Pinning Down Portfolio Rules of Thumb

Investing can be complicated, but common portfolio guidelines can be a good starting point

Amy C. Arnott 25 January, 2021 | 4:28AM
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Investing can be incredibly complicated, with hundreds of thousands of investment choices that can be combined in nearly infinite variations. The sheer number of options available--and the high stakes involved in getting decisions right--can make the process overwhelming. That’s one reason why rules of thumb can be useful. They’re a way of cutting through complexity and helping investors make decisions more quickly without getting bogged down in endless questions about “what if” or “what’s next.” These heuristics, or mental shortcuts, can help investors focus on the most important steps to take without getting trapped in analysis paralysis.

In this article, I’ll take a closer look at some of the most common rules of thumb for portfolio management. Most of them make sense as a useful starting point, but understanding their limitations can help investors use them more effectively.

Keep 100 (or 120) Minus Your Age in Stocks
For decades, investors have relied on this simple formula for basic asset allocation guidance. Using 100 as a starting point effectively means targeting a bond weighing equivalent to your age, with the remainder in stocks. This guideline is based on the notion that younger individuals can afford to take on more investment risk because of their longer time horizons. As investors get older, their time horizons shorten, making an increasing fixed-income allocation more prudent.

More recently, 120 has been showing up as a more common starting point, partly because average life expectancies have gradually increased. Before his death, Vanguard founder John Bogle advocated using 120 minus one’s age to determine equity allocations, explaining that the previous guideline came to fruition in an era of much higher bond yields. In one of his landmark articles, financial planner Bill Bengen recommended targeting equity exposure at 128 minus one’s age as part of a comprehensive strategy to support sustainable withdrawals.

Why it works: This rule has stood the test of time partly because it’s simple and intuitive. There’s a strong link between life expectancy and investment time horizon, since a portfolio only has to last long enough to sustain a person during his or her natural life (unless someone wants to set aside money for bequests after death). In practice, investors implementing this rule would start out with hefty equity allocations that gradually glide down as they get older. Linking portfolio allocations to age might lessen the temptation to engage in market-timing (making dramatic allocation shifts in response to market moves). It also indirectly reinforces portfolio rebalancing, as keeping allocation in line with an age-based target would require pruning back equities after significant gains or adding to them after market corrections.

Limitations: Now that bond yields are even lower, fixed-income allocations are likely to generate lower total returns than in the past. That argues in favor of increasing savings, decreasing planned spending, or increasing equity exposure to boost long-term returns. I discussed the merits of moderately stepping up equity exposure in a previous article.

In addition, the age-based guideline may not be optimal for investors who are either just starting out or approaching the end of life. A 25-year old investor with decades left until retirement doesn’t necessarily need any fixed-income exposure as part of a core retirement portfolio, assuming she already has an emergency fund and is willing to take on the higher risk inherent in an all-equity portfolio. On the other end of the age spectrum, Michael Kitces and Wade Pfau have argued that while a lower equity allocation in the years leading up to and immediately following retirement can mitigate sequence-of-returns risk, older retirees might consider gradually increasing their equity exposure over time.

The verdict: Age-based guidelines are a reasonable starting point but might be on the conservative side overall.

Diversify Your Portfolio to Reduce Risk and Improve Returns
It's often said that diversification is the only free lunch in finance. This quote, usually attributed to Nobel Laureate Harry Markovitz, refers to the power of diversification to reduce risk without necessarily hurting returns.

Why it works: In many ways, diversification does have incredible power. Within an asset class, adding up to about 20 additional securities can dramatically reduce a portfolio’s overall risk profile. And adding asset classes with lower correlations is where the magic really happens. The lower the correlation, the bigger the reduction in volatility. It's one of the few cases where the whole can be more than the sum of the parts; a well-constructed portfolio can have better risk-adjusted returns than its component parts alone.

Limitations: The problem is that correlation coefficients shift over time, so what worked in the past won’t necessarily work in the future. In addition, adding asset classes to reduce volatility can also drag down returns, sometimes over multiyear periods. International diversification, for example, might have seemed like a no-brainer for investors about 30 years ago, given that international-stock indexes had handily outperformed from 1982 through 1991 and also showed a low correlation with U.S. market benchmarks. But over the past 10 years, non-U.S. markets have generally underperformed, and international diversification has dragged down returns more often than not. Other popular diversifiers, such as commodities and precious metals, have also gone through prolonged slumps at times.

The verdict: Partially true, but greatly oversimplified. Diversification remains a sound strategy, but it's an insurance policy that has a cost and won’t always pay off.

