Asset Allocation: My Grandfather Had It Right

Last Updated Feb 12, 2010 9:48 AM EST

"Invest money you can't afford to lose in bonds and cash, but invest in stocks only money you can afford to lose 50 percent or more of." This was one of the investing lessons taught to me by my grandfather, pictured here, who was a stockbroker during the Great Depression. These lessons apply very well to the most recent meltdown--and most likely will continue to apply as we all attempt to protect our retirement nest eggs from future meltdowns.
I've combined my grandfather's advice with my years of actuarial experience and research on investing to develop the following guidelines regarding asset allocation for our retirement savings:

People in their mid-50s and beyond should consider investing no more than two-thirds of their retirement savings in the stock market--to protect against market losses--and no less than one-third of their nest egg in the stock market--to protect against future inflation.


Where you fall in this range depends on your tolerance for risk and the amounts of other retirement income you have that aren't susceptible to market fluctuations, such as Social Security, pensions, and payout annuities.

How Would You Have Fared in the Meltdown?
Let's see what would have happened if you had followed these guidelines for your retirement nest egg during the recent crash and subsequent recovery. I looked at several Vanguard funds because they're widely used and their investment return history is readily available on the Internet. The guidelines stated above are well represented by the Vanguard Wellington fund (about two-thirds of its assets are invested in the stock market), and the Vanguard Wellesley Income fund (a little more than one-third of its assets are invested in equities). I've included other funds for comparison purposes.

First, let's look at the dollar amount of gains or losses returns during 2008 for these funds. Once again, I'm following my grandfather's advice about deciding how much risk I can tolerate. "Don't look simply at percent returns. Instead, ask yourself how much money you can afford to lose."

For instance, suppose you had invested $100,000 in each of the following Vanguard funds at the beginning of 2008. Could you afford to lose these amounts?

Vanguard Fund

2008 Gain/Loss

GNMA

$7,220

Treasury Money Market

$2,100

Wellesley (1/3 in stock

($9,840)

Wellington (2/3 in stocks)

($22,300)

S&P 500 Index (all stocks)

($37,020)

REIT Index

($37,050)

FTSE All World Ex-US Index

($44,090)

If you had invested in the GNMA or Money Market funds, you would have patted yourself on the back, but you would have lost $9,840 with the Wellesley Income fund and $22,300 with the Wellington fund. While these losses were definitely hard to bear, most people can recover from such losses, particularly if they have patience--and reliable sources of retirement income in addition to their investments.

Unfortunately, before the stock market losses in 2008 and early 2009, many people chased high returns and had large allocations in stocks. When warned about the risks, they didn't think that stocks could drop as far as they did. As you can see from the above table, investors in the S&P 500 Index, REIT Index, and FTSE All World Ex-US Index funds all experienced large dollar losses.

An important step to take before you invest a single dime--or decide to modify your retirement investments--is to stop and think about how much money you can tolerate losing. This will help you work out the asset allocation that's right for you.

Nerves and Patience Needed!
Retirement investing also requires the nerves and patience to ride out downturns, and the 2008-2009 downturn is providing a good lesson on this. Let's take another look at the previous table, now updated assuming that you had kept your original $100,000 invested from the beginning of 2008 through the end of 2009.

Vanguard Fund

2008 Gain/Loss

2009 Gain/Loss

Net Gain/Loss

GNMA

$7,220

$5,672

$12,892

Treasury Money Market

$2,100

$255

$2,355

Wellesley (1/3 in stocks)

($9,840)

$14,444

$4,604

Wellington (2/3 in stocks)

($22,300)

$17,249

($5,051)

S&P 500 Index (all stocks)

($37,020)

$16,683

($20,337)

REIT Index

($37,050)

$18,621

($18,429)

FTSE All World Ex-US Index

($44,090)

$21,632

($22,458)

By the end of 2009, the market had rewarded your patience and had started to come back. The Wellesley Income fund has recovered all its losses and more, even beating the Treasury Money Market fund during these two years. The Wellington fund has recovered over 75 percent of its losses, and investors in that fund are probably feeling some relief. Investors in the S&P 500 Index, REIT and FTSE funds have recovered roughly half of their losses, but they're probably still hurting. Only time will tell if and when we will fully recover from all our losses in 2008.

Allan Roth's excellent post Why Your Portfolio Should Be Near an All Time High expresses similar thoughts, showing how a portfolio balanced between stocks and bonds may not be too far off from its all time high in 2007. Not great news, but not disastrous either.

The recent market meltdown and subsequent recovery remind me why it's important to protect my retirement savings through asset allocation and to have the patience to ride out the downturns. I'm hedging my bets: I'll continue investing in stocks for the potential of long-term growth, but I'll limit those investments so that if they continue to do poorly, it won't ruin me. And I'll have other sources of retirement income that aren't as susceptible to market fluctuations.

This lets me invest with confidence and peace of mind. Thanks, Grandpa!

Image from family album of Mary Higgins Vernon
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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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