Asset allocation puzzle

[Broken Arrow]

This is a very interesting thread here, and I'd like to jump in with a quick comment.

The algorithm is stochastic, but it's still just an algorithm.

In the end, we can replace funds easily lost in the beginning, when the amount is still small, whereas I do not believe we can do the same as we near retirement, and when the funds should have far out-grown our earned income. Hence the human rationale for decreasing aggressiveness over time.

If not for this human factor, I can imagine how it can be statistically advantageous to increase the portfolio's aggressiveness over time. But as Jim implies, how many would be willing to take that risk in real life?

[noppenbd]

So maybe the lesson is that asset allocation matters far less when you are young with a small portfolio (accumulation period) than in your later years (growth period)?

[jIM_Ohio]

Why withdraw rate is so important-

if a person needs 40k in income and needs to make a decision on when to retire, they can do things one of two ways:

1) invest however they want (aggressive first, then moderate or moderate then aggressive) and then follow the 4%/25X guideline.

In this case retirement is based on having $1 M saved to generate 40k of income. This is easy to do with a moderate allocation, because the goal is preserving the $1 M- it does not need to grow much, if at all, to last 30 years. The first several years the interest alone on the $1 M would be enough (if a person found bonds returning 5%, they would see portfolio grow 1%). Eventually principal would be spent.

2) Use the return technique the article mentioned and the web site uses. This means as long as the porfolio returns $40k per year the person can just spend that return. A 400k portfolio can generate the 40k income needed (10% return). We know the market historically returns 10% on average.

The key to this discussion (and what the blog did not point out) is what the portfolio values were for each scenario. Look at the post where I showed how much was saved to get the percentages of success- the more aggressive portfolio needed another 800k of assets to get a slightly higher success rate.

The blogger used the success rate to justify the conclusion, where as I looked at the portfolio value, and based on the value I could come up with a much less risky allocation to achieve the same goal.

Like I said- use aggressive up to retirement (get the maximum value possible) then use the moderate in retirement and the interest alone from the moderate should be able to sustain itself for a 30 year retirement.

Trinity study did that a long time ago.

[jIM_Ohio]

So maybe the lesson is that asset allocation matters far less when you are young with a small portfolio (accumulation period) than in your later years (growth period)?

I would agree with this.

I have stated a portfolio has 5 phases:

1) starting out- deposits might be more than the balance and accounts need to be established.
2) accumulation- deposits are more than the yearly gains in current dollars.
3) growth- deposits are still happening, the growth of the porfolio is more than the deposits in current dollars.
4) stability- the porfolio needs to maintain value to provide a needed income
5) draw down- the portfolio is losing value because shares are being sold to provide income.

The sooner a person gets to 5) the failure percentages of those calculators will increase. The goal would be to stay in 4) -stability as long as possible. If market went down and you had to sell shares, the market going down would force you to sell even more than you would have when market was up- double edged sword for sure.

There are many techniques a person could do if there was a bad year and they did not want to sell shares. Having cash reserves is the best thing, reducing spending would be another, working part time would be another.

Once a person sells shares, the likelihood they would not have to sell some the next would be low- meaning once you sell shares that is the point of no return and you would hope you did not outlive your money.

[jIM_Ohio]

One more comment- over time the market has gone up. The longer the time period the more it looks like it generally trends upward.

Assuming the amount withdrawn is less than significant, it would make sense to me that a person could derive a 100% equity porfolio, which back tested, generally provides the less than significant withdraw with regularity.

I wouldn't do this myself. I do not recomend others do this either, but it does not suprise me that the math suggests it is possible for it to work.

A poster above asked about the target retirement funds- you need to read up and see how they allocate themselves once the target date is reached.

One fund company states they will roll the target funds into their "retirement income funds" which are probably 70% bonds or more and just generate a solid 4-5% yield. Some keep themselves invested for 40 years past the target date. Some funds might just dissolve (this might create a significant taxable event in a taxable account).

Generally speaking- a 3% withdraw can be achieved from dividends.
A 4.5% withdraw can be made from the interest generated from bonds.

Those two above generalities are things which most retirees depend on.

