Bogleheads University 101 2023 - Setting Your Asset Allocation with Christine Benz
00:00:00.000 | I am going to talk to you about asset allocation.
00:00:09.200 | So we've been through what I called primordial asset allocation, where you're thinking about
00:00:14.620 | things like an emergency fund and so on.
00:00:17.980 | Alan covered the basics of investing, Rick covered investment selection, Mike talked
00:00:25.520 | about tax-advantaged investing.
00:00:27.680 | I'll talk about apportioning your assets across different investment types and the key considerations
00:00:34.400 | to bear in mind when you do.
00:00:36.900 | So there are really two key jobs that you need to bear in mind when you're setting an
00:00:41.840 | asset allocation.
00:00:43.520 | And I think they can be helpful because asset allocation, the way it's often discussed to
00:00:47.760 | me seems terribly black boxy, but it really requires you to do two key things to find
00:00:54.680 | yourself in the right asset allocation ballpark.
00:00:57.880 | The first would be to take a step back and think about why you are investing, so being
00:01:03.000 | clear on what your goals are.
00:01:05.240 | And the second is to kind of take a look inside and think about how you have behaved in previous
00:01:11.480 | market environments.
00:01:12.680 | If you've had investments, how you felt in sort of that March 2020 period that Alan alluded
00:01:20.320 | to earlier, where we saw our worlds turned upside down very quickly, the markets plummeted,
00:01:27.200 | it didn't feel like a great time to invest.
00:01:29.920 | In hindsight, it was a great time, but many people were retreating to safe investments
00:01:35.120 | during that period.
00:01:37.000 | So thinking a little bit about what's called your risk tolerance is also a job here.
00:01:42.360 | So both of these things are important.
00:01:44.200 | I would argue the first thing, kind of clarifying your goals and your time horizon and your
00:01:49.060 | proximity to needing your money, I would argue that's kind of the top of the heap.
00:01:53.980 | But risk tolerance should also be part of the discussion too, in my opinion.
00:01:59.240 | So knowing your goals determines your risk capacity.
00:02:03.840 | And when you're thinking about your goals, you want to think about your proximity to
00:02:08.680 | that goal as sort of a key point to think through.
00:02:13.560 | When will you need these funds?
00:02:15.840 | So if you are 35 and it's retirement, when you think you'll be 60 or 65 or maybe even
00:02:21.840 | longer, well, you have a very long time horizon for that goal.
00:02:26.680 | You have a high risk capacity.
00:02:30.080 | You can absorb the changes in your portfolio's value because you don't need the funds imminently.
00:02:38.040 | So thinking about proximity to goal and also using what we know about asset class returns
00:02:45.340 | over various time horizons to inform how you would think about how to invest given your
00:02:52.000 | proximity to the goal.
00:02:54.400 | So when we look at stocks, stocks have historically had a higher return than safer investment
00:03:00.800 | types like cash, like bonds.
00:03:04.060 | And if you have at least a 10-year time horizon, stocks have actually been extraordinarily
00:03:09.280 | reliable.
00:03:10.440 | So in more than 90% of rolling 10-year periods, whenever the periods might be, you are most
00:03:18.280 | likely going to gain money over that 10-year time horizon.
00:03:23.000 | But once you start shrinking that time horizon, taking it to like 5 years or 3 years or certainly
00:03:29.880 | even shorter than that, well, you start to see the odds for stocks go down quite a bit.
00:03:35.580 | So the odds are well less than 90% if you have a 5-year time horizon for stocks.
00:03:42.180 | You'd want to be in something that has a much better shot at making you whole over that
00:03:48.580 | fairly short time horizon.
00:03:50.700 | So that would be cash or bonds, for example.
00:03:54.380 | So I would say 10 years is a good guidepost when deciding whether you are going to be
00:04:00.940 | in stocks or not.
00:04:02.140 | If your time horizon is shorter than that, you need to be in safer assets that are most
00:04:06.540 | likely to be in positive territory over that shorter time horizon.
