Asset allocation strategies are usually over simplified and are often discussed around two groups of people: those far away from retirement and those either near or at retirement. In typical financial planning, asset allocation shifts towards more and more conservative as you get older and as you get closer to needing the money. As we’ve looked at previously, asset allocation is actually very overstated in importance for investors during retirement. The reason for this is sequence of returns risk. But that’s a separate topic. In this article, we’re going to look at asset allocation for young or new investors. This is a group that is rarely mentioned specifically with respect to asset allocation strategy, so let’s try to give this group some direct advice.
The common advice
Let’s start with the common advice for young or new investors. It’s all about time frame. Since young investors have decades until retirement, the common advice is that you should be heavily weighted towards equities. Equities offer the highest long-term return, but also bring more volatility. The long-term time horizon means that volatility isn’t an issue since the returns will smooth out over time. Therefore, go with the highest long-term return.
Using Vanguard’s personal portfolio allocation models, we can take a look at some of their allocation data over nearly 100 years (1926-2018):
50% stocks / 50% bonds
- Average annual return: 8.2%
- Best year: 32.3%
- Worst year: -22.5%
70% stocks / 30% bonds
- Average annual return: 9.1%
- Best year: 41.1%
- Worst year: -30.7%
80% stocks / 20% bonds
- Average annual return: 9.4%
- Best year: 45.4%
- Worst year: -34.9%
- Average annual return: 10.1%
- Best year: 54.2%
- Worst year: -43.1%
The advice isn’t wrong. If you can stomach the volatility and you know that you will not bail on your investment plan due to a major move lower, then going all-in on equities (or nearly all-in) is an acceptable strategy if you have multiple decades before you’ll be needing the money. 100% equities is strictly a long-term plan.
Another possible approach
But believing you can stomach the volatility and then actually doing it are two different things, and history tells us that many investors who did not think they would bail on their investments do in fact bail during a major market crash which has two extremely negative results. First, you’re bailing at the worst time, when your investments are significantly lower and right before a typical rebound. Second, when you bail during a crash, many of these investors then stay out of investing for a period of time or bail altogether on the process.
So, there’s a case to be made to be more conservative as you’re building up your initial assets, to minimize volatility a bit and to get used to investing. The interesting thing here is that by going with a more conservative allocation during your initial phase of investing, you actually will not be missing out all that much on returns. Let’s explain why with some examples.
Before we get into the examples, let’s discuss what we think the first phase of investing is. In an older article, I mapped out why the $500,000 in investable assets is so important. We looked at the $500,000 level as the level when your annual returns begin outpacing the annual contributions based on a scenario where you are maxing out 401(k) contributions. This wasn’t an exact picture since there are many variables, but it’s a rough estimate of where the amount of money you’re generating from your money is more than the amount of money you’re adding to your investments from income or savings each year. Regardless of the exact number, this threshold is a powerful one to cross as this is when your money begins to compound faster and faster.
For our discussion today, we want to identify a threshold where we cross from phase 1 into phase 2 with respect to asset allocation. As such, the $500,000 level is too high. Let’s look at two thresholds: a $50,000 threshold and a $100,000 threshold. What we’re going to do here is look at scenarios where we hold a conservative allocation through phase 1 until we reach this threshold, then we change over to a more aggressive allocation.
Let’s start with the $50,000 threshold and let’s assume that the individual is able to save and invest $250 per month. We’ll want to consider the following as we compare the conservative allocation against aggressive allocations: How long does it take to reach the $50,000 threshold? How much in returns did we lose out on average by being more conservative? What kind of volatility did we escape by being more conservative?
The following chart shows the progression of saving $250 per month across four different asset allocations (100% stocks, 80% stocks / 20% bonds, 70% stocks / 30% bonds and 50% stocks / 50% bonds). For each allocation, we use the average return shown from the Vanguard data (listed above).
As you can see, the differences aren’t huge here. The most aggressive portfolio of 100% stocks hits the $50,000 balance threshold at month 120 (10 years) when saving $250 per month and assuming the average return of 10.1% annually. The 50 / 50 conservative split hits the $50,000 balance threshold at month 128 (10 years, 8 months) when saving $250 per month and assuming the average return of 8.2% annually. So, in essence, by going more conservative, it takes eight months longer to hit the threshold than if you went as aggressive as possible. Considering either approach takes ten years, an extra eight months is fairly trivial in the long run.
Let’s look at the same situation but with a savings & investing rate of $500 per month instead.
As you can see in this chart, the differences between the allocations are even less. The reason for this is because we’re now investing $500 per month instead of $250 which means less time is required to get to the $50,000 threshold. Less time means less variation based on rate of return. In this scenario, the 100% stocks allocation portfolio reaches the $50,000 threshold at month 74 and the 50 / 50 portfolio reaches the threshold at month 78. So, only a four month difference between the most aggressive allocation and the 50 / 50 allocation.
Since we also discussed a $100,000 threshold level, let’s look at an example for this threshold, too. In this example, the investor is allocating $1500 per month as he or she works towards the $100,000 threshold level.
Again, very little variation. The 100% stocks allocation takes 54 months to reach $100,000 and the 50 / 50 split allocation takes 56 months to reach it. A difference of two months.
So, we can sum up here that during this initial phase of building your investable assets, the asset allocation choice does very little in terms of moving the needle towards larger sums of money. The reason for this is that in the early years of your investing and saving, almost all of your gains comes from simply saving your money. Returns on your investments really kick in later when the assets are larger. This is why it is so key to get through phase 1 of investing as fast as possible. Until you can get to your next phase where you have sufficient assets to begin generating actual returns, you can’t accelerate your wealth building.
Human behavior & markets
What about volatility? In our example, we did straight modeling based on the average returns of these allocation models. Of course, that’s not how it works in the real world. The worst year for the 100% stocks portfolio is -43.1% and the worst year for the 50 / 50 split portfolio is -22.5%. This is a fairly big difference in terms of size of a drawdown in the event that you are unlucky and experience a “worst case scenario” market event during your early investing years.
While a big drawdown on a small amount of assets won’t harm you very much long-term financially, it can do damage to your emotions and your view on investing. And this is potentially the main reason for going conservative in the early years of investing.
If a major market drawdown – perhaps made worse by an aggressive allocation – makes you bail on the process or changes your view on the value of investing, then it would be much better to go with a conservative 50 / 50 allocation while starting out. We’ve already demonstrated that you aren’t losing all that much in terms of return and progress towards the next levels of wealth, so protecting your small but growing asset base might make a ton of sense.
As we said in the beginning, even for young investors who think they can stomach a major market meltdown, we’d encourage strong consideration of a conservative allocation simply because most young investors don’t know how they will react to a major market crash because they have yet to experience one! Much of investing is setting rules and guard rails for yourself to ensure you make the right move in the rare moments that really put your emotions and psychology about investing to the test. Going with a conservative allocation while you’re in the initial phase of accumulation mode investing could be one of the best guard rails you implement as a young investor.
Remember, during your phase 1, all that matters essentially is your savings rate. Go conservative on the allocation and protect the growing asset base. Once you’re ready to transition to phase 2 when you need to be a bit more aggressive (say, 80 / 20, assuming you still have decades before retirement), you’ll not only have a set of assets return to generate return, but you’ll have a more experience mind and set of emotions ready to handle market turmoil when it comes.