Conventional Wisdom: Asset Allocation

This is the third in an occasional series inspired by a toy at CNNMoney. Previous installments covered how big your housing payment should be and emergency funds.

Today’s topic is asset allocation, which in the dumbed-down context of the CNNMoney "tool" means the NYSE floor Old - Croppercentage of your savings to put in stocks. If you type in that your age is 45 and that you’ve got half your kitty in the stock market, you get a big red flag and a warning. But maybe not the warning you were expecting.

Uh-oh… Looks like your portfolio is invested too conservatively. Stocks can provide good growth, but pose plenty of risks in the short-term. Bonds offer more stability. If you’re saving for retirement and want a quick idea of what percentage of your portfolio should be in stocks, subtract your age from 120.

So at 45 the right answer is 75% in the stock market. In fact, from experimenting with it a little I find that for a 45 year-old anything between 65% and 84.9999% gets the "Good Work" pat on the back.

Where to begin? First off, I’m not a big fan of the widely held belief that age should be the primary driver of how much risk you take, something I wrote about in one of the very first posts on this blog.

If you want to see what your financial advisor looks like with a deer-in-headlights stare, try asking him why a person should take on less risk as they get older. If he is honest he will admit that you’re the first person who’s ever brought it up. The best justification, and it is a weak one, is that younger people have the option of scaling back their lifestyle and saving more later in life if investments sour.

Then we have the old chestnut that stocks are a good engine for long-term growth but are risky short term. There are no such things as short or long term stocks. Stocks is stocks. A twenty year return in the market is made up of twenty annual returns, 240 monthly returns and about 5000 daily returns.

Holding for a long time does give you some risk reduction of a kind, but it’s not diversification in the proper sense. Holding several different assets at the same time is diversifying because you get to average the returns between the assets. It’s the eggs in different baskets argument. But owning stocks for 20 years is not like owning 20 different assets. The returns don’t average, they compound. It’s as if you used different baskets for your eggs by shifting all your eggs from one basket to another periodically on your journey.

Bonds do "offer more stability" but that’s not their only offering. There are many different kinds of bonds, including, for example, short and long term ones. Fixed income investments encompass a spectrum from the practical equivalent of a checking account to assets that are as high risk and high return as a stock.

Amongst the many dangers of reducing the asset allocation question to how much should be in stocks is that it leaves open what happens to the rest of the portfolio. The risk taken with a portfolio split 50/50 between stocks and a money market fund is miles from one split between stocks and high yield corporate bonds.

And yes, these sorts of things are only meant as guidelines and the "How Healthy are Your Finances" thing at CNNMoney is obviously not intended to be detailed or comprehensive. But from such acorns grow great oaks of bad money advice.

Conventional wisdom, as captured in the CNNMoney toy, has young people putting virtually, or even actually, all their savings in the stock market and tapering this down so slowly that even at retirement around half is in stocks. CNNMoney actually calls this question in the quiz "Diversification". Of course, their message is quite the opposite.  It should be called "Stock Market Obsession".

Giving a clean bill of health to somebody with 80%+ of his investments in one risky thing is, or really ought to be, irresponsible. It is based on what can fairly be called a stock market fetish, a half mystical belief that stocks are the magic asset that will return so much more than other things that you should put nearly all your eggs in that one basket.

What’s worse is that if people are buying this idea now, only a few months after a retirement destroying 50% drop in stock prices, then this is a bit of the conventional wisdom that will be with us for a very long time.


  • By Andrew Choi, November 2, 2009 @ 3:20 pm

    my understanding was that the further away from your withdrawal date you were, the more risky investments you can take on.

    as for the suggested percentages, they do seem awfully high..

  • By Rick Francis, November 2, 2009 @ 5:04 pm

    >Fixed income investments encompass a spectrum >from the practical equivalent of a checking >account to assets that are as high risk and >high return as a stock.
    Do junk bonds really have as good a track record as stocks for the same risk? If so shouldn’t they be part of every portfolio? My intuition is that bonds can never compete… Both could lose all of their value but a bond’s return is limited by the interest rate of the bond. The return of the total stock market is only limited by the resources of the Earth and the creativity and industry of the human race.
    >80%+ of his investments in one risky thing >is, or really ought to be, irresponsible.
    Is it fair to characterize all publically traded companies as “one thing”? Don’t all publically traded companies span the range of human economic endeavors? I will agree that putting 80% into a single stock is irresponsible… but can all public companies fail without Armageddon?
    -Rick Francis

  • By Matt, November 2, 2009 @ 6:42 pm

    My allocation is about 25% to commodity index funds, and only about 50% to stocks. Of course CNN Money says I’m too conservative. I say the market is overvalued.

