk tolerance level.

Here is what I got from Rutget – Your Score: 33

You have a high tolerance for risk.

Once you have a ball park for your risk tolerance, you can plug it into these other asset allocation calculators below as well.

  • CNNMoney: CNNMoney steps you through four questions designed to figure out what kind of risk taker you are. It then generates a fairly basic asset allocation mix.
  • SmartMoney – Input your info and see their asset allocation recommendation.
  • Bank Rate’s asset allocation calculator – input your age, asset, savings per year, and a few more things to see the recommended asset allocation.

Get some professional help

The asset calculators are a nice start, but you’d probably want to talk to a real live financial advisor at some point. This is another whole topic which I don’t have much experience with. Here is a financial advisor’s article from Get Rich Slowly that’s helpful.

Another good option is to try Personal Capital. If your investable assets are over $100,000, then they will help you analyze your investment and come up with a personalize asset allocation plan. I had a financial planning session with Michelle CFP at Personal Capital and it was quite helpful for me. This is a great option if you want someone to take an in depth look at your risk tolerance and portfolio. You can also hire Personal Capital to manage your entire portfolio if you’d like. I wanted to continue managing my portfolio and they asked me to keep them in mind in the future. It was very nice that they didn’t try to do a hard sell on me.

Here is my personalized recommendation. It’s quite detailed and it’s very helpful.

financial planning session with Personal Capital

You can sign up with Personal Capital through this link.

asset allocation track finance cash flow investment rebalance retirement

Work on your asset allocation

It’s essential to find your optimal asset allocation plan. It will keep changing as you get older and gain more experience, but the earlier you start, the better off you’ll be. A customized asset allocation plan will guide you through those rocky years.

Do you have an asset allocation plan? Has it changed much over your investment life?

Follow up - Early Retirement Investing 101: Rebalance Your Portfolio

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{ 21 comments… read them below or add one }

Jane Savers @ Solving The Money Puzzle September 25, 2013 at 3:44 am

With just a decade before my planned retirement date I am choosing to be very conservative because I do not have much and won’t have much saved so I cannot afford to take chances.

If I had a large portfolio or a generous employee pension to rely on I would be more adventurous but I am going to stick with Vanguard ETFs and GICs (like your CDs). I want it to be 80/20 for the next 6 years then it will slowly shift to 20/80 or even 100% GICs depending on rates.

GICs are guaranteed by the Canadian government and people who can’t afford to loose can’t afford to take risks.

Reply

Bryce @ Save and Conquer September 25, 2013 at 11:38 am

80/20 for the next six years is not what I would consider conservative. I would call that extremely risky with only 10 years until retirement. Since you seem desperate to increase asset value, I would suggest perhaps 60/40 until near retirement and then reduce to 50/50, or go with the GICs if the rates meet your needs. I go with 50/50 asset allocation, because that is what gave the best results for the 4% safe withdrawal rate (SWR) over 30 years in the Trinity Study. There have been many discussions over that study and ways to increase the initial SWR. To may to go into here, but Google for Wade Pfau. He has written a lot of research papers on this, and is well respected on Bogleheads.org.

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Bryce @ Save and Conquer September 25, 2013 at 11:40 am

Should read, “To many to go into here,”

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davidmichael September 27, 2013 at 8:51 am

I agree that 80/20 is very risky. How would you feel if we had another Great Recession and you lost 50% of your portfolio. Then, the economy stagnated for another 15 years or so…like Japan. It can and does happen. As someone who is retired (me), you might take a longer term viewpoint and make sure you have some investments that are fool proof that balance out any riskier ones. Slow and steady is better than fast and lose. I’ve been there and it’s not fun.

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retirebyforty September 25, 2013 at 1:59 pm

I think 80/20 is pretty risky with 6 years left. You probably need to adjust down a bit.
Try some of those quiz and see what they recommend.

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Fast Weekly September 25, 2013 at 4:26 am

I don’t suppose there is anything so personal as asset allocation in personal finance. Good work showing a few of the suggestions you received from different sources

-Bryan

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Insourcelife September 25, 2013 at 6:57 am

For our 401K/SEP/Roth retirement portfolio, we are investing 100% into Vanguard 2040 Target Date fund. We’ve been doing that for over a decade now and we’ll keep adding to it until our retirement is fully funded (based on my calculations), which should happen very soon actually. Then we’ll stop adding money there and let it ride until we turn 60 when we can start withdrawing to fund our official retirement. I like the simplicity of this investment strategy since the 2040 fund will automatically rebalance and grow more conservative as we get older.

