Over the years, Ive spent more hours than I care to even think about pondering the best ways for investors to allocate the assets in their retirement portfolios.
There are seemingly endless variations. But I think its quite possible to cut through the clutter and noise and reduce the process to three decision steps.
Using data from nearly 90 years of investment returns, I think you can do a reasonable job of finding a combination of investments that will meet your needs without forcing you to lose sleep or (even worse) abandoning your investments in panic.
Assuming you agree with me that you should have at least some of your money invested in equities, I think you face three basic questions or choices:
1. What assets will make up the equity part of your portfolio? Will it be the most popular asset class in the world, the S&P 500 index
? Will it be a world-wide diversified portfolio like the one Ive been recommending for more than 25 years? Or will it be an all-value portfolio that avoids growth stocks as much as possible?
2. If youre going to hold international equities, will you make the international part of your portfolio 50%, or only 30%?
3. How much of your portfolio should be in equities and how much in fixed income?
The first of these topics is much too involved to cover comprehensively here, but I can link to some past articles that will let you fill in the details.
In a recent article I described the hypothetical results of investing exclusively in the S&P 500 from 1970 through 2017, without further equity diversification.
This is a convenient and comfortable equity portfolio for many investors, as it focuses on stocks of familiar and successful U.S. companies.
But for many years Ive been recommending a world-wide equity portfolio that adds nine other asset classes, all but one of which has outperformed the S&P 500. The combination improves long-term returns at no appreciable increase in risk.
If theres any magic in this combination, its the emphasis on small-cap stocks and value stocks.
In the past few years, I have realized that the long-term advantage of value stocks is so strong that I believe theres considerable merit in an equity portfolio that avoids the S&P 500 and other blend funds altogether.
This all-value portfolio is particularly suitable for young investors who can (and should) embrace its slightly higher risks. Further, I think an all-value approach may be valuable even for more mature investors.
The additional risk of the all-value approach is actually very modest, especially compared with its long-term performance history.
Youll see this in table 1.
The world-wide portfolio more than doubles the 40-year return of the S&P 500 at less risk when measured by standard deviation and the worst five-year period. (The return figures for worst 60 months are annualized.)
The all-value portfolio nearly triples the 40-year return of the S&P 500, still at less risk by those two measures. Further, all-value adds very little risk to the world-wide equity portfolio.
Now lets address the second major decision point: How much should you invest in international stocks?
For most of the past quarter-century, I recommended having 50% in U.S. equities and 50% in international ones.
The results of the world-wide and all-value portfolios in Table 1 are based on that split.
This 50/50 diversification reflects a world of opportunities and overcomes a common home country bias we all have for whats familiar.
I still believe in world-wide diversification. However, many U.S. investors are uncomfortable with that much of their portfolios invested outside the United States.
Using data back to 1970, Ive studied the results of having only 30% equities outside the U.S., and some of these results are presented in table 2.
This table compares the results of 70% vs. 50% in U.S. equities for the world-wide diversified portfolio as well as for the all-value portfolio.
As you can see, there is a small difference between 50% and 30% in international equities. However, theres a much more significant difference between the world-wide portfolio and the all-value one.
A more significant difference by far comes from adjusting the percentages of equities and fixed-income funds the third major decision point I outlined above.
We see this in table 3, which compares three equity allocations of the 50/50 world-wide equity portfolio. (In these calculations, the fixed-income part of the portfolio is made up of intermediate-term Treasury bonds.)
Here we see that the 40-year differences are huge.
There are many more choices than just 20%, 50%%, and 100%, of course.
To find all this data, check out this table of results for the world-wide portfolio with a 50/50 split between U.S. and international equities and this table, which has the same data for the all-value portfolio.
For data on owning only 30% in international equities, check this table for the world-wide portfolio and this one for the all-value portfolio.
The sheer quantity of information in these tables can be overwhelming unless you know where to focus.
So first, decide between the S&P 500, the world-wide portfolio and the all-value portfolio.
Second, choose between a 50/50 or a 70/30 split between U.S. and international equity funds.
Once you have made those choices, go to the appropriate table and study the columns of allocations between equities and fixed-income funds.
Ideally, youll find a column that combines the right level of risk for you. However, youll drive yourself nuts if you try to get a precise answer to this. Instead, your goal should be to get into the right ballpark.
Although statisticians like to measure risk by standard deviation, I dont think this is a very relevant guide to the way human beings actually experience risk.
I think the worst 12-month and 60-month periods will give you a better real-world feel for the amount of pain you might have to endure and the patience you should be expected to have.
In the end, this last step is a simple choice between risk and return.
Over extended time periods, equities have almost always outperformed bond funds. At the same time, equities can dish out significant losses without warning.
The future will be different from the past. But the past is a decent guide to what we may reasonably expect.
In the past, these losses have always been temporary for investors who stayed in the game.
But many people struggle with volatility; when they bail out in fear, they tend to lock in their losses and are left without any reliable way to know when to get back in.
So its important to choose thoughtfully, being careful not to get in over your head.
Getting this right is so important to you, your family, and your heirs that its well worth your while to buy a few hours of professional help, if necessary.
The cost in dollars will likely be in the hundreds. The eventual payoff in dollars will likely have a comma in it possibly even two commas!
For more on this topic, check out my podcast: How to get the most out of the fine-tuning tables.
Richard Buck contributed to this article.
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