Below are links to resources for you to review as you research asset allocation for your retirement withdrawal strategy:
Callan Periodic Table of Investment Returns 2000-2019:
Morningstar – The Bucket Investors Guide To Setting Asset Allocation For Retirement:
Vanguard – The global case for strategic asset allocation:
Roger Ibbotson – The Importance of Asset Allocation:
Setting the Record Straight on Asset Allocation:
Welcome back, America, to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement.
And now here’s your host, Jason Parker.
America, welcome back to another round of Sound Retirement Radio. So glad to have you tuning in this morning. I’ve got a great show lined up for you. And you’re listening to episode number 316. The title is Why Asset Allocation is so Important. And as always, we want to get the morning started, right? Two ways. So we’ll start here with a verse. This comes to us from first Peter, 4:10 as each has received a gift. Use it to serve one another as good stewards of God’s varied grace. And then I’m so excited to be able to say that we have Emelia joining us this morning to be able to share a joke. Emilia, what do you got for me?
Oh yes. Thank you. It’s been too long. All right, here we go. What happens to an egg every time you look at it?
It gets boiled.
It becomes egg sighted.
I don’t understand, Emil, why would you get egg sighted? If-
So it’s like you say it. The way it’s written, it’s just the word egg and then sighted. So you’ve sighted the egg.
That’s why. It’s not excited, it’s egg sighted.
Ah, I’m so glad you’re back to share this. Egg cited. S-I-G-H-T. Play on words-
… On a podcast.
Where no one can see it.
Well, that’s all we have from Emelia today. She’ll be working on another joke for next week. It’s nice to have you back on the show though, Emilia. Thanks for being here.
Thanks. Have a great show.
Okay, so let’s get into this episode. Number 316, why asset allocation is so important? You know, I had the opportunity to meet with just a lot of wonderful people around the country and help them with their retirement planning. We also had the opportunity to look at how people have been investing. And now that the stock market has almost fully recovered, this is a good time to reevaluate your asset allocation strategy and consider making some changes before the next big thing hits and causes more volatility. Especially, especially if you have retirement on the horizon.
As I’ve met with people around the country, I’ve found that many people don’t really have an asset allocation strategy. Many people just have made investments in various mutual funds with no real guidance on portfolio construction or asset allocation. They just know that they should have some money in stocks, some money in bonds and some money in cash. And this is just a real basic understanding of asset allocation. But in today’s show, I want to explore why the subject is so much more important than just that simple structure. And my hope is after our time together, you will see why asset allocation is so important, especially in a draw down scenario when your ability to earn or your human capital is gone.
So risk is different once you retire and it’s different in the sense that you’re no longer saving and accumulating because during that time risk is really just noise. But if anything, volatility helps you accumulate wealth because when you’re making regular contributions and dollar cost averaging into the market, volatility allows you to buy the dips.
So I’ve heard the analogy and people compare investing to climbing Mount Everest. Climbing Mount Everest would be like the accumulation phase, whereas the distribution phase would be like coming back down off the peak from Mount Everest. And many of you know this, but the interesting statistic is that more people die coming down, Mount Everest than going up. An article in Scientific American said that only about 15% of deaths occur from attempting to scale Mount Everest, whereas 56% of the deaths occur on the way down. And the analogy helps us understand that sometimes the way down or the distribution phase can be more important than the way up or the accumulation phase.
Today’s show is focused on the distribution of wealth, which is so much different than how most people think many of the investment podcasts that I listened to are, are focused on the accumulation of wealth. And very few of the shows that I listened to are actually talking about portfolio distributions or how asset allocation is applied in the distribution phase of retirement.
So let’s start out with answering kind of the most basic question. What is asset allocation? Asset allocation is balancing risk and reward by investing in different asset classes with the expectation that not all asset classes move in tandem. It’s finding the sweet spot on the efficient frontier that maximizes returns for a given level of risk. And if you’ll remember from show 315, we talked about modern portfolio theory and the efficient market hypothesis and the efficient frontier.
An overly simplistic example of asset allocation would be to determine how much to hold in cash, how much to hold in bonds and how much to hold in stocks. Asset allocation, even more simply means not having all of your eggs in one basket. In order to create an asset allocation strategy, you would want to understand what the rate of return required is to meet your future cashflow needs. And you will also want to know how different asset classes have performed historically. And then you’re going to want to make some forward-looking assumptions about how the asset classes will perform forward.
