IN THIS CHAPTER AND the next, we tackle two complex issues: the general principles of asset allocation, and allocation funds specifically designed for your retirement years. These are issues that have no easy answers.

Why? First, because we investors have a wide range of investment goals, risk tolerances, and behavioral characteristics.

Second, because we’ve had 35 years of extraordinary returns in the stock market and the bond market alike, returns that are highly unlikely to recur in the coming decade. (See Chapter 9, “When the Good Times No Longer Roll.”)

Third, authors of books on investing, are, in a real sense, captives of the eras that we have experienced. For example, when Benjamin Graham wrote The Intelligent Investor in 1949, he had never experienced a year in which the interest rate on bonds exceeded the dividend yield on stocks. By way of contrast, as I write this chapter in 2017, I have witnessed 60 consecutive years in which the dividend yield on stocks has never exceeded the interest rate on bonds. Turnabout, it seems, is fair play.

So instead of looking back and mining the voluminous data on past returns and risks on stocks and bonds, I’ll discuss clear principles that you can apply in your current situation. Whether you are accumulating investment assets during your working years or are making withdrawals from your assets in your retirement years, I hope to help you establish appropriate asset allocations for your future.

Ninety-four percent of the differences in portfolio returns is explained by asset allocation.

Benjamin Graham believed that your first investment decision should be how to allocate your investment assets: How much should you hold in stocks? How much in bonds? Graham believed that this strategic decision may well be the most important of your investment lifetime.

A landmark 1986 academic study confirmed his view. The study found that asset allocation accounted for an astonishing 94 percent of the differences in total returns achieved by institutionally managed pension funds.

That 94 percent figure suggests that long-term fund investors might profit by concentrating more on the allocation of their investments between stock funds and bond funds, and less on the question of which particular funds to hold.

Benjamin Graham’s standard division: 50/50.

Where do we begin? Let’s start with Benjamin Graham’s advice regarding asset allocation in his 1949 classic, The Intelligent Investor:

We have suggested as a fundamental guiding rule that the investor should never have less than 25 percent or more than 75 percent of his funds in common stocks, with a consequent inverse range of between 75 percent and 25 percent in bonds. There is an implication here that the standard division should be an equal one, or 50–50, between the two major investment mediums.

Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace (à la Rochefoucauld¹ ) from reflecting how much better off he is than many of his more venturesome friends.

Asset allocations and differences in yields.

To today’s investors and their advisers, that 50/50 stock/bond allocation—and that range of 75/25 to 25/75—may well seem too conservative. But in 1949, when Graham wrote his book, the yield on stocks was 6.9 percent, and the yield on bonds was 1.9 percent. Today, stock yields are 2.0 percent and bond yields are 3.1 percent—a world of difference in deciding on how much to allocate to stocks and to bonds.²

That difference can be measured in two major ways: (1) The gross income yield on a 50/50 stock/bond portfolio has dropped by fully 40 percent, from 4.4 percent to 2.6 percent. (2) The yield tables have been turned upside down, with stocks providing an annual yield premium of 5.0 percent in 1949 (amazing!), and a yield discount of 1.1 percent in 2017.

When I discussed Graham’s philosophy in my 1993 book Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, the use of just two asset classes was my starting point. My recommendations for investors in the accumulation phase of their lives, working to build their wealth, focused on a stock/bond mix of 80/20 for younger investors and 70/30 for older investors. For investors starting the postretirement distribution phase, 60/40 for younger investors, 50/50 for older investors.

Bumps along the road.

Despite today’s far lower level of interest rates and dividend yields, the great bull market since Graham’s era, and the bumps along the way (including the stock market crashes in 1973–1974 and 1987, the bursting of the dot-com bubble in 2000, and the global financial crisis of 2008–2009), the general principles Graham enunciated all those years ago remain remarkably intact. His suggested asset allocation percentages still form a sound starting point for a sensible investment program.

Ability to take risk, willingness to take risk.

There are two fundamental factors that determine how you should allocate your portfolio between stocks and bonds: (1) your ability to take risk and (2) your willingness to take risk.

Your ability to take risk depends on a combination of factors, including your financial position; your future liabilities (for example, retirement income, college tuition for your children and/or grandchildren, a down payment on a home); and how many years you have available to fund those liabilities. In general, you are able to accept more risk if these liabilities are relatively far in the future. Similarly, as you accumulate more assets relative to your liabilities, your ability to take risk increases.

Your willingness to take risk, on the other hand, is purely a matter of preference. Some investors can handle the ups and downs of the market without worry. But if you can’t sleep at night because you’re frightened about the volatility of your portfolio, you’re probably taking more risk than you can handle. Taken together, your ability to accept risk and your willingness to accept risk constitute your risk tolerance.

A basic allocation model for the investor who is accumulating assets, and the investor who is retired.

Let’s begin with a basic allocation model for the accumulation of assets for the wealth-building investor. The main points to consider are merely common sense. (1) Investors seeking to accumulate assets by investing regularly can afford to take somewhat more risk—that is, to be more aggressive—than investors who have a relatively fixed pool of capital and are dependent on income and even distributions from their capital to meet their day-to-day living expenses. (2) Younger investors, with more time to let the magic of compounding work for them, can also afford to be more aggressive, while older investors will likely want to steer a more conservative course.

Graham’s allocation guidelines are reasonable; mine are similar but more flexible. Your common stock position should be as large as your tolerance to take risk permits. For example, my highest recommended general target allocation for stocks would be 80 percent for younger investors accumulating assets over a long time frame.