[simpletron]

When in the withdraw phase of a portfolio, the risk is volatilty (not a given return). So maybe 80% stocks shows something positive because in a given 30 year time period that 80% trended upwards.

here are some statistics, the stock market has been up for EVERY 10 year period and has been up for over 90% of the 5 year periods(I believe it is 97%, but don't remember exactly). the reason I will have 80% stock will be because I will have a 5 year buffer in cash and bonds to spend down if the stock market tanks to give my stocks a chance to rebound. the buffer is then rebuilt during good times. this sounds similar to the bucket method you describe. I see no point in going below 60% stock because you can have a 10 year buffer in bonds and cash to draw upon.

my dad manages a couple hundred retirement accounts and the method he uses for the withdraw phase depends upon risk adverseness and withdraw rate of his clients, but everyone is 50-80% stocks, 1 to 2 years worth of cash and the rest bonds. the money flows from stocks to bonds in good stock market times, from bonds to cash most of the time and from cash to spending all the time(similar to your bucket method). everyone of his clients in retirement has more purchasing power now than when they started retirement.

another risk in the withdraw phase of retirement is the length of time. there is always a chance that you will out live your money if you go too conservative because of the lack of growth compared to inflation. this is a big concern of mine because I have 4 grandparents in their 80s in good health and every great grandparent that die because of natural causes was in their 90s or a 100. so I see living 40+ years in retirement as a good chance. the longer you think you'll live, the more aggressive you want to be or have a lower withdraw rate.

jim, your analysis with the SWR of the aggressive versus conservative is flawed by the fact that there is greater variation of the starting retirement amount in the aggressive case. there will be cases where the aggressive case will starts lower than the lowest of the conservative case when entering retirement. this give an initial advantage to the conservative case when the withdraw phase starts. the only thing you prove was by taking the same amount of money and investing it aggressive you can generate a slightly higher income at the same chance as the conservative case or in other words it is better to be aggressive all the time than conservative all the time.

I ran the calculator with 1 million in deferred savings, an after tax withdraw rate of 40K(=50k withdraw pre-tax), starting age 65 and got:
moderate risk - 89%
above average risk - 87%

Assuming the amount withdrawn is less than significant, it would make sense to me that a person could derive a 100% equity porfolio, which back tested, generally provides the less than significant withdraw with regularity.

I wouldn't do this myself. I do not recomend others do this either, but it does not suprise me that the math suggests it is possible for it to work.

I must agree that withdrawing on a 100% stock portfolio is too risky even for me and I love risk(40% of my retirement accounts is individual stocks).

there is always a trade off in investing. the more conservative cases gives better chances in a shorter retirement and the aggressive gives better chances in a longer retirement. see chart below.

probablity of success
|
|*/*/*/*/*/*/*/*/*/*/*/*/*/*****
|--------------------------------- ////////*/*///////
|----------------------------------------------*** //////////
|---------------------------------------------------** ----- ///////////
|------------------------------------------------------ ** ------------ //////
|----------------------------------------------------------**
|_________________________________________________ _time

/ is more aggressive
* is more conservative
- are spacers because the post won't keep a lot of spaces

here are some results from your standard firecalc with a 4% withdraw rate
at 30 years
0% stock - 37.4%
20% stock - 70.1%
40% stock - 92.5%
60% stock - 95.5%
80% stock - 94.4%
100% stock- 92.5%

at 50 years
0% stock - 13.8%
20% stock - 26.4%
40% stock - 52.9%
60% stock - 79.3%
80% stock - 86.2%
100% stock- 87.4%

interesting how much of a drop the more conservative one did versus the more aggressive one did for an extra twenty years.

It shows "statistically" that growth will "win out". But the key to that whole puzzle is what the market does those first 3-5 years of retirement. If you get by those first 3 to 5 years with a risky portfolio doubling or tripling the needed withdraw (each year), your risk level goes down. The calculator does not take into account how the withdraw is taken.

most failures of a risky portfolio are caused by a major down turn in the first few years. I rather know early on that there is a problem when I could possibly go back to work and fix it than 20 years later when I can't return to the work force(reasons: health, lack of skills,...) because I didn't get enough growth and I'm living longer than expected.