So now that we have an idea of how to define asset allocation, why do we even say asset allocation is important in the first place? Well, this all started back in 1986 with, it’s called the BHB study is the Brinson, Hood, Beebower study was updated in 1991. And in that study, they concluded that asset allocation explained to 93.6% of the variation in a portfolio is quarterly returns. And that stock picking and market timing played minor roles. Some of the more recent discussions around this early work is that its focus was on the variability of returns, not on return levels or relative performance, which is what most investors are interested in. So it’s really the academic community that has informed our understanding of the importance of asset allocation. And I wanted to take a second to talk about diversification because that’s another word that gets thrown out there a lot. And I think of diversification different than I think of asset allocation.
I define diversification as, especially in a retirement portfolio, a withdrawal strategy, diversifying your investments for retirement cashflow planning. The first step is to diversify the time horizon when you’re going to need the money. Then depending on how long before you need access to the investments will determine how much risk you should take for each time segment. Once we know how much you plan to spend again, key is how much you plan to spend think about this whole thing. The reason you saved it in the first place was to spend it once we know how much you plan to spend each time segment, we would create an asset allocation strategy to match up with each segment of the plan. The segments needed in the early years would be invested more conservatively, while the segments that are needed in the later years would be invested more aggressively.
This concept seems pretty easy to understand, but from my experience and from meeting with a lot of people out there, a lot of people liked the idea. They think it makes sense, but very few actually implement it. So now that we know what asset allocation is and why it’s important to look at it, let’s look at how this applies to you. As you shift from making the transition from the accumulation phase of asset allocation into the distribution phase of asset allocation. If you’re a visual learner, I want to encourage you to visit the show notes for episode number 316, because I’m going to include a link to this table. It’s very colorful and it’s a great tool for people who are geared toward visual learning.
We’re going to look at what’s called the Callan periodic table of investment returns, and I’m hoping to be able to paint a picture for you over the podcast. I’m going to do my best to describe to you what I’m looking at, but if you’ll imagine a spreadsheet or a grid, or a table, if you will, along the top of the spreadsheet are columns. And each column represents a year starting with the year 2000 and going through the year 2019. In each row of the column are colorful little boxes in each of these boxes, each of these colorful little boxes represent an asset class.
The asset classes being represented are as follows: real estate, US fixed income, cash, small cap equity, global fixed income, excluding the United States, high yield, large cap equity, international developed, excluding the United States, and emerging markets.
Again, if you go to the show notes for this episode, number 316, I’ll include a link so that you can follow along. But this colorful table really helps to illustrate that no one asset class is consistently the top or the bottom performer. But, if you’re like me, what you try to do is recognize patterns. And, and you think to yourself, “Boy, if I could just identify the asset class, that’s consistently at the top, wouldn’t that be a winning strategy?” Or maybe just avoid the asset classes that are consistently at the bottom. I think the chart does a pretty good job. The table does a pretty good job of showing you why trying to play that game is not going to get you very far.
But a couple of things that I did notice as I looked at kind of the top performers and the bottom performers over this period from 2000 to 2019, the asset classes that consistently that showed up the most in that very top, the best performer real estate showed up five times as did emerging markets, five times out of the last 20 years. US fixed income showed up three times. And so did small cap equity. Large cap equity was in the top spot twice. And then global fixed income was in there in that top spot once and cash was in the top spot once.
As I look at the bottom performers over this period of time, cash was the very worst performer eight times over this 20 year period. Emerging markets was there four times, global fixed income and developed international excluding the United States was there twice. And then large cap equity, US fixed income, and real estate were all there one time.
The real power of looking at the Callan periodic table of investment returns helps you to understand that it’s going to be a really tough game if you think you’re always going to pick the best performing asset class each year. And what it encourages you to consider is instead of trying to just pick the best performer, what if we were broadly diversified across all of the different classes and then rebalanced. Because if you think about rebalancing, what rebalancing forces you to do is to sell some of the positions that have done well in the good years and buy more of the positions that have done poorly. It’s counter-intuitive, it forces us to think different about the market. It forces us to think different than the way that most people want to do this. Most people want to hold onto their winners and sell their losers. And when you rebalance a portfolio, it’s forcing you to do the exact opposite of that.
