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THE REAL TRUTH ABOUT ASSET ALLOCATION (WEALTH MAXIMIZING PORTFOLIO)
Imagine that you have an income and that you want to save and invest money each year for thirty years and that you hope to become significantly wealthy through this investment program, perhaps to fund a very comfortable retirement.
Should you invest the money in a balanced fashion in stocks, (long term) bonds and short-term cash? Or should you invest all the money in stocks? This is known as the asset allocation decision.
Virtually the entire investment community will advise you to take a balanced approach to asset allocation.
The future will surely be different from the past. Still, when contemplating a 100% stocks approach, versus a balanced approach, it seems wise to ask: How would this have worked out if it was tried in the past?
This article looks at the results that would have been achieved over all the possible 30-year investing periods starting from 1926 through 1955 and ending with 1977 through 2006. The annual returns and volatility of both fully balanced and 100% equity approaches are studied.
The data suggests that you might want to consider ignoring conventional advice and keep all of your investments in stocks rather than using a balanced approach to your asset allocation decision.
Results from Actual Data
Using Actual U.S. data for past returns from Stocks, Bonds, and Treasury Bills going back to 1926, this article presents some rather startling conclusions about the actual returns and volatilities that have been experienced in the past over 30-year savings periods. Actual returns and volatilities over various historic 30-year periods have varied over an enormously wide range.
Past savers were impacted to an extremely large degree by the "luck-of-the-draw", in terms of how the markets did over their particular saving years. For example an all-equity savings program started at the beginning of 1944 accumulated an amazing 68% more than a similar savings program started just one year later.
This article presents data that suggest that a 100% allocation to equities has historically worked out very well, by the end of all historical 30-year saving periods - using data that begins in 1926. However the 100% equity approach features some truly ugly volatility along the way.
Portfolio growth scenarios are often worked out using assumed average returns that are expected to be achieved. The return assumptions tend to range from 6% to 10% per year. Usually, it is assumed that an annual contribution is made (such as to a tax-deferred retirement savings account) and that the portfolio of money is invested in a balanced manner, between stocks, corporate bonds and short-term cash deposits.
A huge flaw in many studies is that they work with nominal (not adjusted for inflation) figures rather than real (constant purchasing power) inflation-adjusted figures. Most models may also be highly unrealistic in that they assume some constant return level each year. The reality is that returns vary enormously from year-to-year. Returns also vary enormously over different 30-year periods.
This article is based strictly on real inflation-adjusted returns and volatility. We assumed a savings level of $500 per month or $6000 per year for 30 years. This is in real dollars, so in nominal dollars, an initial $500 per month savings would be adjusted up or down each year for inflation or deflation.
For these scenarios we will assume there is no tax paid until withdrawal, so this is a tax-sheltered retirement savings account.
The question is, what will happen? How much money (in real dollars) will we accumulate over a 30-year savings period.
When we applied this scenario to someone who retired in each of 1926, 1936, 1946, 1956, 1966 and 1976, using actual historical return data, the results were quite startling.
We compared two asset allocation approaches. One approach was to notionally invest the portfolio in 100% equities as represented by the S&P large stock index in the U.S. The other approach notionally invested the funds in a fully balanced manner with 1/3rd in each of the S&P large stock index, Corporate Bonds and Cash, and rebalanced each year. Our data was taken from the annual yearbook, Stocks, Bonds, Bills, and Inflation, by Ibbotson Associates. Their figures show real total returns (inflation adjusted and including dividends and re-investment of dividends). These figures ignore any transaction and money management fees.
We used $500 per month ($6,000 per year) as a round figure and as an amount that is perhaps within the reach of most two-income families. This was equivalent to about $50 per month in 1926 but the same math applies.
First, let's look at how much money was accumulated after 30 years, using both a 100% equity strategy and a fully balanced approach to asset allocation.
