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The Asset-Allocation Fallacy
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By JAMES B. STEWART
A time-honored investment adage is that your asset allocation should mirror your age: 60/40 stocks and bonds at age 40; 50/50 at 50; 40/60 at 60 and so on. An entire industry of so-called target-date funds has risen in recent years to help investors implement this simple strategy. (See article on page B9.) Many of these funds, which are a popular option in 401(k) plans, target an investor's expected retirement date and then allocate and rebalance accordingly.
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Fed Chairman Ben Bernanke
On the face of it, the logic of increasing an allocation to less-risky, less-volatile bonds as one gets older seems unassailable. As investors approach and enter retirement, their ability to earn their way out of a stock-market plunge evaporates. So does their ability to outlive a market decline.
So what is wrong with the allocation adage and the many funds based on it?
Plenty. Like many adages, this one strikes me as grossly simplistic at best, and dangerous at worst.
I don't know when the age/allocation rule originated, but it must have been a time when bonds were yielding considerably more than the near-zero investors are facing today. The Wall Street Journal ran a page-one article this week illustrating the hardships the Federal Reserve has inflicted on retirees trying to eke out a living from their savings. The 10-year Treasury is yielding a paltry 3.46%. That could easily be eaten away by loss to principal should yields ever go up, as they surely will someday.
The adage also fails to consider that as investors age and their life expectancy declines, so do their long-term financial needs. It also seems to assume that stocks are really high-risk assets that aging investors should steadily cut back on.
There isn't any question that returns are correlated with risk, and that stocks are more risky (and volatile) than bonds over most periods. But as long as your time horizon is 10 years or longer (which should include everyone up to age 75, based on life expectancies) the risk in owning stocks seems exaggerated. The worst 10-year period for owning stocks since 1926 (1929-1938) produced annualized losses of just 0.9%, adjusted for inflation. By contrast, the average return for all 10-year periods was an annualized gain of nearly 10%, and the best returns were over 18%.
Even in the last decade, with two market crashes, returns on stocks were essentially flat. In other words, the percentage of savings in stocks isn't likely to decline by much, let alone vanish, over 10 years or more.
Investors should recognize that the adage is very conservative and risk-averse even for people age 60 and over. This may be appropriate for some investors who are close to retirement and haven't saved enough and thus can't tolerate even the modestly higher risk of loss associated with long-term ownership of stocks. They face a difficult dilemma, especially with risk-free returns currently so low. As far as I can tell, the only solution is to keep working as long as possible, and free up some money for potentially higher-earning assets.
By embracing policies that encourage risk-taking, the Federal Reserve has helped ensure generous returns for shareholders—and correspondingly paltry returns for those who can't afford the greater risk. But the Fed's job is to promote growth and monitor inflation, not to worry about the needs of retirees living on fixed incomes. The best solution is to never be in this plight in the first place, by saving and investing from a young age.
The adage also is essentially a passive buy-and-hold approach that makes no accommodation to current market conditions. This is fine for many people, and certainly better than panic selling at market lows and euphoric buying at peaks. But as this column has long advocated, a modest amount of market timing can yield higher returns over time. Right now, interest rates can't go much lower, which means longer-maturity bonds face a risk of erosion of principal. Stocks aren't exactly cheap, either, but buying opportunities will surface eventually, as they always have.
Like so many aspects of investing, simplicity is appealing but rarely effective. No matter what a person's age, an asset-allocation plan has to start with an investor's net worth, balance expected returns with expected needs and take into account risk tolerance. Everyone's circumstances will be different. Some people simply can't stomach volatility. But my hunch is that the age/allocation adage makes little sense for most people, and that many older investors should allocate more to stocks than they do.
“Los dos guerreros más poderosos son paciencia y tiempo.” (León Tolstoi)