    I also use Quicken Premier (“Manage Your Investments”) that has an asset allocation feature. It has no commodity asset class at all; if I’m remembering correctly, the choices are “US Bonds”, “Foreign Bonds”, “US Large Cap”, “US Small Cap”, “Foreign Stocks”, and cash. Useless.

    I’ve tried several websites like Mint, several stock market sites that should know better, and even input my portfolio at Vanguard’s website, all without finding one single diversification/allocation “tool” that would recognize a commodity index fund.

    I’m partly miffed, but another part of me thinks that sheeple herding into my diversifiers would cause their correlation to creep toward unity with the Dow. So it’s okay.

  • By Rob Bennett, November 2, 2009 @ 6:45 pm

    Our understanding of how stock investing works is today primitive.

    We should stop pretending otherwise.

    I see big flaws in this blog entry. I also see big flaws in the conventional wisdom being criticized in this blog entry. I of course think I have it pretty much figured out. But my sense is that there are more than two or three out there who see big flaws in my take.

    Our economy is under great stress. This has reduced confidence in our political system. It’s a mess.

    We need a national debate on what we got right and what we got wrong during the Passive Investing Era.

    It cannot start until some of the Big Shots who have been pushing this stuff for 30 years work up the courage to acknowledge that there are things they don’t understand as well as they once pretended to understand them.

    The longer we hold off getting this debate started, the worse we all look for having failed to act re so important a matter for so long now.

    The Elephant in the Living Room doesn’t disappear because we pretend that we cannot see him.


  • By Neil, November 2, 2009 @ 7:18 pm

    Actually, I think the reason why younger people are encouraged to have riskier portfolios is the benefit of time. It fits in with the generally accepted “buy and hold” advice. If you hold a risky but well-diversified portfolio over a long period of time, it’s average returns should be substantially better than a safe portfolio. But over any particular short period of time, they may be much worse. So the longer the period of time you have to wait for a market recovery and a return to long-term averages, the more secure a risky portfolio can be.

    Also, there is the law of diminishing returns. If your risky portfolio outperforms by 2% per year, this will add up to a much more substantial amount of money over a 40-year period that over a 10 year period.

    In either case, though, I’d suggest that working out a formula based on years-to-intended-retirement, rather than age alone.

  • By Patrick, November 2, 2009 @ 11:23 pm

    Other commenters have named several obvious reasons people farther from retirement can rationally own more stocks. One I didn’t see yet was that stock prices tend to revert to the mean over long time scales. Long-term investors see price drops not as a loss of capital (that happens only if they sell) but as a buying opportunity that is likely to give above-average returns when the price eventually reverts.

    (And increases in prices are an opportunity to rebalance back into other asset classes and take some profits. It’s win-win for the long-term investor, so long as the market gradually increases in the long run.)

    Short-term investors, however, do need to sell their stocks soon (by definition), so price drops are indeed a loss of capital. This disqualifies stocks as “investments” under Benjamin Graham’s definition, and puts them in the realm of speculation.

  • By Patrick, November 3, 2009 @ 8:48 am

    I can’t seem to post a comment on your earlier article, so let me comment here.

    When you say “the returns from each of the forty years are equally important to the final value of the portfolio” that glosses over one very important point: the unidirectional nature of causality. If stocks drop when you’re 25, you can take action when you’re 26. You can rebalance; you can wait out the drop (because stocks tend to revert to the mean); heck, if it’s a real disaster, you can get a second job. If stocks drop when you’re 65, and just about to retire, it’s pretty hard to make up for it when you’re 64. You have to make up for it when you’re 66, either earning additional money or lowering your standard of living.

    25-year-olds are probably staking a few months’ salary on their investment choices, and have 40 years to make up for it if the investments tank. 65-year-olds could have over 10 years’ salary invested, and earning that back, if that’s even possible, would pretty much destroy their retirement.