Saved $6,000 Per Year for 30 - Years Analysis is in Real Inflation-Adjusted Dollars Ending Balance 30 Years Later Start End 100% Equities Fully Balanced 1926 1955 $1,022,308 $332,568 1936 1965 1,295,297 341,680 1946 1975 470,812 241,350 1956 1985 364,152 274,885 1966 1985 675,658 423,948 1976 2005 813,011 479,326
The Table shows what would have happened if we started, in each of the years shown, and saved $6000 per year for 30 years and fully adjusted the $6,000 for inflation each year. If the portfolio was 100% invested in large stocks (The S&P 500 index and its predecessor), then in all six cases, this 100% equity approach significantly out-performed a balanced portfolio.
A 100% equity allocation, especially as retirement approaches is generally considered very risky, because of annual volatility and because of high uncertainty in the returns. The usual advice is to move to a balanced portfolio. This is expected to offer a somewhat lower return, but with significantly less volatility.
And, looking at the Fully Balanced Portfolio, in the table above, it certainly did deliver far less return in all six cases.
Looking at the table above, it is not at all obvious that the Balanced Approach to asset allocation is preferred. But this is based on only six cases. (However, the six cases are 30 year savings periods that start in six different decades so they may be reasonably representative of a range of possibilities). And the table does not show the volatility experienced over the years. Below we will provide graphs for all 52 possible 30-year savings period scenarios from 1926 through 1955, all the way to 1977-2006.
But first, let's take a graphical look at just the six retirement scenarios presented in the table above.
Graphs allow us to see the annual volatility through the years.
Graph below is a 100% Equity Portfolio $6000 per year saved in real dollars
The above graph is for risk-taking savers who decided to remain 100% in large stock equities for 30-year savings periods starting in 1926, 1936 etc. and who saved $6,000 per year adjusted annually up for inflation and down for deflation to maintain a constant $6000 worth of purchasing power, in dollars of the starting year, saved each year.
As was apparent from the table above, the results for the different starting years varied across an extremely wide range. The ending amounts (in real dollars, adjusted for inflation) varied from $364,000 to $1.3 million. The variance is explained simply by the luck-of-the-draw in terms of how the markets did.
Each of the six lines had years of relatively steep drops. The drops in the early years look small in comparison to drops in later years even though the percentages may have been similar. However, a 30% drop in year 4 of a savings program is very minor compared to a 30% drop in year 28. A 30% drop in the early years would not represent a large amount compared to a person's salary. The 30% drop in the early years may even be advantageous since the future annual contributions would be made at lower market prices. By the last few years the annual contribution is a drop-in-the-bucket compared to the portfolio and so at that point market dips have no silver lining.
Perhaps surprisingly, the 1926 savings scenario (in red) turned out to be a very good one. This saver suffered through the horrific market crash of 1929 through 1932 but this was outweighed by gains in later years. The 1946 through 1975 scenario (in yellow) suffered horribly in its last few years as it ran into the crash of '73, '74 and also suffered greatly from the high inflation of the 70's. The 1976 through 2005 scenario (in light blue) ended up at a high value but was well down from its peak in 2000.
A notable feature, of the above graph is that all six savings scenarios featured significant volatility (in two cases there were extremely large drops in the later years). And this is based on annual data. The actual distance from peak to trough would be noticeably greater with daily data.
Now, let's examine the graph for the Fully Balanced approach to asset allocation. Note that the balanced approach is fully re-balanced to 1/3rd in each of stocks, bonds and short-term cash investments at the start of each year. (It is often claimed that the dollar-cost-averaging associated with rebalancing will bring tremendous benefits.)
Graph for Fully Balanced Approach to Asset Allocation with $6000 per year saved in real dollars
This graph uses the same scale as the 100% equity graph, to aid comparability.
As indicated in the table there is far less variability in the ending values, although there is still quite a range.
As expected, these scenarios climb much more steadily but also much more slowly. There are still some very notable drops which correspond to crashes in '73, '74. The crash of the early 2000's produced a flat spot on the line for 1976 through 2005 (in light blue) but no noticeable dip using annual data.
