Our 2016 Asset Allocation: Baking the Perfect Pie
I can’t believe it’s been almost a year since we last wrote about our asset allocation. A year ago we were trying to figure out what kind of asset allocation we needed to have, in order to enjoy our long retirement without depleting our funds. After all, this investing journey is a means to an end. After we become financially independent and are able to retire early, we’ll be able to enjoy traveling for months at a time, preparing most of our meals, tending to our hobbies and just doing whatever the heck we want with our time. Just the thought of it is so liberating!
We’ll be able to do all of that thanks to our hard-earned dollars that will be working for us while we rest in a hammock. And those dollars need to be properly allocated in order to maximize the returns while avoiding unnecessary risks. After a year of further research and analyzing, I now feel that I can speak with strong confidence about the asset allocation we should have heading into early retirement and beyond. So let’s look at how we’re lining up our assets to enjoy the early retirement we just described.
A word about our portfolio and other assets
We typically invest in index funds. Our investment strategy is simple and requires very little maintenance from us. We also have a rental property that is part of our Freedom Fund composition. For the purpose of this article, we’re only going to discuss the asset allocation in our portfolio of mutual funds and ETFs.
Where our portfolio asset allocation stands today
Asset class and current allocation
Personal Capital created an investment profile after we answered a few questions about our investment styles and risk tolerance. Their recommendations are pretty close to what we were looking for in an asset allocation. We wanted an equivalent of 10 percent in bonds, 10 percent in REITs and anywhere from 20-25% in International stocks. We’re going to follow the target allocation recommendation below closely because it serves our investment objective.
The Cash portion is the cash that the index funds and ETFs hold. We don’t allocate cash in our portfolio on our own per say. Most of the assets under Alternatives are REITs. Our goal is to invest up to 10 percent while decreasing the U.S. stock allocation. It’s going to take us a while to get there because we’re allocating these investments in our Roth IRAs to lower our tax bill. We invest on a regular basis, and when looking where to invest our money, we usually look at this chart to see in which category we’re under target, and buy more into that. It’s that easy! We buy low.
Risk & returns
“Why would you hold such a small amount in bonds when you’re so close to retiring? Isn’t that way too aggressive?”
The truth is that we’re planning on following the safe withdrawal rate. We’ll be withdrawing 3-4% of our investments on an annual basis. Out of that withdrawal, 2% will come from dividends and income returns. The other 2% will come from capital gains. Our current allocation has a historical return of 8.9%. That would leave 4.9% on the table for investment growth. Of course, these returns are not guaranteed since past results are not representative of future results.
“An 8.9% return sounds sweet, but you’re not always going to get those returns from the market. Remember 2008?”
That’s correct, those returns are not realistic if you’re referring to getting a 8.9% return year after year. The return is an average over a longer period of time. For example, the market could give you a 30% return in one year and then drop to a 10% return the next year, and provide negative returns over the following years. This is why we estimate based on average returns. My 401(k) portfolio had negative returns in 2008 and it took until the end of 2009 to show a positive return. My 10 year rate of return has been 8.3%. Not bad considering that those first 10 years of investing have been a big learning curve without paying for financial advice.
An investment rule that I follow is that any money that we need within five years does not get invested in stocks. That’s one of the reasons why we have bonds. If the market tanks and we don’t want to sell low, the bond allocation should be enough to cover five years of expenses along with dividend income.
We use the Efficient Frontier from Personal Capital to see the historical risk and return for our allocation. It represents a set of efficient asset class mixes based on historical results. If the portfolio is inside the frontier, it means we are likely taking more risk than necessary.
Asset location and tax minimization
We’ve done some shifting around in our portfolio to ensure that the assets are in the right location for tax treatment. We can minimize taxes by knowing where to hold each investment. For example, we’re keeping bonds in our 401(k)s to shield them from taxes because interest from bonds gets taxed as ordinary income.
Also, we’re keeping REITs in our Roth IRAs because the REITs have to distribute 90% of the income to shareholders and are also taxed as ordinary income. Dividends and capital gains get favorable tax treatment while interest income gets taxed at the taxpayer’s top marginal tax rate.