00:04:10.900 | So you're thinking about your proximity to needing your money to spend.
00:04:15.220 | You're also thinking about the duration of that goal.
00:04:18.500 | So if you're thinking about retirement and you're someone who's embarking on retirement
00:04:22.640 | in your 60s and you're in good health, well, that's sort of a long-duration goal.
00:04:28.880 | So you'd want to think about having probably 25 years or 30 years overall that you'll have
00:04:37.640 | where you'll be spending your money.
00:04:40.440 | On the other hand, college is a good example of a shorter-duration goal, where if you're
00:04:46.320 | lucky, your child will make it through college in four years, maybe five on the 5-year plan.
00:04:52.320 | And so that's a fairly rapid spend-down pace.
00:04:56.080 | That means that when that goal date arrives, you'd want to have the money in very safe
00:05:02.040 | investments.
00:05:03.040 | Even though maybe stocks helped you grow that 529 plan or grow whatever portfolio you're
00:05:08.380 | using for college nicely, by the time you get to college, you pretty much just want
00:05:13.360 | to hold the assets steady.
00:05:15.520 | You don't want to risk losses in your investment at that time.
00:05:20.120 | So you're thinking about the proximity to goal.
00:05:22.600 | You're thinking about the duration of goal.
00:05:25.200 | And of course there are other goals that we might have where it's kind of one and done.
00:05:29.920 | So the home down payment, for example, where it's a one-time purchase.
00:05:36.840 | And so you don't want to risk having the funds move around when you need the money.
00:05:43.240 | And then another thing to bear in mind when thinking about your risk capacity is thinking
00:05:48.640 | about your flexibility with respect to that goal.
00:05:52.120 | So here again, I think college funding is a great example.
00:05:55.440 | If you have, say, a 17-year-old, you don't want to be-- you don't want to have any wiggle
00:06:00.320 | room and say, your investments are down.
00:06:03.000 | I think you might need to wait until you're 21.
00:06:05.680 | Your child probably would not love that as an answer.
00:06:09.500 | So there's an investment goal where there's not a lot of wiggle room in terms of timing.
00:06:15.760 | Same with retirement.
00:06:16.760 | You may have actually some wiggle room to delay retirement if the market's really bad
00:06:22.600 | and it's not a good time to tap your investments.
00:06:25.080 | You might say, well, I think I'll continue working a couple more years.
00:06:29.760 | But you may not want to have to work eight more years until your investments start looking
00:06:34.720 | better.
00:06:35.720 | So think about the flexibility of whatever goal you have in mind.
00:06:40.160 | A lake house purchase or something that's totally discretionary, well, there you have
00:06:44.800 | more flexibility about your goal date and so forth.
00:06:51.680 | So I mentioned human capital earlier on.
00:06:55.020 | We talked about the importance of really thinking about human capital, especially for young
00:06:59.560 | accumulators, thinking about trying to find ways to grow your earnings power over your
00:07:06.120 | lifetime.
00:07:07.360 | There's kind of an intersection with asset allocation.
00:07:11.160 | So this slide comes from some of my colleagues in Morningstar Investment Management.
00:07:15.240 | But the basic idea is when you're young and just starting out, most of us don't have much
00:07:20.920 | in the way of financial capital.
00:07:23.240 | We have small portfolios most of the time.
00:07:25.960 | We may even have negative portfolios if we have a lot of student loan debt.
00:07:31.040 | But we're long on another tremendous asset, which is that we're long on human capital.
00:07:37.120 | If we're well educated, we have a really powerful source of income that will take us through
00:07:43.720 | our working years.
00:07:46.040 | By contrast, when we are older, one would hope that our financial capital would have
00:07:52.960 | grown over that period.
00:07:54.520 | But as we're getting close to retirement, our human capital may not be as rich as it
00:08:00.120 | was when we were younger.
00:08:01.520 | In fact, it's not as rich.