[Broken Arrow]

If I could just sneak in with an additional comment....

In the end, the key is to encourage retirees to minimize the withdraw rate as much as is comfortably possible. Especially during the early phase of the retirement. Over time, this is where it pays in spades with little to no risk.

Otherwise, we'd have to increase the aggressiveness of the investments, except that also comes with relatively significant real life risk. That's the problem.

Anyway, great thread, wonderful thoughts. Thanks for bringing it up.

[jIM_Ohio]

here are some statistics, the stock market has been up for EVERY 10 year period and has been up for over 90% of the 5 year periods(I believe it is 97%, but don't remember exactly). the reason I will have 80% stock will be because I will have a 5 year buffer in cash and bonds to spend down if the stock market tanks to give my stocks a chance to rebound. the buffer is then rebuilt during good times. this sounds similar to the bucket method you describe. I see no point in going below 60% stock because you can have a 10 year buffer in bonds and cash to draw upon.

I'm going to reply in pieces to keep the posts short. It will boost my post count too, but that means little. Take my responses as generating discussion because this is a good thread. I ask point blank questions, I do not mean to offend.

Is your math solid here?

Assume a $1 M portfolio which generates a 40k pre tax income stream.

60-40 suggests that $400k is in bonds and this 10 years income-before inflation. Anything more aggressive than 60-40 would not have 10 years expenses in bonds.

In another sentence you said you had 5 years expenses in bonds- which is it- 10 or 5? A 5 year buffer in cash when market could stay down for 10 years does not make sense (to me). If market went down in 2000, would the stocks have caught up in 2005.

Are the 10 year periods rolling periods? If someone invested in 2000, do you think they will be ahead in 2010? I don't know if market has fully recovered from 2000-2002 bear, but thought I would ask.

In general, design withdraw portfolios for a worst case scenario.

[jIM_Ohio]

my dad manages a couple hundred retirement accounts and the method he uses for the withdraw phase depends upon risk adverseness and withdraw rate of his clients, but everyone is 50-80% stocks, 1 to 2 years worth of cash and the rest bonds. the money flows from stocks to bonds in good stock market times, from bonds to cash most of the time and from cash to spending all the time(similar to your bucket method). everyone of his clients in retirement has more purchasing power now than when they started retirement.

another risk in the withdraw phase of retirement is the length of time. there is always a chance that you will out live your money if you go too conservative because of the lack of growth compared to inflation. this is a big concern of mine because I have 4 grandparents in their 80s in good health and every great grandparent that die because of natural causes was in their 90s or a 100. so I see living 40+ years in retirement as a good chance. the longer you think you'll live, the more aggressive you want to be or have a lower withdraw rate.

Not only is time a risk- it is the second biggest risk (withdraw rate is the #1 risk).

The bucket method has many applications. It is also not an original concept.

I have no issue with an 80-20 portfolio in retirement. I will probably retire with 80-20 around age 55 and move that too 40-60 by the time I am age 70.

The issue with 80-20 is that means I will have a lower withdraw rate, which means I need to save more, which means I need to work longer.

For 80-20, I would expect to use around a 3.5% withdraw rate, and most of the withdraws would come from dividends on the equity portion of the portfolio.

[jIM_Ohio]

jim, your analysis with the SWR of the aggressive versus conservative is flawed by the fact that there is greater variation of the starting retirement amount in the aggressive case. there will be cases where the aggressive case will starts lower than the lowest of the conservative case when entering retirement. this give an initial advantage to the conservative case when the withdraw phase starts. the only thing you prove was by taking the same amount of money and investing it aggressive you can generate a slightly higher income at the same chance as the conservative case or in other words it is better to be aggressive all the time than conservative all the time.

HUH? I was taking the data in the original post and showing it needed more detail.

I knew (and I thought I stated) that the aggressive portfolio had more when retirement started.

This was my whole point- the aggressive portfolio gave a higher starting amount- so using a moderate portfolio (to stablize returns) in retirement would increase the probability of success.

But I could not find a way to make the calculator give me that data or let me run that scenario (except to hand type the returns and deviations).

I did not conclude it was better to be aggressive all the time- how did you come to that conclusion?