It’s important to understand that we’re talking about asset allocation, for people who are transitioning into retirement, and the advice that people who are accumulating wealth will likely not be the same as for people who are making the transition into the distribution phase. What got you here might not get it there.
In fact, I would say like that analogy about climbing Mount Everest, the accumulation phase, while there are certainly risk, the risk doesn’t feel as daunting when you have a job and you have income coming in. But all of a sudden when you’re heading back down that mountain, and now what you’ve saved is what you’ve saved. And you’ve got to make that money last, the rest of your life. That is not a time to be experimenting with what you think is going to work. You’ve got to have a really good disciplined strategy. Keep your fees as low as possible. Choose the asset allocation that you think is going to work for you, diversify your money across time segments. That’s what I would encourage you to consider.
So here are a few questions that I think are worth asking yourself as you began to make this transition. Why did you select your current asset allocation strategy? Second question is what was the methodology used for creating your asset allocation strategy? Was there a methodology? Is your asset allocation strategy designed for an accumulation strategy or is it designed for a distribution strategy? What did you design it for? Have you started to think about making the shift?
Next question. Will you rebalance your investments? If so, how often? Have you started the process of diversifying across time segments? Creating different buckets, different segments, investing each one of those segments based on the appropriate amount of risk. Given the fact that money that we need in the short term, we’re going to be taking distributions from Monday that we don’t need for a longer period of time could be invested more aggressively. Do you plan to do that?
The next question is when’s the right time for you to take action? And then I would say the final question is what are the consequences for not taking action?
Remember, retirement is all about cashflow. It’s all about making your income matches up with your expenses. Ultimately, the reason that you saved this money, isn’t to try to earn the highest rate of return. The reason that you saved it is so that you could be able to afford and enjoy a great quality of life. And so it’s important to understand, not just how do we optimize a portfolio, but what’s the rate of return that we need to earn in order to make your plan work? Once you know, what rate of return is needed, it can help us understand how much risk you might want to take within the portfolio and within the asset allocation strategy.
All of this comes from having a good plan. It comes from understanding the numbers. And so there are key components to having a good plan. You have to understand when you’re going to start social security, we have to make some projections about life expectancy. We have to know how much money you spend both now and in the future and how it’s going to change. We have to understand how inflation is going to impact that spending over time. We have to have some understanding of what rate of return you need to earn on your money. Then we need to create an asset allocation strategy that you’re going to be comfortable with from a risk standpoint. We need to rebalance that portfolio to maintain the asset allocation. Many of the people that we serve like to create different time segments based on when they’re going to need it. So the money that they need in the short-term is more conservative in the money that they need in the long-term is more aggressive.
So this, for many people, it was one of the most important decisions of your financial life. This transition into retirement. You don’t want to give up some of the highest earning years, the years where you’re making just probably the most money you’ve ever made in your life until you’re pretty darn confident that these numbers are going to work. So I’d encourage you to have a good plan, make adjustments as necessary. Things are not going to work in the future. The way that we’re planning on them. We have to be nimble and we have to be flexible, and we have to be willing to make adjustments when things aren’t going exactly as planned.
But at the end of the day, I don’t think this is how most of you want to spend most of your time thinking about the investments, thinking about the money, what you want to be thinking about is how do we live the best life? How do we make an impact? Who are the people’s lives that we touched? What are the things we’re going to do? If this isn’t an area that you enjoy, well, I would encourage you to consider reaching out to somebody. Have your financial advisor help you put together a good plan that you feel confidence in so that you can go out and really live your best life. Until next week, this is Jason Parker signing out.
Information and opinions expressed here are believed to be accurate and complete for general information only, and should not be construed as specific tax legal or financial advice for any individual and does not constitute a solicitation for any securities or insurance products. Please consult with your professional before taking action on anything discussed in this program. Parker Financial, its representatives, or its affiliates have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance related discussions are subject to the claims paying ability of the company.
Investing involves risk. Jason Parker is the president of Parker Financial, an independent fee-based wealth management firm located at 9057 Washington Avenue Northwest, Silverdale, Washington. For additional information, call +1 800-514-5046, or visit us online at soundretirementplanning.com.