PoF ran a recent article on asset location and tax efficiency in early retirement. Interesting article. As such he proposed the following AA in retirement:
I decided to model this portfolio on the Efficient Frontier plane
The efficient frontier plane looks at both risk and return for any given asset. You can look at this plane and see where your asset choices place you. For example owning Emerging Markets buys you a lot of risk for mediocre return compared to owning US Stocks. These are averages since 1995 so any one year EM could outperform but on the average it under performs decade after decade.
Rank ordered Bonds provide most diversity about half as good are REITS. From a risk perspective Bonds are least risky and US stocks are next. In this portfolio you pay for your “diversity” with excessive risk, and you own way more risk than you need to own
For every 9 cents of return you pay with 12 cents of risk
The more efficient AA
Same return but under a dime of risk. The first portfolio is an AA of 80/20 the second an AA of 67/33. I find this important. owning 33% bonds is more stable than 20% and in retirement stability is more important to me than emerging markets. It means when the recession comes you drop less and recover sooner both very desirable. A portfolio isn’t open to SORR till you start withdrawing money. In time of accumulation you don’t really care because you live on a W2 income. If recession comes just work another year. In the above portfolio if the US market dropped in half (50%) you could expect the above portfolio to drop 40% If you owned the efficient portfolio a 50% drop in US would yield only a 33% drop in portfolio value. To get even in the 50% case you need to make 100%, in the 40% case you need to make 80% and in the efficient case only 66%. I can assure you 66% comes faster in recovery than 80 or 100. It means your recession is milder than the economy’s recession.
So I think AA makes a big difference. I think not owning risk makes a big difference once the portfolio is open to SORR. Like the article says optimize optimize optimize. I don’t really care what you own but you should understand the cost of owning it. A given portfolio may have made you wealthy and brought you to the retirement party but because of SOR it may not be the one to carry you into the future once you leave the retirement party. Do I hear 50/50?
Here is a 50/50 portfolio made of the top 3 diversifies from the previous example
It provides 8.5 cents of return at only 7.5% risk. At some point you may ask yourself how much return is enough a different question that how much is enough. The 80/20 paid 9.4 cents at 12 cents risk. This one pays 8.5 cents at 32% less net risk. Maybe 8.5 cents is good enough to sustain your retirement.
4 Replies to “Retirement and AA”
It makes sense to keep highly taxed bonds in my tax deferred account. Then keep mainly equities in my taxable corporate account.
Unlike most people, I am buying a tax inefficient (80/20) self balancing ETF in my taxable to avoid the “one hand clapping” scenario when the market plunges.
I do not trust myself to balance adequately or I could also be traveling and this gives me one less thing to deal with.
I am sure many others have better and more optimized plans than we do. But our plan will get us most of the way to where we want to go.
And it is so brutally simple. Hee hee.
It makes sense to store bonds and REITS in tax deferred or tax free accounts since these spew ordinary income and ordinary income is what drives taxes. Bonds and REITS also provide actual non correlated diversity especially bonds. One thing I really liked about the PoF portfolio was Bonds and stocks in the TIRA in a 20/80 mix. This is the tangent portfolio which I believe is the right portfolio for a TIRA. It gives you best stability and the ability to re-balance within the TIRA without jumping through a lot of hoops by re-balancing across accounts like between the Roth and the TIRA. Re-balancing across accounts is completely doable but I find it a bit more complicated than having the re-balance occur in the same account. I’ve sold nearly all of my REITS down to 1.25% in favor a simpler asset allocation and a less complicated tax picture. I do still own GLD which gives me something to sell high in case of recession. GLD and stocks tend to be inverse in a down turn, as stocks go down GLD goes up so if I need to sell something, sell high is my motto. I use Personal Capital to monitor my portfolio and my present mix places me on the EF with acceptable return and risk.
Thanks Gasem for providing visual representation of the various portfolios and how they behave on the efficient frontier. I was surprised to see REITS so far up and to the right of the frontier (is this because of the 2008 real estate debacle?) If you took out those few years would it have normalized to the other assets better?
I just think REITS are much more volatile than one might think. They also have the highest returns of the classes chosen. The averaging goes back to 1995 so it basically covers 25 years of market data. I think it points out REITS are not the eggs of a portfolio but maybe the pepper.