For our taxable portfolio, I will be putting 60% into VTI (Vanguard stock index), 30% into BND (Vanguard bonds index) and 10% into VNQ (Vanguard REITs). These are all ETFs with very low fees. I feel like with a paid off house it will provide a solid foundation for our pre-retirement FI money… what do you think?

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Andrew@LivingRichCheaply September 25, 2013 at 10:50 am

Most of my Roth IRA is in Vanguard 2045. I think it’s close to 90% in stocks. I still have a lot of time before retirement so I can afford to be a little aggressive. Plus I do have a pension which is another reason why I think I can be more aggressive.

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Bryce @ Save and Conquer September 25, 2013 at 11:28 am

It’s funny that Vanguard’s questionnaire gave you a conservative asset allocation. It gave me a moderate 60/40 stock/bond allocation, but that is still more aggressive than our current 50/50 allocation. We are at 50/50 because my wife and I are within 10 years of retiring using the expected returns of that allocation.

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EL @ Moneywatch101 September 25, 2013 at 5:01 pm

How about REIT funds? I have about 50% stocks, 20 % Bonds, 15% International and 15% in a REIT. Thanks for the info..

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retirebyforty September 25, 2013 at 10:02 pm

REIT funds can be classify as “alternative” along with gold and other hard assets. See the Personal Capital pie chart above. 15% is pretty good. It give you some diversification.

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Charles@Gettingarichlife September 25, 2013 at 5:17 pm

Joe,
I’m pretty agressive with my allocations so I am currently at 90%. Even in retirement I plan to be around 60% as I have a pension. People with pension should consider more stocks as the pension is a hedge.

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retirebyforty September 25, 2013 at 10:04 pm

That might be a good idea since you don’t need as much fixed income. If you can handle the volatility, then it’s probably fine. I’d probably go with less stock even with a pension though. Maybe 50/50.

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krantcents September 25, 2013 at 5:34 pm

My asset allocation has not and will not change as I get older. I factor in my fixed income portion (pension & Social Security) so my portfolio is set on growth.

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Justin @ RootofGood September 25, 2013 at 7:22 pm

This is crazy, but I’m still about 97% equities even though I’m not working any more. I have started looking at increasing the cash or short term bonds allocation. Thanks for the impressive oversight of allocation tips and tools from different places. Good to get it all in one place here.

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retirebyforty September 25, 2013 at 10:06 pm

That’s really high. You should try those quizzes and see what they recommend. Perhaps talk to Personal Capital.
Can you handle a big 20-30% drop in the stock market now that you’re not working anymore?

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Pretired Nick September 26, 2013 at 10:39 am

I really need to do some serious work on this. I’ve been so focused on just straightening out my real estate world that I haven’t gotten back into this. I tend to look at my pretirement fund and my traditional retirement fund separately, though. My traditional retirement fund, I tend to follow broad industry recommendations, whereas I’ll take on some higher risk with my pretirement money in return for more income.

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retirebyforty September 27, 2013 at 3:19 pm

My pretirement fund are separate from my retirement fund, but I look at them as a whole.
I think it’s better to have the whole picture.
I’m taking a bit more risk in my dividend portfolio too.

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RICHARD September 26, 2013 at 5:37 pm

I am within one year of pulling the plug so to say and I am 99% in dividend stocks. As long as they pay me I am hoping to be OK.
But, just in case, I am considering building my cash, GIC position here on in. Why? To weather any down turn in the stocks. I also have some non-registered investments and will draw those down before tapping the RRSP’s (converting to RIF). Remember that at 71 years of wisdom you get to withdraw 7.38% (increasing yearly) from you RRSP’s (RIF or Annuity) whether you need it or not. If you convert to an RIF prior to that then it is a lesser amount (4% at 65yrs). You can check out the percentages on the web.
So if the stocks are lower at that point then I draw less from them (principal X 7.38%). Hoping that the dividends do not diminish I may be able to weather several years of stock market fluctuations before actually drawing down the principal. And if it is more than I actually need than I can always contribute to my TFSA.
Hoping to re-invest some $38K from dividends this year. SO far i am on track.

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retirebyforty September 27, 2013 at 3:22 pm

99% in dividend stocks seem very volatile. Can you really handle a big downturn in the stock market?
I’d build up more cash reserve and GIC unless you have other sources of income.
$38k is great! Nice job.

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Ben September 26, 2013 at 6:09 pm

I have a hard time deciding how much to allocate to bonds for a long term strategy. I will hold them for diversification and to smooth volatility, but I think they are incorrectly thought of as less risky than stocks. I think they simply have different risks than stocks. Especially in a low to rising interest rate environment.

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