00:08:03.600 | We can't expect as many years of earnings during those remaining years as we could have
00:08:12.160 | when we were younger.
00:08:13.280 | So even though our salary may be at its highest point in our lifetimes, the number of years
00:08:18.040 | that we expect to continue working would not be.
00:08:22.520 | So there's an interplay here where if you are very long on human capital, like the new
00:08:28.320 | worker who's just graduated with a degree in something worthwhile, that new worker doesn't
00:08:33.720 | have much in financial capital, doesn't have any imminent need for retirement funds, those
00:08:40.160 | funds should be invested really aggressively.
00:08:43.400 | On the other hand, as we get close to retirement, as we get close to needing to tap our funds,
00:08:48.960 | we want to make those investments more conservative.
00:08:51.960 | We want to have them kind of on standby, or at least a portion of that portfolio.
00:08:57.040 | So if we happen to retire in a bad market for stocks, well, we're not having to sell
00:09:01.720 | stocks into a trough.
00:09:03.960 | So thinking back to 2008, for example, during the global financial crisis, stocks dropped
00:09:10.000 | about 50% during that period.
00:09:12.480 | You wouldn't want to be the all-equity investor.
00:09:15.520 | So thinking about your own life stage, thinking about the status of your own human capital,
00:09:21.600 | your own proximity to retirement, can be really helpful in terms of determining how to position
00:09:28.360 | your portfolio.
00:09:30.800 | So that's risk capacity.
00:09:32.380 | All that stuff, thinking about your proximity to spending, thinking about your duration
00:09:37.880 | of spending, thinking about your flexibility with respect to the goals, those are all risk
00:09:45.200 | capacity questions.
00:09:47.440 | The second part of the equation is risk tolerance.
00:09:51.440 | And many of you have probably done these questionnaires and surveys online.
00:09:55.480 | If you work with a financial advisor, many of them use what are called risk tolerance
00:10:00.600 | questionnaires.
00:10:02.480 | The bottom line is that people tend not to be great judges of their own risk tolerance.
00:10:07.840 | They might think themselves really risk tolerant, and then when push comes to shove and it's
00:10:14.240 | March 2020 again, that investor might have fear in his or her heart.
00:10:19.560 | So that's a key thing to know, and one reason why I think risk tolerance questionnaires
00:10:25.120 | have been downplayed a little bit in the financial advice space, probably rightly so, that people
00:10:30.640 | aren't great judges.
00:10:32.200 | But still, I think it's a component.
00:10:34.680 | And the reason why risk tolerance is such an important concept is that people do bad
00:10:41.600 | things when they have a portfolio that's not aligned with their risk tolerance.
00:10:47.000 | So they might be inclined to sell themselves out in that really risky, bad market environment
00:10:53.400 | where they're inclined to move into cash and safer investments at the worst possible time.
00:10:59.800 | And we see this again and again.
00:11:02.200 | I believe Rick alluded to it, and Alan alluded to it in his presentation.
00:11:07.080 | We have a study that we run at Morningstar called Mind the Gap, and we see that investors
00:11:11.640 | systematically undermine their own results due to these poor timing decisions.
00:11:17.640 | And a lot of them come up in these fear and greed cycles.
00:11:21.440 | So when the market is really frothy, like it was in 2021, early 2022, we see that investors
00:11:29.200 | oftentimes glom on to the things that have performed really well in the recent past,
00:11:34.400 | and they retreat to safer stuff in bad market environments.
00:11:39.120 | So risk tolerance is something that should sit side by side with risk capacity.
00:11:44.280 | I would say put risk capacity in the front seat, put risk tolerance in the back seat,
00:11:49.280 | but both are important concepts that work together.
00:11:53.820 | So this is just an example of how at Morningstar we've got different glide paths, different
00:12:00.060 | asset allocations for people at different life stages, and we have a conservative, moderate,
00:12:05.840 | and aggressive version.