Future “Home, sweet home” plan
After we retire and travel for a bit, we plan to buy real estate again, whether it will be in a form of a house, condo, or multi-family unit is to be determined. This is a slight departure from our previous plan of buying real estate abroad sooner rather than later. One reason is that we don’t know how things will be different a couple of years from now. World economies can and will change.
Plus, who knows what new place we may fall in love with along our travel journeys. If the path is not clear, it’s okay to have a little patience and perseverance. Let’s just see where things might lead. So we don’t want to rush into buying and locking ourselves in before early retirement. We want to keep our options open and our best strategy is to invest that money in a very conservative way until we are able to make a decision.
How are we going to fund our home purchase?
Our plan is to sell our rental property and save in order to complement the purchase of our future home. Since we’re keeping our plans flexible and don’t need to buy by a certain date, we figured we can let the money grow a bit. An investment time horizon of 3-5 years is perfect for our goal. We did some research and decided to go with the Vanguard LifeStrategy Income Fund, which is made up of 80% bonds and 20% stocks.
This allocation has a historical return of 6% when plugged into Personal Capital’s asset allocation models. If by the time we’re ready to withdraw, the investments provide a 3% return, then at least we’ll beat inflation. Even if they provide a 2% return, we’ll be okay, because it’s still a better decision than putting the money in CD accounts. It doesn’t take a lot to keep us happy. After all, you never lose money when you make a profit. 🙂 A good friend of ours, and an avid Enchumbao reader, also recommended the LifeStrategy Funds for these type of savings, so we are not alone in this approach.
We could’ve saved this money in our current portfolio holdings to avoid paying taxes on the bond’s income returns, but the beauty of the Lifestrategy Fund is that it rebalances itself on a daily basis. Therefore, we won’t need to worry about rebalancing and can just keep investing as we go. Portfolio rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation.
This investment is not accounted for under the portfolio asset allocation we discussed earlier. We account for this asset separately because we don’t want the LifeStrategy holdings to distort the asset allocation model we’re targeting. The great thing about Personal Capital is that we can select which accounts to exclude from our calculations.
Home fund: Asset class and current allocation
“Hmmm, but if you add up the International and U.S. stocks holdings, you have a total of 20% of the money invested in stocks. Didn’t you say that you don’t invest any money that you need within 5 years in stocks?”
I did say that but we don’t consider buying a property in 3 years a must. So we’re keeping the buying time flexible. That’s why we’re okay with taking a little risk with the money. A 20% stock allocation has a very limited volatility exposure for us. If there was a big stock market drop and we saw an opportunity to buy real estate, we’d consider the purchasing power of our funds before we were to make a decision. Again, buying is a choice not a must for us. If we could rent anywhere in the world while our money continues to grow, why would we rush to buy? 🙂
For personal reasons, which we might discuss at some point, we’re extending our retirement date to our original retirement year of 2019. This means that we’ll have a bigger portfolio by retirement and decided to save money for the home fund in cash and invest the rest of the money in the market according to our asset allocation. By the end of 2016, we sold the LifeStrategy investment and continue to rebalance our portfolio by investing new money.
What has been working for us on our path to FIRE
If we had to explain in a nutshell the steps that we took to get to this point in our lives over the past 5 years, financially speaking, I’d summarize it like this:
- track and minimize our spending
- paid off all of our debt
- save aggressively
- stay away from a lifestyle based on consuming
- spend on things and experiences that bring value to our lives
- don’t inflate our lifestyles
No one has a crystal ball on what the market is going to do and we are certainly not an exception. We believe in long-term investing and are not worried about the ups and downs. I have full confidence that our portfolio will carry us through retirement. We’re not looking to outperform but for an allocation that help us sleep well at night. We’ll continue to invest over the next couple of years according to our allocation, which is well aligned with our FIRE plans. You can receive our monthly FI updates by signing up to receive new posts by e-mail. Scroll down to see sign up link.
I’d like to leave you with the following quote that captures the essence of long-term investing:
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for ten years.” –Warren Buffett
If you were preparing for an early retirement what would you do differently from us? If you’re an early retiree, what asset allocation is working for you?
Risk disclosure: All investing involves risk, including the possible loss of principal. The material contained on this website is for discussion purpose only and should not be misconstrued as financial advice.