Based on these 6 Scenarios, which is better 100% Equity or the Balanced Approach?
With the benefit of hindsight, we can see that the Balanced Approach to asset allocation, in these six cases, sacrificed, a huge amount of wealth in return for substantially less annual volatility. The graphs confirm the rule of thumb, that an all-equity approach usually outperforms balanced portfolios in the long run, but at the cost of extreme volatility.
It is tempting then to suggest that this evidence argues strongly in favor of a very high allocation to equities throughout the savings phase of life.
But the graphs show high (and in some cases extreme) volatility with a 100% equity approach. It's entirely possible that seeing our portfolio lose perhaps more than we are making in salary in a single year would drive many of us crazy. We might feel awfully dumb for not having moved partially out of equities at market peaks.
Evidence Based on More Data
The above analysis was based on just 6 retirements dates, one per decade from 1926 through 1976.
Let's now graph all the possible 30-year retirement scenarios using each retirement year from 1926 through 1977. The first graph is for the all-equity approach.
Graph below is 100% Equity Portfolio $6000 per year saved in real dollars
The above graph is for risk-taking savers who decided to remain 100% in large stock equities for a full 30-year savings period. The graph shows what would have happened for all possible 30-year savings periods starting with1926 through 1955,then 1927 through 1956 all the way to 1977 through 2006. Each scenario is for $6,000 saved and invested per year adjusted annually up for inflation and down for deflation to maintain a constant $6000 worth of purchasing power saved annually.
There is quite a range in the ending portfolio values, all the way from $462,000 to over $2 million. One thing that the graph illustrates is that there is really no such thing as a "typical" ending value. The average ending value is actually $1.3 million. But that is a pretty useless figure. What good is it to know that the average was $1.3 million, when in reality in some cases the ending portfolio was only around $462,000?
The above graph vividly illustrates that what will happen to a 100% equity portfolio over a 30 year period, is highly uncertain. Analysis that focuses on so-called average outcomes such as a steady real 6% gain (which in fact never happens) are highly mis-leading because they do not consider the range of likely outcomes.
If you look closely though you can see many huge near-vertical drops. Most of these 100% equity scenarios see a number of large drops over the 30 years (although most years see gains) and most have one absolutely devastating period corresponding to living through the market crashes of 1929 through 1932, 1973 through '74 or the early 2000's.
Given the extreme volatility illustrated, lets examine the fully balanced approach. Conventional investment advice argues that a balanced approach is preferred in order to smooth volatility.
Graph for Fully Balanced Approach with $6000 per year saved in real dollars
Note that the same scale has been maintained in all four graphs for easier comparability.
The Balanced asset allocation approach to 30-year savings periods started in each year from 1926 through 1977 delivered a much tighter range of ending portfolio values. The range is from $306,000 to $907,000, with an average of $565,000. Technically then, the balanced approach has less risk, because the outcome is not subject to as much uncertainty.
However, the balanced approach in each and every one of these 52 real data cases, delivered a lower ending portfolio value. Every time! In many cases the 100% equity approach delivered two to three times more wealth by the end of 30 years. The biggest out performance was for the brave investor who started at the end of 1931 at the end of the great crash and used a 100% equity approach. For a 30 year period from 1932 to 1961, the 100% stocks approach delivered an amount that was 4 times higher than the balanced approach. The lowest amount by which the 100% equity approach exceeded the balanced approach was 28% which occurred for the 1955 to 1984 period.
The Balanced approach provided substantially less annual volatility but at a huge cost in terms of foregone wealth, for the vast majority of the scenarios (and there was some foregone wealth in all scenarios).
Observations and Conclusions
The above is the U.S. data for 30 year retirement scenarios starting 1926 trough 1977. I believe my calculations are correct but there is always a chance that I have made an error in calculations and or data entry.