00:12:07.260 | The reason is that they're all sort of trending in the same direction, but the more conservative
00:12:13.600 | versions are a little bit more heavy on the fixed income and cash investments.
00:12:19.720 | So I just want to run through a few case studies here to illustrate how these two things work
00:12:26.640 | together.
00:12:27.860 | So we're assuming 68-year-old Mary has been investing for a while, and she was a person
00:12:34.180 | who felt terrible during the global financial crisis, where she saw, she was watching CNN,
00:12:42.300 | she was watching a lot of news, and her investment portfolio seemed to be going from bad to worse.
00:12:48.860 | She was checking it day by day, and she did what I said a lot of investors do at those
00:12:53.900 | market inflection points, where she just said, I can't stand it, I am getting close to retirement.
00:13:01.900 | By then she would have been in her early 50s, and she retreated to safe investments and
00:13:07.980 | never got back in.
00:13:09.940 | And I will say that this is not an uncommon profile.
00:13:13.500 | I still sometimes encounter people who are older adults who did this very thing, where
00:13:20.660 | they retreated to safe investments and never got themselves back into stocks, and unfortunately
00:13:27.980 | have missed the whole subsequent market rally.
00:13:31.700 | So this is not an unusual phenomenon.
00:13:34.540 | It's something that we see again and again.
00:13:37.220 | So her risk capacity is what I would say medium.
00:13:41.980 | So at age 68, she is embarking on retirement, but assuming she's in good health, well, she
00:13:47.660 | probably wants to plan for 25 or 30 years of retirement.
00:13:53.060 | So she can't afford to be hunkered down in very safe investments, even though we've seen
00:13:57.980 | yields on those investments tick up quite a bit over the past couple of years.
00:14:03.580 | Inflation still is what it is, and it takes a bite out of the purchasing power of those
00:14:08.660 | very safe investments.
00:14:10.580 | So it's not prudent for her to be just in safe investments.
00:14:14.780 | She needs to take some risk with the hope of actually growing her portfolio a little
00:14:19.900 | bit and hopefully outpacing inflation over her time horizon.
00:14:24.540 | So I would rate her risk capacity, her ability to take risk, as kind of medium, because she
00:14:31.660 | has that long time horizon.
00:14:33.780 | Even if she incurs some losses from the stocks in her portfolio, she has time to recover,
00:14:39.340 | right?
00:14:40.340 | So she might not want to be spending from that fall in equity portfolio, but assuming
00:14:45.380 | she has some sort of a balanced portfolio, that gives her time for her portfolio to recover.
00:14:51.700 | So I would say that her risk capacity is kind of medium.
00:14:54.980 | Her risk tolerance, well, we know it's low, right?
00:14:58.660 | She is really uncomfortable in equity markets' wounds.
00:15:03.460 | So she would want to have kind of a balanced exposure.
00:15:07.180 | She'd certainly want to have some safer assets that she could call upon in an equity market
00:15:13.860 | downdraft, but she needs stocks for their long-run appreciation potential and for their
00:15:19.740 | ability to outpace inflation.
00:15:22.900 | So we'll take a look at another extreme.
00:15:25.780 | We'll assume that we've got Abby and Zach here, and I will also say that some of these
00:15:30.380 | people are ripped from my own life.
00:15:33.460 | Their names have been changed, but they resemble some people in my life.
00:15:39.460 | So Abby and Zach live in a big urban center, which they love, but they now have a baby.
00:15:44.940 | And they live in a one-bedroom apartment in this very costly urban center.
00:15:48.820 | And they have their sights set on buying a place to live, probably some sort of a townhouse
00:15:54.140 | or something like that.
00:15:56.580 | And when you talk to them, these two, they're both 32, they rate their risk tolerance as
00:16:03.000 | very high, because they've been doing this for a while, they feel.
00:16:07.180 | And they have gotten comfortable with equity market volatility.
00:16:11.080 | Their retirement accounts are parked in long-term investments.
00:16:14.700 | They don't bother with them when the market's down.
