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Posted by on Jan 20, 2014 in ETF Strategist, Investment Perspective

Turning Asset Allocation Upside Down

By Roger Nusbaum, AdvisorShares ETF Strategist


After the second 50% drawdown of the US equity market in one decade, the investment industry began to reassess the idea of what asset allocation should look like. Unlike the 1980’s and 1990’s, financial professionals can no longer rely on an almost static 60/40 or 70/30, watch the equity portion triple in 15 or 20 years  and then flip the whole thing to fixed income for a safe 6%.

As the S&P 500 cascaded lower in 2008 and into early 2009 fear dominated and investors questioned whether any equity exposure was suitable. Many advisors were no doubt answering questions about putting it all in bonds or relatively sophisticated clients may have been asking about absolute return or long/short strategies.

Fast forward to mid-2013 and clients started to think they did not have enough equity exposure and that sentiment still exists today and will likely persist until the next bear market commences.

Of course the important thing is a disciplined approach of choosing a suitable asset allocation and adjusting it appropriately and hopefully infrequently for life events. And while adjusting allocation every few months is not a disciplined approach, it does make sense to consider longer term return expectations, what we’ve learned in the last 15 years of how markets perform and the differences between retirement choices made by baby boomers versus the boomers’ parents.

The Wall Street Journal had an article titled Everything You Know About Retirement Investing Is Wrong which address this point. It raises the very real threat that newly retired investors face which is a large decline in the equity market right after retiring.

Assuming the 4% withdrawal rule, a couple with $1 million in investment accounts having run their numbers and determining that $40,000 from their investment accounts plus other sources of income will get the job done goes ahead and retires.

For the couple who went through this process in December, 1997 everything worked out fine. In a 50/50 portfolio the equity portion grew by 30% in 1998 to $650,000, their fixed income allocation paid them 4.5-5.5% all year, they took their $40,000 and started 1998 with $1,135,000 and feeling comfortable.

A couple going through the exact same exercise in December 2007 of course endured a much rougher time as the financial crisis was dawning.

What was the difference? Luck. No one can control the circumstance of the stock market does in the first year of their retirement, or ever. The couple retiring at the end of 2007 with all the same assumptions probably would have gone into 2009 with just $810,000.

The Journal article linked above makes the argument for greatly reducing equity exposure upon retiring, not as a permanent solution but as a means of protecting against a 2007-like start to retirement permanently impairing capital. This strategy was referred to as the U-shaped path.

The WSJ cited research from the Journal of Financial Planning that found a 20-30% allocation to equities early in retirement and then increasing it slowly to 50-70% was the optimal strategy although the WSJ did not define slowly.

The Journal of Financial Planning actually found that starting retirement at a “normal” equity allocation of 60% and then gradually reduced that exposure in favor of fixed income actually increased the likelihood of running out of money.

This is an interesting concept and there is another reason to support the idea not mentioned in the article. How many people retired in 2007, took an immediate hit to their portfolios, panic sold close to the low and never came back. While the answer is unknowable it obviously happened to some number of people, repeating from above, permanently impair capital and causing people to unnecessarily lock in a lower standard of living.

The nature of markets, investment and retirement planning is that they all evolve. Clients will be best served by advisors who keep current with where the industry and research goes.