Life is balance and choice. Add more of this, lose a little of that. When it comes to investing, that balance and choice is informed by your temperament and goals.
If I had it to do over, this blog would be likely named The Simple Path to Wealth after one of my very earliest posts and currently the working title of my upcoming book.
Financial geeks like me are the aberration. Sane people don’t want to be bothered. My daughter helped me understand this at just about the same time I was finally understanding that the most effective investing is also the simplest.
Complex and expensive investments are not only unnecessary, they under-perform. Relentlessly fiddling with your investments almost always leads to worse results. Making a few sound choices and letting them run is the essence of success, and the soul of the simple path to wealth.
The Wealth Acquisition Stage and the Wealth Preservation Stage. Or, perhaps, a blend of the two.
The wealth acquisition stage is when you are working and have earned income to save and invest. For this stage I favor 100% stocks and VTSAX is the fund I prefer. If financial independence is your goal, your savings rate in these years should be high. As you invest that money each month it serves to smooth out the market’s wild ride.
You enter the wealth preservation stage once you step away from your job and regular paychecks and begin living on income from your investments. At this point I recommend adding bonds to the portfolio. Like the fresh cash you were investing while working, bonds help smooth the ride.
Of course, in the real world the divisions might not always be so clear. You might find yourself making some money in retirement. Or over the years you might move from one stage to the other and back again more than once. You might leave a high-paying job to work for less at something you love. For instance, in my own career it was never about retirement and there were many times when I stepped away from working for months or even years.
But using this framework of two stages and two funds, you have all the tools you need to find your own balance. In determining that balance you’ll also want to consider two additional factors: How much effort you are willing to apply and your risk tolerance.
For the wealth acquisition stage an allocation of 100% stocks using VTSAX is the soul of simplicity. Further, most studies have shown that this allocation provides the best return over time. But not all. Some studies suggest that adding a small percentage of bonds, say 10-20%, actually outperforms 100% stocks. You can see this effect by playing with this calculator: Vanguard Retirement Nest Egg Calculator You’ll also see that adding too great a percentage of bonds begins to hurt results.
Now remember that these studies are not carved in stone and like all calculators this one relies on making certain assumptions about the future. The difference in projected results between 100% stocks and an 80/20 mix is tiny. How those results actually unfold over the decades is likely to be equally close and the ultimate winner is basically unpredictable. For this reason, and favoring simplicity, I recommend 100% stocks using VTSAX.
That said, if you are willing to do a bit more work, you could slightly smooth out the wild ride and possibly outperform over time by adding 10-25% bonds. If you do, about once a year you will want to rebalance your funds to maintain your chosen allocation. You might also want to rebalance anytime the market makes a major move (20%+) up or down. This means you will sell shares in whichever asset class has performed better and buy shares in the one that has lagged.
Ideally you will do this in a tax-advantaged account like an IRA or 401k so you don’t have to pay tax on any capital gains. Having to pay capital gains taxes would be a major drawback and another reason to focus on holding just VTSAX. This rebalancing is simple and can be done online with Vanguard. It should only take a couple of hours a year. But like changing the oil in your car, it is critical that you actually do it. If you like this idea but are unsure you’ll remember to rebalance or simply don’t want to be bothered, here are two fine options:
Both allow you to choose your allocation and then they will automatically rebalance for you. They cost a bit more than the simple index funds you’d use doing it yourself — you are paying for that extra service — but they are still low-cost.
Basically, bonds smooth the ride and stocks power the returns. The more you hold in stocks the better your results and the more gut wrenching the volatility you’ll be required to endure. The more bonds, the smoother the ride and the lighter the results. If you are going to hold stocks you need to be mentally tough enough not to panic when they plunge. And make no mistake, over the decades you own them, plunge they will. Usually at the most unexpected times.
There is a major crash coming and you’ve got to…
Let’s be clear. Everybody makes money when, as it has now since 2009, the market is on the rise. But what determines whether it will make you wealthy or leave you broken and bloody at the side of the road, is your ability to stay the course and ride out the storms. If you have any doubt as to your ability in this regard, you will be better off avoiding stocks. Regardless of what the calculators say.
Factors to consider in assessing your risk tolerance.
Temperament. This is your personal ability to handle risk. Only you can decide, but if ever there was a time to be brutally honest with yourself this is it.
Flexibility. How willing and able are you to adjust your spending? Can you tighten your belt if needed? Are you willing to move to a less expensive part of the country? Of the world? Are you able to return to work? Create additional sources of income? The more rigid your lifestyle requirements, the less risk you can handle.
