Asset Allocation 2.0

What if everything we’ve been taught about asset allocation is all wrong? No more questions about how much risk you can tolerate, how you coped in 2008, or putting more and more of your portfolio into bonds as your age. What if instead, you divvied up your assets based solely on the goals you want to achieve, and the time you have to achieve them? Let’s look at an example.

Matching Goals to Assets

1.5 Million Net Worth
$1.5 Million Net Worth

Consider a client, age 65, with $1 million to invest. The client owns her home, which is worth $500,000. Here is a chart of her total net worth.

Every year, the client withdraws $50,000 from her investments to sustain her lifestyle. To be safe, we assume that she will need this money for 35 years, until age 100. We separate this period into the first 10 years and then the following 25 years, primarily because if there’s a market drop in the first few years, it’s harder for her portfolio to recover in time to fund those first 10 years of withdrawals.

For the first 10 years we estimate that $500,000 of bonds will best cover her withdrawal needs. The money she will need in years 11 through 35 is best matched today with $500,000 in the ownership of companies and real estate (collectively, “equities”). You might wonder how she’s going to fund 25 years of spending with the same amount ($500,000) that she’s using to fund the initial 10 years. The answer is that for the longer and later period, the equities will have 10 years to grow before she starts withdrawing from them, and over full market cycles, equities earn roughly twice the annualized return of bonds. The client would also like to leave $500,000 to her son as an inheritance, for which we could earmark the equity in her home.

Matching Each Goal with Assets
Matching Each Goal with Assets:
50% Equities/50% Bonds

In this diagram, we show what matching of her assets to her goals looks like. As you can see, this approach tells us that the mix of equities versus bonds for this client should be split 50/50.

Just the Right Amount of Risk

This approach is in stark contrast to a popular school of thought that says the bond allocation percentage should be equal to one’s age (so for this client, 65%), since that allocation would fall short in providing the growth required for the client’s spending needs in her later years. Our approach also differs from the tendency to go with the popular 60/40 balanced portfolio for almost all investors (60% equities, 40% bonds), which would unnecessarily increase the client’s risk. When we start with the client’s goals, we can ensure that the amount of risk the client takes meets the “Goldilocks and the Three Bears” test: not so aggressive that we’ll have sleepless nights and not so conservative that we’ll run out of money. Instead, the amount of risk for each client is “just right.”


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