Use 4% of Assets to Determine Portfolio Withdrawals in Retirement
Investors and financial advisors have long relied on Bill Bengen’s landmark research on sustainable withdrawal rates, which found that for a portfolio combining 50% stocks and 50% bonds, setting an initial withdrawal equal to 4% of the portfolio’s starting value and then adjusting each year’s withdrawal amount for inflation has historically never fully depleted portfolio’s value, even during some of the worst market periods since 1926.

Why it works: This is another rule of thumb that has stood the test of time because of its ability to cut through complexity and provide reassurance about one of the biggest fears for retirees: running out of money. It’s also useful because it can be easily reverse-engineered to determine a required savings amount for retirement. A 4% spending guideline would dictate a starting portfolio equal to 25 times annual spending. If you know that you want to spend $50,000 per year in retirement, for example, you can multiply that amount by 25 to figure out that you’ll need a portfolio size of $1.25 million.

Limitations: The 4% rule assumes that inflation-adjusted withdrawals remain at the same level year in and year out during retirement, regardless of market performance or changes in spending needs. In practice, many retirees spend more in the early years of retirement on travel and other pursuits, then spend less as they age and more toward the end of life because of medical costs or long-term care. There has also been extensive research about more flexible approaches to withdrawals, such as setting guardrails based on portfolio size or market performance. In addition, there’s some question about whether 4% will still be sustainable in an era of lower bond yields, which will likely weigh down returns for portfolios that include fixed income.

The verdict: The 4% rule is still a reasonable starting point, but investors may want to use a slightly lower number to account for potentially less robust long-term returns. I’ll be digging into this issue in more detail in an upcoming article.

Match the Duration of Your Assets and Liabilities
This guideline was born in the pension-fund world, where investment managers need to ensure they have enough highly liquid assets to meet each year’s pension obligations. For an individual, asset/liability matching means keeping the duration of fixed-income assets in line with when you anticipate needing the money. If you plan to make a down payment on a house in five years, for example, you might invest in bonds with five-year maturity dates.

Why it works: Asset/liability matching is another way of using time horizon to help determine an asset allocation. Matching up maturity dates between assets and planned spending helps ensure that you’ll have access to funds when you need them. The retirement "bucket" strategy--which involves setting aside several years' worth of spending in cash or other highly liquid assets—is basically a liability-matching strategy at heart.

Limitations: It’s easy to target specific maturity dates if you buy individual bonds. Financial advisors often recommend creating a ladder of bonds or CDs, which allows you to either shorten a portfolio’s maturity as you get closer to a planned spending date or reinvest the proceeds as each bond matures. It gets trickier if you’re using funds, though, because their maturities won’t adjust over time. To avoid this problem, it makes sense to shift assets into shorter-term bond funds as you get closer to a planned spending date.

The verdict: The principle makes sense, but it can be tricky to implement.

Keep 3-6 Months’ Worth of Spending in Emergency Savings
Beginning investors are often advised to start by establishing an emergency fund. Life can be unpredictable, and unforeseen events like car breakdowns, medical costs, or sudden unemployment often involve large cash outlays. Without a cash cushion, people may be forced to take on debt or dip into long-term investments to cover these costs.

Why it works: Setting aside cash to deal with unexpected events is an essential foundation for personal financial planning. Without this foundation in place, it’s difficult to make progress toward other financial goals, such as paying down debt, building retirement savings, or setting aside money to help pay for a child’s college education.

Limitations: I’d consider three to six months of savings a bare minimum. Individual risk tolerance varies, but I’m personally more comfortable keeping cash reserves closer to 12 months’ worth of spending. That makes it easier to cover any unexpected expenses without selling investment assets at an inopportune time. Unemployment remains a huge issue for many people around the world, and it often takes several months for a laid-off worker to find new employment, particularly in an environment such as the coronavirus pandemic, which has shuttered many businesses and forced others to cut back on staff.

There are some specific situations where keeping an even bigger allocation in readily available cash can be helpful, such as if you have a highly specialized career, if commissioned sales make up a large percentage of your total compensation, if you're the sole household earner, or if you're a contract worker or part of the gig economy.

The verdict: Three to six months is a good starting point, but consider setting aside more if you can.

Most of the rules of thumb discussed above have stood the test of time. But understanding some of the nuances behind how they can--or can’t--support a sound portfolio strategy can help investors apply them more effectively.

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Amy C. Arnott  Amy C. Arnott, CFA, is director of securities analysis for Morningstar.

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