  • By bex, November 3, 2009 @ 4:08 pm

    I’m thinking these calculators would be better if they included 2 other things:

    1) how many YEARS worth of living expenses do you have in liquid assets?

    2) how many HOURS PER WEEK do you plan on monitoring your investments?

    Question #1 is a pretty good indicator of how much risk you can take on… but #2 is a good metric of how informed of an investor you are. They should probably also give you a “financial literacy quiz.”

    After THAT, then they could see what bond mix would work out. Not much in cash, and no time to monitor your investments? Stick with a “buy your age (+20%) in bonds” approach, and some index funds. Less cash, but literate, and lots of time? Pile on the risk.

    One thing that many of these quizzes ignores is the fact that retired people have more time to read, research, and make better investments.

  • By kitty, November 4, 2009 @ 12:18 am

    “Both could lose all of their value but a bond’s return is limited by the interest rate of the bond.”
    Except for you can buy a bond at a discount or at a premium. If you buy it at a discount and sell at a premium (or even wait till maturity) than your return is higher… And if you buy a bond fund, then you buy bonds at market price now and sell at market price later. Last fall there were some nice opportunities.

    I also got “too conservative” comment. This was a couple of weeks ago, and I was about 45% in stocks and commodities (smaller percentage of stocks in retirement funds, higher in taxable accounts) with the large chunk of the rest in stable values/CDs and some amount in investment grade bonds – both funds and individual. I am 50 and hope to retire in 5 to 10 years. Last week I further reduced the percentage of stocks in 401K by moving a bit more money to stable value – I figured I have nice gains for the year, so maybe I shouldn’t be too greedy. I have no clue where the market is going, but there is some strong risk it may go down so do I really want to gamble?

    I was also told I am supposed to have life insurance. Except for I am single.

  • By Frank Curmudgeon, November 4, 2009 @ 7:10 pm

    On the age-driving-risk thing, I really think the only good explanation is that young people have the option to save more later if things go bad. Yes, there is a short-term vs. long-term risk aversion issue, but the way the math works ten years is pretty long term in that sense. So a 25 year old and a 55 year old would have the same allocation if that was the reason.

    On how big a slice of your savings should be in stocks in general, which is the main point of the post, I think Rick Francis touches on the key issue when he asks if junk bonds return the same for the same risk. Measures of risk and return are a little bit fuzzy at this level, bit it’s not out of line to say that junk bonds appear to give roughly the same returns on a risk-adjusted basis as stocks. In fact, it’s arguable that all broad classes of investments give similar returns on a risk-adjusted basis. Doesn’t it make sense that they would? Does it really make big-picure sense that stocks could be a free lunch that gives out more return than is justified by their risk?

  • By ParkerBohn, November 5, 2009 @ 7:20 am

    I’m in my early 30′s, and I have 80% of my funds in stocks.

    Conventional wisdom is that, since I’m young, I should take more risk, and therefore invest in stocks.

    The way I see it is that, since I’m young, stocks are actually less risky for me.

    Most of the market risk comes from short term factors, such as change in market valuation (ie market wide P/E ratios).

    Most of the market returns comes from long-term steady compounding of
    1) Earnings growth
    2) Distributions to shareholders (dividends, buybacks, buyouts).

    Expected earnings growth + expected distributions typically returns a couple percent per year more than bonds – but at a price of having huge short-term swings in asset prices.

    For someone who is about to retire, it may not be worth taking the short-term market risk (bear markets can dump 50+% off the market price), just for a small expected annual edge over bonds.

    Over a 30 year investment horizon, two things happen.
    1) Changes in market valuation are mean-reverting, and do not compound.
    2) Even a small annual edge over bonds compounds out to be a huge advantage over decades.

    This makes stocks a risky 1 year investment, but a safe 30 year investment.

  • By Patrick, November 5, 2009 @ 5:02 pm

    @Frank – Yes, it makes sense if people dislike volatility. Then, all else being equal, people should assign lower prices to volatile assets with the same growth/income prospects as less volatile assets.

  • By Patrick, November 5, 2009 @ 5:12 pm

    @Frank – sorry, I just noticed the weasel-word “risk-adjusted” in your question. Well, haven’t you answered your own question? If you have less than average aversion to volatility (a kind of risk), you should be buying volatile assets, all else being equal. Someone with a long investment timeframe has lower than average aversion to volatility.

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