My lowest target stock allocation, 25 percent, would apply to older investors late in their retirement years. These investors must give greater weight to the short-run consequences of their actions than to the probabilities of future returns. They must recognize that volatility of returns is an imperfect measure of risk. Far more meaningful is the risk that they will unexpectedly have to liquidate assets when cash is needed to meet living expenses—often in depressed markets—and perhaps receive less in proceeds than the original cost of the assets. In investing, there are no guarantees.

Four decisions.

As an intelligent investor, you must make four decisions about your asset allocation program:

• First, and most important, you must make a strategic choice in allocating your assets between stocks and bonds. Differently situated investors with unique needs and circumstances will obviously make different decisions.
• Second, the decision to maintain either a fixed ratio or a ratio that varies with market returns cannot be sidestepped. The fixed ratio (periodically rebalancing to the original asset allocation) is a prudent choice that limits risk and may well be the better choice for most investors. The portfolio that is never rebalanced, however, is likely to provide higher long-term returns.
• Third is the decision as to whether to introduce an element of tactical allocation, varying the stock/bond ratio as market conditions change. Tactical allocation carries its own risks. Changes in the stock/bond ratio may add value, but (more likely, I think) they may not. In our uncertain world, tactical changes should be made sparingly, for they imply a certain prescience that few, if any, of us possess. In general, investors should not engage in tactical allocation.
• Fourth, and perhaps most important, is the decision as to whether to focus on actively managed mutual funds or traditional index funds. Clear and convincing evidence points to the index fund strategy.

All four of these decisions require tough, demanding choices by the intelligent investor. With thoughtfulness, care, and prudence, you can make these choices sensibly.

The link between risk premiums and cost penalties.

Yes, the allocation of your investment portfolio between stocks and bonds will likely be an important determinant of your wealth accumulation. But too few investors are aware of the critical linkage between fund costs and asset allocation.

A low-cost portfolio with a lower allocation to stocks (and therefore lower risk) can earn the same or even a higher net return than a portfolio with a far higher allocation to stocks (and therefore higher risk); provided only that the costs of investing in the lower-risk alternative are materially below those in the higher-risk alternative.

Perhaps this simple example will help (Exhibit 18.1). Here, we assume that one investor holds a 75/25 stock/bond portfolio with expected gross annual returns of 6 percent on stocks and 3 percent on bonds. The investor in actively managed funds incurs all-in costs, respectively, of 2 percent and 1 percent annually. The expected net return on that portfolio would be 3.5 percent.

Holding those returns on stocks and bonds constant, now assume that a much more conservative investor holds a 25/75 portfolio—precisely the reverse allocation. But the investor replaces those high-cost actively managed mutual funds with low-cost index funds charging 0.05 percent for stocks and 0.10 percent for bonds. With that balanced index portfolio, the expected net return on the portfolio would actually increase, to 3.66 percent annually.

Low costs enable lower-risk portfolios to provide higher returns than higher-risk portfolios.

In this example, simply by taking the drag of excessive costs out of the equation, the 25/75 stock/bond portfolio would outpace the 75/25 portfolio. The index fund changes the conventional wisdom about asset allocation.

Cost matters! Risk premium and cost penalty, ever at war with each other, must find their way into the process of balancing the stocks and bonds in your portfolio. It’s about time.

Let me be clear: I am not suggesting that you should slash your equity allocation if you replace your high-cost actively managed funds with low-cost index funds. But I am suggesting that if you hold actively managed stock and bond funds in your asset allocation, with fees far higher than those of low-cost index funds, you should consider what is likely to produce the best net return. Just do the simple math.

A human perspective: advice to a worried investor.

There is little science to establishing a precise asset allocation strategy. But we could do worse than beginning with Ben Graham’s central target of a 50/50 stock/bond balance, with a range limited to 75/25 and 25/75, divided between plain-vanilla stock and bond index funds.

But allocations need not be precise. They are also about judgment, hope, fear, and risk tolerance. No bulletproof strategy is available to investors. Even I worry about the allocation of my own portfolio.

In the letter that follows, I explain my concerns to a young investor worried about possible future catastrophes in our fragile world and in our changing society, as he tries to determine a sensible asset allocation for his own portfolio.

I believe that the U.S. economy will continue to grow over the long term, and that the intrinsic value of the stock market will reflect that growth. Why? Because that intrinsic value is created by dividend yields and earnings growth, which historically have had a correlation of about 0.96 with our nation’s economic growth as measured by GDP. (Close to 1.00, a perfect correlation.)

Of course there will be times when stock market prices rise above (or fall below) that intrinsic value. This may well be a time when some overvaluation exists. (Or not. We can never be sure.) But in the long run, market prices have always, finally, converged on intrinsic value. I believe (with Warren Buffett) that’s just the way things are, totally rational.

Substantial risks—some known, some unknown—of course exist. You and I know as much—or as little—about their happening as anyone else. We’re on our own in assessing the probabilities as well as the consequences. But if we don’t invest, we end up with nothing.

My own total portfolio holds about 50/50 indexed stocks and bonds, largely indexed short- and intermediate-term. At my age of 88, I’m comfortable with that allocation. But I confess that half of the time I worry that I have too much in equities, and the other half of the time that I don’t have enough in equities. Finally, we’re all just human beings, operating in a fog of ignorance and relying on our circumstances and our common sense to establish an appropriate asset allocation.

Paraphrasing Churchill on democracy, “my investment strategy is the worst strategy ever devised . . . except for every other strategy that has been tried.” I hope these comments help. Good luck.

J.C.B.

And good luck to the readers of this chapter. Do your best, for there are no easy answers to the challenge of asset allocation.