How much do you have? As we’ve discussed, the basic 4% rule is a good guideline in deciding how much income your assets can reasonably be expected to provide over time. If you need every penny of that just to make ends meet, your ability to handle risk drops. If, on the other hand, you are spending 4% but a big chunk of it goes towards optional hobbies like travel you can handle more risk.
Taking all these considerations into account, here’s what we do personally:
Our daughter is just beginning her career and her wealth acquisition stage. She wants things to be a simple as possible. She is 100% in VTSAX and likely will be for decades to come.
I am retired and my wife will be shortly. Assessing the three risk factors above our personal tolerance is very high. We hold an aggressive allocation of 75/25 stocks/bonds. The more common and conservative recommendation for our age would be 60/40 or even 50/50.
Our allocations very well might not fit your needs. But this post should give you an idea of how to approach the question and reading the Stock Series will help you understand just what you are dealing with when investing in the market. After that, you have to know yourself.
What would the bursting of the bond bubble look like? (Thanks to Kenneth in the comments for this one)
When should I make the shift into bonds?
This is very much a function of your tolerance for risk and your personal situation.
For the smoothest transition you might start slowly shifting into your bond allocation 5 or 10 years before you are fully retired. Especially if you have a fixed date firmly in mind.
But if you are flexible as to your retirement date and more risk tolerant, you might stay fully in stocks right up until you make the change. In doing so the stronger potential of stocks could get you there sooner. But if the market moves against you, you’ll have to be willing to push your retirement date back a bit.
Of course, anytime you shift between the acquisition and preservation stages, you’ll want to reassess and possibility adjust your allocation.
Balance and choice. Yin and yang
Does age matter?
As you’ll note from above, I’ve divided investment stages by life stages rather than using the more typical tool of age.
This is an acknowledgment of the fact that people are living much more diverse lives these days. Especially the readers of this blog. Some are retiring very early. Others are retiring from higher paid positions into lower paid work that more closely reflects their values and interests. Still others, like I did, are stepping in and out of working as it suits them, their stages fluidly shifting.
So age seems not to matter. At least not as much as it once did.
But that said, age does begin to limit your options as it advances. Age discrimination is a very real thing, especially in the corporate world. As you get older you may not have all the same options readily available as in your youth. If your life journey involves stepping away from highly paid work occasionally, you’ll do well to consider this.
Further, as you age you steadily have less time for the compounding growth of your investments to work.
Both these considerations will influence your risk profile and you might well want to consider adding bonds a bit earlier if that’s the case.
Is there an optimal time of year to rebalance?
Not really. I’ve yet to see any credible research indicating a particular time of year works best. Even if someone were to figure it out, everybody would rush to it negating the effect.
I do suggest avoiding the very end/beginning of the year. It is a popular time for rebalancing and many are engaged in tax selling and new buying. I prefer to avoid the possible short-term market distortions might cause. Personally, we rebalance once a year on my wife’s birthday. Random and easy to remember.
I have some of my investments in tax-advantaged accounts and some in regular accounts. How can I rebalance across those?
This can be cumbersome and you’ll just have to work with what you have. While it is best to hold bonds in tax-advantaged accounts, it does complicate rebalancing.
First, you should be considering all your investments as a whole when figuring your allocation.
Next, as a rule it is better to buy and sell in tax advantaged accounts to avoid creating taxable events.
Unless you happen to have capital losses in a given year. Then it is best to take them in your taxable accounts when possible.
For instance, you might own VTSAX in both an IRA and in a taxable account. Should you need to sell to rebalance that year, sell in the taxable account to capture the loss. You can deduct it against any other gain you happen to have, including any capital gain distributions. You can also deduct up to $3000 against your earned income. Any loss leftover you can carry forward to use in future years.
Does more frequent reallocation improve performance?
Some contend it can over time. Betterment makes this case. I’m not sure I fully buy the premise, but I do like the way they use your new contributions and any dividends to make it happen efficiently. It is a bit more work, but if you like you can also do this yourself with your index funds.
What might my taxes look like in the Wealth Preservation/retirement stage?
While everybody’s situation will vary, here are two excellent posts from my pal Jeremy detailing his own tax strategy as he travels the world as an early retiree: Never pay taxes again and his actual 2013 tax return.
There you have it: The considerations you’ll need to review and the tools you’ll need to use to create the asset allocation that best fits your situation. I’d be very curious to hear what your asset allocation looks like and why. Please leave a comment if you are willing to share. Oh, and let me know if I missed anything that belongs in the FAQ.
Addendum: The Path to 100% Equities