00:16:18.140 | So they rate their risk tolerance as really high.
00:16:23.000 | But their risk capacity is low.
00:16:26.140 | So they're expecting a second baby.
00:16:28.180 | They're in this too small place, so they need to get into a larger home.
00:16:33.400 | They know that they want to buy, and they have the down payment fund set aside.
00:16:37.240 | Well, their risk capacity with that portion of the portfolio, not their retirement portfolio,
00:16:43.480 | but that portion of their portfolio, their risk capacity is really low.
00:16:48.000 | They are not in a position to absorb losses with that down payment fund, right?
00:16:53.400 | They don't want to have to change their goal.
00:16:56.080 | They don't want to be stuck in this too small place with two children.
00:17:00.500 | So their risk capacity is really low.
00:17:03.260 | So there can be these disconnects, where you've got what you feel is high risk tolerance,
00:17:08.740 | where actually your risk capacity is low.
00:17:12.380 | I would argue that this is the case for a lot of pre-retirees and retirees who I talk
00:17:17.820 | to, who have had a great experience with stocks over their holding periods.
00:17:23.580 | They've been comfortable holding stocks through periodic down drafts, and they rate their
00:17:28.700 | risk tolerance as high.
00:17:30.580 | But the fact is, their risk capacity has changed a little bit over their lifetimes.
00:17:35.640 | And as they get close to retirement, they want to start putting in place safer assets
00:17:41.160 | that they could draw upon while they let their equity portfolio recover and repair itself.
00:17:48.120 | So Zach and Abby, I would say, are a great example of high risk tolerance, they think,
00:17:55.640 | and low risk capacity.
00:17:58.560 | Now we'll take a look at Jack and Ellen, who are already retired.
00:18:03.320 | This couple is-- Jack was a retired college professor, and he has a good pension, as college
00:18:11.520 | professors often do.
00:18:13.640 | But they're in the luxurious position of having everything that they need coming from the
00:18:19.520 | combination of Jack's pension and Ellen's social security.
00:18:24.400 | So they're not really needing to touch their portfolio on an ongoing basis, except maybe
00:18:29.860 | they want to do so for special trips or sort of extras.
00:18:35.240 | So this portfolio is not getting touched on a regular basis.
00:18:41.080 | It's not getting subtracted from on a regular basis.
00:18:44.600 | So their risk capacity, despite their ages, is actually kind of on the high side.
00:18:52.000 | They can afford to build and hold a fairly aggressively positioned portfolio with lots
00:18:58.940 | of stocks because there's not an imminent need of them turning around tomorrow and saying,
00:19:04.440 | I need $100,000 for this thing because our other income sources aren't doing the job.
00:19:12.760 | So this is a good example of high risk capacity, high ability to absorb portfolio withdrawals,
00:19:20.600 | or absorb spending shocks, I should say, and also fairly high risk tolerance.
00:19:27.040 | Because this couple has invested through a lot of market cycles, and they know that they're
00:19:31.920 | not going to upend their plan at the worst possible time.
00:19:36.160 | So it's important to kind of customize this.
00:19:38.320 | I do think that off-the-shelf sources of asset allocation guidance can be a help in terms
00:19:44.440 | of getting yourself in the right ballpark.
00:19:47.080 | So you can look at say a target date fund or even use a target date fund if you're someone
00:19:52.040 | who's in your 20s and 30s or even your 40s to kind of guide your portfolio's asset allocation.
00:19:58.560 | But if you have shorter-term goals or intermediate-term goals, or as you're getting close to retirement,
00:20:04.720 | I think it's terribly helpful to customize your portfolio's asset allocation based on
00:20:10.160 | these two inputs, risk capacity and risk tolerance.
00:20:14.600 | So I am going to leave it at that.
00:20:16.800 | We have time for a five-minute break, and then we'll be right back here at 3 o'clock.
00:20:22.640 | Thank you.
00:20:22.960 | [END]
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