roll your own target date fund, part 2: allocations

Pie chart made with 100% real pie. Photo by echang via stock.xchng.

Hopefully, last week convinced you that while a target date fund is a good place to start, ultimately it’s up to you to make the right decisions for your portfolio. Of course, you already know that the most important investing rules are 1) save earlier, 2) save more, and 3) be tax-efficient, but asset allocation is right up there; it can make the difference between a smooth transition to retirement and losing half your portfolio the year before! So: following are some simple guidelines for constructing your asset allocation. I could write a book on this — and many people have — but I’m going to fly through a top-level summary here, so that you have just enough information to construct a decent allocation.

Step 1: Cash. Any money you’re going to need in the next two years should be in cash or cash-equivalents; generally, this means a money-market or stable value fund. Why? Because even a short-term bond fund isn’t guaranteed to maintain its value, and in fact, it was a full year before many such funds recouped their losses from their peak in 2007.

Step 2: Stock/bond allocation. The rest of your money should be broadly divided between stocks and bonds. Stocks are riskier but have a higher expected return; bonds are more stable, but have a lower expected return. Your stock/bond allocation is absolutely critical; much of the rest is gravy, if you’re making halfway decent decisions. An allocation to all stocks means the risk of losing half your portfolio in a given year; an allocation to all bonds means having inflation devour your returns. Let’s walk through one way to calculate your stock/bond split:

Step 2a: How much can you lose, without losing sleep? This is probably the hardest question to answer honestly. A lot of folks thought their appetite for risk was greater than it actually was…and then 2007 happened, and they panicked so badly that they sold everything and went to cash. This is precisely what you want to avoid; you want to balance your maximum equity allocation with your maximum tolerable loss. You can thank Larry Swedroe and William Bernstein for the following table:

 Maximum Tolerable Loss  Maximum Equity Allocation
5% 20%
 10% 30%
 15% 40%
 20% 50%
 25% 60%
 30% 70%
 35% 80%
 40% 90%
 50% 100%
Step 2b: When will you need the money? Your appetite for risk may be sky-high, but your portfolio’s might not be, depending on how far out your goals are. Here’s another table, again courtesy of Swedroe and Bernstein.
 Time Horizon (years) Maximum Equity Allocation 
 0-2 cash
 3 10%
 4 20%
 5 30%
 6 40%
 7 50%
 8 60%
 9 70%
 10-14 80%
 15-19 90%
 20+ 100%

Step 2c: Use 2a and 2b to determine your equity allocation. In other words, choose the lesser of the two; this represents the most risk you should take with your portfolio, both from your personal point of view and your portfolio’s. 

Step 3: Divide your equity portfolio into international and domestic components. Basic allocation: 30% international, 70% domestic. The US is about 50% of the global market, but there is some uncompensated risk to international investments (namely currency fluctuations and event risks caused by restrictions on foreign investors, if you’re interested).

Step 4: Divide your domestic equity portfolio into sub-categories. Basic allocation: 10% of your equities be in real estate, because it often (not always!) tends to move in an uncorrelated fashion from other equities, with the rest divided equally between large-cap equities, large-cap value equities, small-cap equities, and small-cap value equities. (I recommend the tip towards value because growth stocks tend to be less “efficient”, i.e. less stability for their lack of return compared to value.)

Step 5: Divide your international equity portfolio into sub-categories. Basic allocation: equal portions developed, international small-cap, and emerging markets. (If that sounds like a high allocation to emerging markets, remember: this is only 30% of your equity portfolio.) If you don’t have access to an international small-cap fund, feel free to put that part in developed, as well.

Step 6: Divide your fixed income portfolio into sub-categories. Basic allocation: equal portions short-term bonds, intermediate-term bonds, and inflation-protected bonds. I don’t recommend long-term bonds because they’re generally quite volatile for the modest increase in returns they give you, and I don’t recommend junk bonds because they put instability into the stable part of your portfolio.

There you have it — your own personal asset allocation. Note that beyond the cash/stock/bond split, I pretty much dictated the sub-allocations; this was done for simplicity’s sake. If I ever write that book, I’ll probably have a lot more to say on the matter; for now, however, this will get you most of where you want to go.

An asset allocation is really an abstract concept, however; next week, we’ll talk about the actual investments you’ll use to implement your allocation!