I ran the calculator with 1 million in deferred savings, an after tax withdraw rate of 40K(=50k withdraw pre-tax), starting age 65 and got:
moderate risk - 89%
above average risk - 87%


there is always a trade off in investing. the more conservative cases gives better chances in a shorter retirement and the aggressive gives better chances in a longer retirement. see chart below.

(jim edit- I did not understand the chart)

here are some results from your standard firecalc with a 4% withdraw rate
at 30 years
0% stock - 37.4%
20% stock - 70.1%
40% stock - 92.5%
60% stock - 95.5%
80% stock - 94.4%
100% stock- 92.5%

at 50 years
0% stock - 13.8%
20% stock - 26.4%
40% stock - 52.9%
60% stock - 79.3%
80% stock - 86.2%
100% stock- 87.4%

interesting how much of a drop the more conservative one did versus the more aggressive one did for an extra twenty years.



most failures of a risky portfolio are caused by a major down turn in the first few years. I rather know early on that there is a problem when I could possibly go back to work and fix it than 20 years later when I can't return to the work force(reasons: health, lack of skills,...) because I didn't get enough growth and I'm living longer than expected.

I agree the longer retirement needs more stocks.

One issue when discussing withdraw rates is how the withdraws occur.

There are many camps-
always leave 95% of porfolio there (max withdraw of 5%)
always take 4% of value (money will never run out- 4% of $1 leaves $.96).
4% adjusted upwards for inflation- do not adjust for inflation in down markets.
3 year rule (avoid a negative return over 3 year periods)- there is a 7 asset allocation which shows how to do this- add a commodities index, REIT index and various other securities to prevent portfolio from losing money in any 3 year period.
always take withdraws from dividends

I am in the dividend camp, or the 7 asset class camp to keep a stable portfolio.

The 7 asset class portfolio would be the bucket approach already mentioned.

The dividend approach is preferred because it has 100% success. This is where the calculator was flawed, because it had a 2.4% withdraw rate in some of the cases mentioned and kicked out an 85-90% success rate in those 2.4% SWR cases. If that 100% equity (or 93% equity) portfolio was 100% dividend paying stocks, every person I have spoke to has more money now than they did when they retired. 2-3.5% withdraw rates in those cases (some even quoting as high as 4.2% yield).

[noppenbd]

A few thoughts.

On the FRP calculator, it is important to note that "spending" is not the same as withdrawal, since spending is after-tax (for this calculator) and withdrawal is gross of taxes. So spending of $50K on a $1.25M portfolio is more than 4% SWR. It is more like 5% since you have to withdraw $62.5K to net $50K.

Also, on the experiments Jim did that came out with above average risk, getting an 80% success with 50K spending and $1.6M median portfolio at retirement, it is important to note that since the program runs 1000s of scenarios, that half of them will start with less than $1.6M at retirement, and half with more. So that is what is causing the 80% success rate, even though $50K in spending (from $62.5K withdrawal) represents 4% withdrawal on $1.6M. If you run the program starting at age 65 with $1.6M portfolio with above average risk, you get 96% success. Moderate risk with the same starting value, 98% success. Below avg risk 100%. Risk averse, 100%.

If you just look at AA prior to retirement, using an aggressive to below avg (with risk ratcheting down every 10 years) gives you median portfolio value at retirement of $1.2M (assuming age 25-65, 11K a year to tax deferred). Using the reverse (below avg to aggressive) gives you $1.47M. Using below average for the first ten years and then aggressive the rest of the way through gets you $1.65M at retirement. Using aggressive the whole way through gets you $1.76M at retirement. Surprisingly, using aggressive up till age 55 and then going straight down to below avg makes a huge dent in portfolio value at retirement, reducing it to $1.37M.

My initial experiment wasn't well thought out and confused the issues. There are 2 separate issues as I see it: asset allocation during accumulation and growth, and AA after retirement. When I ran the experiment initially I was confusing the two. So it is starting to make sense now. AA during initial accumulation is not that critical to final outcome, since account values are low and contributions are high relative to gains. AA during growth (pre-retirement) matters more, so aggressive investing (>90% stocks) wins. Especially critical is the last 10 years before retirement, and it seems to be important to get a lot of growth in that period and not be too conservative too early. Once in retirement, a low risk portfolio results in the best chance of success, although using virtually any portfolio with a 4% initial withdrawal seems to have a good chance of success.

