Looking over a sample portfolio from a recent Seeking Alpha interview, a reader requested an asset allocation plan for someone who has 30 to 35 working years before retirement. What might a portfolio look like and will the assumptions used in this analysis be sufficient to carry the person through retirement years?
Before laying out an asset allocation plan and analyzing the results, several basic assumptions need to be stated as they have an impact on the final results. The software I use for this analysis is Quantext Portfolio Planner, developed by Geoff Considine.
I am assuming this investor already saved $100,000 and is putting away $1,000 per month or $12,000 per year. The S&P 500 (SPY) is expected to grow at a rate of 7.0% over the next few years. This may be an optimistic growth rate. If so, then one will need to increase the savings rate or expect to live on less than $70,000 per year in today's dollars. The following screen shot shows the assumptions used in this analysis.
(Click charts to expand)
In the following screen shot we have a sixteen ETF portfolio. Many of these ETFs are commission free ETFs if one is a TDAmeritrade customer. Other brokers have their own commission free ETFs. This is an important factor if one wishes to implement any sort of timing model that involves buy and selling ETFs.
The projected return from the following value oriented portfolio is 1.4% above that projected for the S&P 500. We give up this good return with a rather high uncertainty percentage of 16.5%. Our goal is to come in under 15%, but that is difficult without a significant increase in bonds. Holding a high percentage in bonds is not something we want to do with 30 to 35 years before retirement.
The Diversification Metric is a respectable 36%. Once more, we fall a little shy of our 40% goal, but the current market value and the inherent volatility makes it difficult to come in over 40%.
The following slide is a table I title the "Delta Factor." Now is not the time to hold a full position in every ETF included in this asset allocation plan. RWX is a beaten down ETF and therefore has a high probability of performing well over the next year to three years.
This type of analysis can also be used with individual stocks. When the market was in the pits in the spring of 2009, the Delta and Delta Factor columns were "screaming" - BUY.
The following screen shot is a Monte Carlo retirement analysis of the above portfolio and the associated assumptions. For example, inflation is assumed to be an annualized 3.5% for this analysis. While the 50% probability of running out of money at age 94 may be comforting to some investors, I'm uncomfortable with these results. I prefer a greater cushion. For that reason, I'm not satisfied with the buy and hold strategy implied in this analysis. Scroll down for an alternative.
How can we push out the above probability percentages? What if we want the 10% probability to only show up in our 80s? The options are several. 1) Come up with a portfolio that lowers the risk or uncertainty while maintaining the 8.4% return. 2) Increase savings. 3) Work longer. 4) Anticipate living on a lower income. 5) Learn how to use the ITA Risk Reduction model.
Numbers 2, 3, and 4 are obvious solutions. Number one may work, but it still carries the potential of not working out. Future projections always are inherently dangerous. Number 5 is a very simple model articulated in detail over on my blog and is too long to include in this article. The basic ideas are explained in Mebane T. Faber and Eric W. Richardson's book, "The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets." It is "avoiding bear markets" that I discuss in the ITA Risk Reduction model.
This sample portfolio with its global structure and value tilt has a high probability of serving a 30-year old well over the next three decades.