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January 25, 2016

The “Right” Asset Allocation

We are often asked how much a retiree should allocate to stocks. It’s a good question. Risk tolerance may lead you to take a certain amount of risk. However, if the goal is to maximize income, is there a “right” asset allocation?

I’ve written before about the research done by William Bengen about the safe amount that a retiree can withdraw from an investment portfolio. You can read about that research here. When Bengen expanded his research in 2006 he looked at how asset allocation impacts the safe withdrawal rate. The resulting graph is a good place to start our analysis.

Recall that “SAFEMAX” is the term for the maximum withdrawal rate that has never failed. Notice that there is relatively little difference between the safe withdrawal rate for stock allocations beginning with 40% and going up to 70%. This suggests that the “right” allocation is contained between 40% and 70% stocks. Investors with a higher allocation of stocks are likely to have more left at the end of their retirement. The risk is that higher stock allocations lead to portfolio failure when markets go against the retiree.

Bengen did go on to look at improving the results by including small company stocks, but this did not materially affect the total equity allocation. Other researchers have looked at including small company stocks and international stocks to improve the results. The higher return of small company stocks did improve the results, but did not change the overall equity allocation results from Bengen’s research.

Other research has showed that adjusting asset allocations over time does improve results. These are commonly called dynamic asset allocations. One simple rule that seems to work is based on Shiller P/E ratios. This is a measure of how “expensive” the overall stock market is at a point in time. Retirees can take more income by owning more stocks when stocks are cheap and owning fewer stocks when stocks are expensive. This is easier said than done. It means selling stocks as stocks move higher and buying stocks when they are lower. Buying low and selling high improves results. Imagine that!

This research supports the advice we give to retirees. We usually suggest a diversified portfolio with either 50% or 70% allocated to stocks. We then work to reduce the stock allocation when prices look high and add to the equity allocation when prices look low.

Bottom Line: A moderate or moderately aggressive allocation should maximize the probability of success. You can improve results when you are willing to add to your stock positions when markets are bad.

From the desk of Kris Carroll


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