So, not so mindblowing after all, although the discussion has been very interesting.

[jIM_Ohio]

My initial experiment wasn't well thought out and confused the issues. There are 2 separate issues as I see it: asset allocation during accumulation and growth, and AA after retirement. When I ran the experiment initially I was confusing the two. So it is starting to make sense now. AA during initial accumulation is not that critical to final outcome, since account values are low and contributions are high relative to gains. AA during growth (pre-retirement) matters more, so aggressive investing (>90% stocks) wins. Especially critical is the last 10 years before retirement, and it seems to be important to get a lot of growth in that period and not be too conservative too early. Once in retirement, a low risk portfolio results in the best chance of success, although using virtually any portfolio with a 4% initial withdrawal seems to have a good chance of success.

So, not so mindblowing after all, although the discussion has been very interesting.

I knew you would come around.

I will add one more anecdote-

Most people will want to stay moderately aggressive (not too conservative) the first 3-5 years of retirement as well. Being able to live off dividends and interest for a short period of time before drawing down makes a huge difference in not running out of money.

[Scanner]

I did recently read an article about a man in his 80's who was 100% in stocks - always was and always will be. . .the idea did intrigue me.

Of course, with diversfication (stocks and commodities and REITS), you would hope the max down year would be 20% as you chewed on your prinicipal.

So. . .you have 1.2 million. . .it drops to $960,000 (20% loss). . .you withdraw let's say $60,000 in one year to live off of.

Then, the next year, it's up 10%. You add 90K to the total. . .but subtract 60K to live off of. . .making your gain to $930,000.

You get a great rally next year, let's say 30% and you could be back, hardly chewing your prinicpal in the long run.

You would be at $1,209,000. . .you withdraw 60K in cash to 1,149,000 the money you are now left with after 3 years.

I don't think my scenario is too far off

Year 1 = -20% return
Year 2 = +10% return
Year 3 = +30% return

I think that would be a typical across the board stock performance.

That being said, I would probably have to remove commodities from that as when commodities are down, stocks are up as a general rule.

I'm always open to contrarian philosophies.

[jIM_Ohio]

I did recently read an article about a man in his 80's who was 100% in stocks - always was and always will be. . .the idea did intrigue me.

Of course, with diversfication (stocks and commodities and REITS), you would hope the max down year would be 20% as you chewed on your prinicipal.

So. . .you have 1.2 million. . .it drops to $960,000 (20% loss). . .you withdraw let's say $60,000 in one year to live off of.

Then, the next year, it's up 10%. You add 90K to the total. . .but subtract 60K to live off of. . .making your gain to $930,000.

You get a great rally next year, let's say 30% and you could be back, hardly chewing your prinicpal in the long run.

You would be at $1,209,000. . .you withdraw 60K in cash to 1,149,000 the money you are now left with after 3 years.

I don't think my scenario is too far off

Year 1 = -20% return
Year 2 = +10% return
Year 3 = +30% return

I think that would be a typical across the board stock performance.

That being said, I would probably have to remove commodities from that as when commodities are down, stocks are up as a general rule.

I'm always open to contrarian philosophies.

$60k out of $1.2 M is a 5% withdraw rate. Extropolate what you did out 20 years and tell me how often you have enough money...

My guess is about 40% of the time the plan runs out of money before the person dies.

If you can lower that percentage to 3% the failure rates should be around 2% (98% success).

[noppenbd]

$60k out of $1.2 M is a 5% withdraw rate. Extropolate what you did out 20 years and tell me how often you have enough money...

My guess is about 40% of the time the plan runs out of money before the person dies.

If you can lower that percentage to 3% the failure rates should be around 2% (98% success).

Also don't forget that if you stay with a fixed withdrawal you are losing spending power every year. 60k in 12 years only has 2/3 of the spending power at 3.5% inflation.

Most withdrawal rate studies assume the withdrawal starts out at a certain percentage of the initial portfolio and then is adjusted upward with inflation each year.