Asset allocation might be the most important financial decision that you will ever make.
The asset classes that you invest in and the fraction of your investments that each class represents are the greatest determining factor of your investing success. Greater than the specific funds that you pick, whether they’re actively or passively managed, or what type of account you put them in.
Vanguard studied 1484 different fund combinations and found that asset allocation determines 88 percent of volatility and return!
I’ve studied this concept throughout my investing career, and carefully selected three model portfolios that map to the four stages on the Pathway to FI. They were made as simple as possible without sacrificing the key features that they seek to provide. I cover these features in detail in my model portfolio white paper.
You’ll notice that these portfolios diverge significantly from the conventional wisdom that financial planners and mainstream media typically preach. It goes something like this. “Your portfolio should be a mix of stocks and bonds, the ratio of which is a function of your age”.
They are also more complex than the simple advice given by the Financial Independence Retire Early (FIRE) community. “Put all of your money in a Total Stock Market fund until you have enough to retire. Then consider some bonds—no more than 25%—to smooth the ride”.
Don’t get me wrong. These are both perfectly acceptable approaches. The thing is, they’re both sub-optimal. And we now have tools and data to show that you can do better with a high probability. Simultaneously, you can have more peace of mind when the market is down 40%, 50%, or more and you’re not!
So what should your asset allocation be? Let me introduce the Pathway to FI model portfolios.
Model Portfolios for Every Stage
Figure 1 shows the 3 Pathway to FI model portfolios. These have performed very well at every point in the last 52 years, which is the time frame that I had data for.
The first thing that jumps out is that Stages 1 and 2, when you are building toward financial security and independence, share a single portfolio. Notice that although five asset classes are represented, this is a 100% stock portfolio. The different asset classes serve to diversify across company size, country, and industry.
Until you reach the Summit of financial independence, you want to be very aggressive and stick with high growth investments. Bonds and alternative assets that aren’t actively producing profits have no place in your portfolio at these stages, in my opinion.
Diversify with uncorrelated stocks during wealth accumulation.
Don’t add bonds or gold until you’re financially independent.
At the Summit of FI, you can throttle back the market risk and volatility. You can also improve the chances that your money will last a lifetime by increasing your theoretical Safe Withdrawal Rate. Therefore, the Stage 3 portfolio further diversifies into small positions in gold and bonds. These assets are uncorrelated and sometimes inversely correlated with the stock market. They tend to go up during bad economic times, when stocks are plummeting and investors are looking for a safer place to put their money.
During the Descent, you’re relying on your portfolio to support your daily lifestyle. Your biggest concern becomes Sequence of Returns Risk—the risk that the market declines significantly within the first 10 years of retirement. This is when you can take more risk off the table and further diversify into uncorrelated asset classes. The Stage 4 portfolio does this. Note that it still maintains 70% in stocks to provide enough growth in the event of a very long, 40+ year retirement.
By adding to the Real Estate and Utilities sectors, the Descent portfolio is also increasing dividends that can be immediately used as retirement income and reducing exposure to high volatility growth companies.
For a detailed analysis of the historical performance of these portfolios and a comparison to four other popular portfolios, read my white paper. The results are surprising!
Summary
Every serious investor has asked “what should my asset allocation be”.
Asset allocation is the key decision in every diversified portfolio. You can find better fees and funds that track the target index with better precision. But those decisions are less critical than the mix of assets that you hold.
There are many nuances around these portfolios and modifications that can be made if you enjoy that kind of stuff. You may also have a reason to build a more aggressive or conservative portfolio than I have presented here. I will save those discussions for another time.
This was a high level summary of the Pathway to FI model portfolios. Read the white paper to dive much deeper and see how and why they were chosen.
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