Many books have been written about the proper asset allocation to use for a savings program and about the only universal agreement is that the proper asset allocation is very much dependent on each individual's unique circumstances including particularly the financial ability to accept risk and the emotional willingness to suffer large losses along the way.
Therefore it is perhaps best if readers draw their own conclusions from the graphs and seek other opinions as well.
However, I will provide my thoughts (why stop now?)
The evidence seems clear, a 100% equity approach to asset allocation will almost certainly out-perform a balanced approach over a savings lifetime. But the 100% equity approach will probably feature at least one truly sickening drop of 35% or more. If you can't take that heat ... stay out of the kitchen, but realize you will likely give up substantial wealth to avoid the volatility
Given the rewards of the all-equity approach, most of us should probably try to increase our risk tolerance.
Young investors who are saving for retirement will almost certainly be wise to fully commit to a 100% equity approach for at least the first 10 to 15 years. After that the bias should be to remaining 100% in equities but an exception should be made if the market seems definitely over-valued.
Other analysts have claimed that the Balanced approach can often be superior, so please check other sources.
In the end, there simply are no easy answers to the asset allocation problem. Each individual will have to choose their own allocation based on their unique circumstances.
The evidence seems to suggest that if you can both stomach high volatility and can afford the risk, then a very high allocation to equities might be appropriate all through the savings phase. This might apply to people who are convinced that equities will win out in the end and that occasional devastating losses are simply part of the price to be paid for having accumulated a large amount in the markets in the first place.
My personal savings period started at the beginning of 1989. My personal approach since then has been to invest essentially 100% in equities at essentially all times. This has worked out very well for me. At this time I plan to continue to have a strong bias towards being 100% in equities. However, I intend to move partially (say 20 to 50%) into cash or short-term bonds if the market appears to become more than mildly over-valued.
I am not suggesting that any particular individual should pursue a 100% equity approach. This is very much a personal decision.
Why then do Advisors so often Recommend Balanced Approaches?
It seems to me that Advisors have an incentive to recommend balanced approaches. If an Advisor were to suggest a 100% equity approach, it is the investor who would reap most of the benefit. However when the market inevitably crashed (even temporarily) the Advisor would take the heat. The investor might leave and look for a new Advisor. The Advisor therefore has an incentive to suggest conventional but mediocre approaches.
Caveats
Again, the above is the U.S. data for 30 year savings scenarios starting 1926 trough 1977. I believe my calculations are correct but there is always a chance that I have made an error in calculations and or data entry.
The graphs are based on annual year-end data only . Actual daily volatility and distances from peak to trough based on daily data are not shown but would show more volatility.
The future is not the past. Even if equities always beat balanced approaches over 30 year periods in the past since 1926, there can be no assurance that the same will apply in the future. Certainly if one remained 100% in equities at a market bubble peak, the results could be emotionally (and perhaps financially) devastating, even if history suggests that eventually the portfolio would recover.
The above analysis is based on U.S. data from 1926 onward. This was a golden age of progress and it is possible the future will be far less rosy for equities.
Data for Canada and other Countries may not show the same ultimately favorable (although volatile) picture for equities.
We have ignored taxes. However in general, taxable accounts would sway the results even more in favor of equities because of the favorable treatment of capital gains historically and of dividends more recently.
The equity allocation here is to the S&P 500 index. Allocations to less diversified or smaller cap equities would have different results.
We have ignored portfolio management and transaction costs. However, it is not clear that these are materially higher for equities versus bonds and cash. With the 100% equities approach, little trading might be needed if one were tracking an index. In the Balanced approach the annual rebalancing would add to trading costs. Management and trading costs would likely lower the curves in the graphs but not change their shapes much.
The bottom line is that there are no easy answers in investing. Asset allocation during a savings period is a highly personal choice. However, the above analysis will hopefully allow the choice to be made from a more educated level.
See also our related article about Asset Allocation in Retirement
END
April 20, 2007 (with minor edits to April 25, 2008)
Shawn Allen
President
InvestorsFriend Inc. www.investorsfriend.com