Feb 28, 2023

My Goodbye to Asset Allocation

For as long as I can remember, I’ve read endless variations on two basics of investing. One is that you should maintain an asset allocation between stocks (equities) and bonds (fixed income), moving to a larger percentage of bonds as you near retirement. The second is that you shouldn’t own individual stocks, and instead you should buy them in indexed funds.

There are valid arguments for both claims. But there are quieter places that challenge some of these assumptions. I’ve challenged both for years and now I’m slowly abandoning both.

Today, I will discuss my move away from the standard asset allocation formulas so widely recommended. Later in another post I will walk through my concurrent move away from any stock funds, including indexed funds.

Last year’s markets blew up the asset allocation model between stocks and bonds. In 2022, for a variety of reasons, stocks (S&P 500 including dividends) lost over 18%. But U.S. bonds didn’t do much better, losing over 13%. The theory for owning bonds is that they will neutralize some of the stock losses in a market downturn. That theory failed miserably this past year.

I acknowledge that bonds did perform five percentage points better than stocks. And I acknowledge that this is the worst bond performance in forever. But this is small consolation to the fact that over decades, bonds generally return about one percent more than inflation, and stocks return at least six percent more than inflation. In inflation-adjusted value, stocks have returned about six times more than bonds. Six times. That’s hardly reason to invest up to half of your life savings in bonds.

For years, Warren Buffett has repeatedly said that stocks are a better and an even safer investment for long-term investors. Yes, in the short-term, stocks can be painful. But in the long term, after inflation return on stocks is much, much better than bonds. Six times better, in fact.

But surprisingly, even in the short-term, bonds can be poor performers. Although 2022 is an outlier, bonds can lose money. And the short-term bonds that are almost certainly not going to drop significantly in value normally return less than inflation.

For my first 15 years investing in a 401(k) plan, I kept almost 100% of my wife’s and my retirement money in stock funds. They did fine. Turning forty, I bought into the asset allocation formula to a degree, and moved us to about 20% bonds and 80% stocks. As we aged, I did the "responsible" thing – something I have always struggled with – and increased our allocation of bonds. I entered the Great Recession of 2008 with nearly 30% of our money in bonds.

When stocks dropped 56%, high to low, in the Great Recession, I admitted defeat and slowly moved us to nearly 50% bonds. Now we were safe. Or so I thought.

Then 2022 came. After having up to half of our life’s savings in bonds during one of the greatest bull markets ever, I saw our bonds trashed. I expected it with stocks that had doubled and tripled and more. But bonds?

Yes, over the past ten years, our bonds have not even kept up with inflation. Safe? Secure? Hardly. And they were mostly investment grade.

I did a backtest of our investments the past ten years, testing my results if I had held no fixed income and instead had all of our money in the mix of equities I did own. Although returns are more volatile, the returns are notably higher than what I experienced. And it was interesting that the test never had us with less invested than we had with the asset allocation models I was using.

This reminded me again of other ideas I’ve heard periodically, probably from Jeremy Siegel or Jonathan Clements. The counter idea to asset allocation is to keep 5-7 years of money you may need for an emergency or a market correction in cash and short-term bonds. In the event of a strong market correction, you then have five years to wait it out, using this emergency fund that is virtually guaranteed to hold its value in any market.

(It is noted that as in life, nothing is guaranteed in the financial world. But for our discussion, let’s assume we trust the dollar to hold a reasonable value and for the U.S. government to honor all of its debts.)

For the rest of the money, if you can handle the turbulence, the best returns will be in stocks. However, if you can’t sleep at night, then adjust stocks downward to the point you can sleep. That’s different than keeping a set percentage of your life’s savings in bonds.

It's important to know yourself and how you handle volatility. If you know you're the sort of person who may panic sell when the market drops 25% in a short period, bonds might be safer for you. But if you can keep a long view and not make impulsive orders, over five years you are virtually guaranteed to be in a far better position with your money in stocks rather than bonds.

For me, I can’t sleep thinking what a mistake asset allocation has been. As we speak, financial analysts and journalists are busy both justifying and readjusting the asset allocation models they’ve pushed for decades. As is normally the case, they’re telling us to now go where we wished we had been a year ago.

As is true for most forecasting, there’s a heavy bias from the most recent history, a human tendency referred to kindly as “recency bias.” It mostly reminds us of how bad humans are at forecasting anything.

But I’ve already moved on. Been there, done that. I’m not interested in a new asset allocation model that may have worked in the past but probably won’t work in the future any better than past models.

I’m moving ahead with a 5-year emergency fund that will always have all the money we may need for five years sitting in a stable place that earns little – but doesn’t drop in value. That will be mostly I-bonds and short-term Treasuries. I can ladder Treasuries in over 5 years at over 4% interest. That should probably keep up with inflation. But they won’t drop. Both investments guarantee the return of our principal plus about 4% interest.

For the rest, I’m mostly walking away from other fixed income.

How far will I go? I don’t know. I don’t make fast moves. I started by ending the reinvestment of dividends and gains from bond funds. I’m looking for opportunities to sell longer-term bonds and replace them with either short-term bonds or stocks.

Then it’s a waiting game, watching what happens, monitoring everything we have. I hate selling anything, almost to a fault. And if markets go by their historical averages – which they rarely do – our allocation to bonds will continue to drop.

If I’m right that bonds are a lousy place to be, I’ll get to where I want to be without a lot more work. If I’m wrong, I’ll find myself writing a mea culpa – and trying something else.

But since I mostly don’t sell low, my opportunities to return to a higher bond allocation would only come when stocks are doing well. And then it’s hard to justify any such move since my theory is then working. That is, I may just be stuck in my own investment Catch-22.

My next step is to move away from indexing as my primary means of investing in stocks, and instead move to owning more individual stocks than I have in the past. But that’s another discussion.