How a Good Asset Allocation Model Can Impact Your Financial Future

DSC00011Assets allocation is just not one of those topics that most people find particularly sexy.  Usually it’s the sort of thing that gets about as much attention as the instruction manual to your Blu-ray player.

But as you’ll see below, it’s one of those parts of investing that you simply can’t ignore – largely because it can have a MAJOR effect on your finances and how long they ultimately last.

The reason I wanted to bring this up is because of the roller-coaster of market activity lately.  In case you haven’t checked your stocks or 401k balance in a while, there have been some pretty big up’s and down’s to the stock market.  Sometimes the Dow index has been down as much as 300 points – that’s almost a 2% down in one day!

How does your stomach feel after seeing a 2% drop in one day?

Or more importantly if you look at the Dow over the first 3 months since 2015 started, all the gains we’ve accumulated so far have been erased (notice how the chart starts and finishes pretty much right at the 17,800 line).

DowJones-First-3-Months-2015

Again – how does your stomach feel after hearing that news?

It’s okay to answer “NOT GOOD!”  We’re humans, and humans base a lot of our decisions on emotion.  Try as hard as we do to separate emotion from logic when it comes to investing, it’s still admittedly very difficult not to admit that you feel a sting when you see something like that.

So what can we do about this?  Well … obviously you can’t change what happens in the markets anymore than you can stand out in the middle of the expressway and expect to stop moving cars with your bare hands.  So that’s where coming up with the right asset allocation model comes in.  Deciding how you want to divide up your money between stocks, bonds, and whatever other types of investments is pretty much your only line of defense when it comes to protecting your fortune.

But I ask the question – how effective is this really?

To answer that, I put together a fun little experiment to see just how all of this would work.

 

Testing My Asset Allocation Model Against An Index Fund:

Read pretty much any financial blog or book and they will have you believing that the only thing you need to invest in is a stock market index fund.

While an index fund can be a strong part of your portfolio, it’s probably not the only thing you’d want to have in there – especially if you get the jitters when you see the markets take a nose dive.

So I ask this: Can we create an asset allocation model that gives us the best of both worlds?  Strong returns BUT ALSO less fluctuation?

I decided to put this experiment to the test by creating a very simple portfolio made up of just three Vanguard Index Funds:

  • Vanguard 500 Index Inv (VFINX) – 35%
  • Vanguard Intermediate-Term Treasury Investor (VFITX) – 25%
  • Vanguard Long-Term Treasury Inv (VUSTX) – 40%

(In other words, if every month I sent in $1,000 to Vanguard, I’d invest $350 in the S&P 500 stock market index, $250 in intermediate-term government bonds and $400 in long-term government bonds.)

It was pretty easy to download all the historical prices from Yahoo Finance, drop it all into Microsoft Excel, and then put together a mock portfolio to see how much money you’d have with a $1,000 investment every month.  (My model starts at 1992 because that’s as far back as the Yahoo data went.)

So how does our asset allocation (blue line) stack up 23 years later by January of 2015 against JUST the S&P 500 stock market index fund (red line)?

Asset-Allocation-Model-vs-Index-Fund-My-Money-Design

Interesting!  There’s a few things we can learn from this experiment:

  • You actually DO make more money with only S&P 500 index fund (or at least during the years used for this data set). You would have ended with $822,017 for the Index fund versus $712,116 for our made-up portfolio.  Percentage wise, that’s an annual compounded rate of 8.9% for the benchmark versus 7.8% for our asset allocation model.
  • You actually had about the same number of bad years (years where you lost money): 5 for the index fund, 4 for our portfolio. However the amount of loss was much less significant for our portfolio: -8.9% versus -39.4% for the stock market index fund.  By the way – both of those losses were during the infamous 2009 Great Recession!
  • Similarly to Point No. 2, you actually had about the same number of bad months (months where you lost money): 96 for the index fund, 93 for our asset allocation. Again, the amount of loss was much less significant for our portfolio: -7.3% versus -16.8% for the stock market index fund.

(Note that author Daniel Solin published very similar results in his book The Smartest Retirement Book You’ll Ever Read.)

Hmmm … so what does this experiment say about asset allocation during the accumulation phase of wealth building?  So far just proved to ourselves that over the last 23 years:

  • We’d have made less money (although the annualized returns were very close)
  • We’d have approximately the same number of “bad” years
  • We’d have approximately the same number of “bad” months

So then … why bother?

Because that’s not where the story ends ….

 

Protecting Your Fortune During the Distribution Phase:

Suppose we were in retirement (or close to it) in what’s called the distribution phase.  That’s when we’re taking money OUT of our nest egg for expenses.

Notice how our model (blue line) had far less “noise” as it climbed upward from left to right along the graph.  That’s not true for the stock market index (red line).  The fluctuations were far more jagged and more vertically spread.

Let’s come back to emotions: What would that do to your nerves?  Remember in 2009 when there was that 39% drop in the stock market?  How did you (or your parents) feel about seeing almost half of your 401k disappear?  Suppose there was a million dollars in there.  Then suddenly it’s only $610,000.  Holy cow!  It would be time to panic!

That’s where a good asset allocation model can help.  It can reduce the severity of market swings to align with your tolerance for risk.  In our portfolio we only lost as much as 9% during that same year.  While that’s not great, that’s not nearly as scary as a 39% drop.  Your million dollars would now only be $910,000 which is much safer than $610,000.

I believe the next scariest loss in our diversified portfolio was 4% followed by 2%.  Now those are losses I can live with!

And the best part – it only cost you approximately 1% in overall annualized return to have that stability.

My second point and the crux to this whole discussion: During retirement as you made withdrawals that you will use for living expenses, losses can compound over time and eventually cause you to lose all your money more quickly.

The easiest way to prove this yourself is to use a cool program called FireCalc.  Basically what this does is take any stretch of time over the past 100 years and show you how long your portfolio would have lasted (in other words how many periods your money would have lasted as opposed to how many periods you would have ran out of money).  Not only is this a great way to test different withdrawal rates, but it also allows you to work with REAL historical market data.

FireCalc-30Years

Again – having the right asset allocation can make all the difference in the odds of how long your money will last.  You have no idea what the stock market is going to do over the next 10, 20, or 50 years.  This is perfectly okay while you’re working and building up your fortune in the accumulation phase.  But when you retire and no longer are earning an income, you don’t want that!  In the distribution phase you NEED consistency and confidence that your money will not run out before you die.  And that’s where a diverse portfolio can really be useful – both for your emotions and your wealth.

Readers – How much do you pay attention to diversifying your investments?  Does anyone have a good asset allocation model that they follow and swear by?

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