Equity/Bond allocation using ABILITY, WILLINGNESS & NEED

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
sonowwhat?
Posts: 43
Joined: Sat Jan 02, 2010 10:39 am

Equity/Bond allocation using ABILITY, WILLINGNESS & NEED

Post by sonowwhat? »

I am reading The Only Guide to a Winning Investment Strategy You'll Ever Need by Larry Swedroe and it appears to bring clarity on how one should make an asset allocation. In the current tumultuous market, it may not be the right time to revaluate one’s allocation, but then again it may be the best time. For those of you who are familiar with this approach, I would really appreciate you reading this and given me some insight into my allocation between equities and fixed income using the three pronged approach of 1) Ability to take risk, 2) Willingness to take risk and lastly 3) Need to take risk. The following is a discussion of applying each of these criteria to my situation.

Background:

I am retired since December, 2007 and am currently 48 years of age. I am married with 3 Children (ages 18, 15, 13). My home is paid for and I have no debt. My kids are just beginning the college phase of life and I have promised to pay for a college of their choice if I am able. First one chose a private liberal arts college (very pricey). PS. Never promise your kids anything! My only source of income is from investments.


Ability to take Risk

My investment horizon is 42 years to age 90 (Currently 48). I used the Horizon vs. % Max equity allocation table (Swedroe) and applied yearly outlays against the table. This weighted average approach yielded an estimated 66% equities allocation. Swedroe also talks about stability of earned income. I am not considerring this in my allocation decision given that I am retired and also since my labor capital in a “Plan B” scenario of going back to work is low compared to my net worth. In terms of liquidity I have approximately 9 months of cash on reserve. Lastly, Swedroe discusses what the availability of “Plan B” options one has (i.e. Worst Case Action Plans). For me the following could be done in order of priority:

1) Living expenses cut in half to 1 ½% of portfolio
2) Refocus undergrad to instate schools so yearly outlay reduced to $50k per year for all three kids
3) Get a job or start a business conservatively estimated at $60k income given skill set
4) Graduate schools paid for by kids with student loans

Conclusion: In isolation, the allocation to equities considering the “Ability to Take Risk” considering both the quantitative and subjective factors above is IMO 60% equities.

Willingness to Take Risk

I am the type of person who plans for the storms of life. As a result I always think about the “worst case scenarios” and thus this kind of thinking keeps me up at night. My Maximum tolerable loss is based on the level which I find myself needing sleeping pills and becoming just too irritable to be considered a nice person. The being said, using Swedroe’s Table as a suggested guideline, my Maximum Tolerable Loss is 15% and thus my Maximum Equity Exposure should be 40%.


Need to take Risk

My understanding here is that that if the need to take risk is low, a lower allocation to stocks is prudent. Another words, the marginal benefit of making more money is just not worth it. In my situation, I can maintain my current standard of living, remain retired and send my kids through college with an average 4% Required Withdrawal Rate over the next 10 years and then reduced to a 2% thereafter. I have no desire to increase my personal standard of living. My approach here, (I and do not know if this is right or not because I just made it up) was to run Firecalc using a constant rate of assumptions but I kept lowering my equity % allocation as low as it could go without the success rate falling below 100%. My constant assumptions were as follows:


- Spending starts at 4% of starting portfolio
- Model Using "Reality Retirement Plan" as described by Ty Bernicke, withdrawals after age 55 are reduced by 2-3% per year until age 76.
- 42 Year Time Horizon (to age 90)
- No Income other than from Investments (No SS considered)
- 3% (default) inflation adjustments to historical data
- .18% Expense Ratio

Conclusion: In isolation, the allocation to equities considering the “Need to Take Risk” using the above approach yielded a minimum 30% equities allocation before success fell below 100%.

Overall Conclusion

Under Swedroe’s methodology your allocation to equities should be the lower of the willingness, ability and need tests.

60% Ability to Take Risk
40% Willingness to take risk
30% Need to take risk

Therefore, my current equity allocation of 38% is too high and should be no more than 30%.

Am I approaching this correctly? Feedback please!
pkcrafter
Posts: 14901
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Post by pkcrafter »

I'll provide some comments to get this going.
I am retired since December, 2007 and am currently 48 years of age. I am married with 3 Children (ages 18, 15, 13). My home is paid for and I have no debt. My kids are just beginning the college phase of life and I have promised to pay for a college of their choice if I am able. First one chose a private liberal arts college (very pricey). PS. Never promise your kids anything! My only source of income is from investments.
Later in your post you say you will begin 4% withdrawals and do that until 55 (for 7 years or 10 years?). The 4% rate is based on 30 years, but since you will reduce it substantially in 7 years you might be OK, but there is some risk.

Is the withdrawal method you are going to use begin with 4% and increase by an inflation adjustment each year? If so, the early years can be critical to success. For instance a significant drop in the market in the first 5 years can ruin plans if adjustments are not made immediately.

Your retirement money is irreplaceable while college can be paid by students who enter the work force after graduation. I would be very careful of spending down large amounts of retirement money on college expenses in those first seven years.
Ability to take Risk

My investment horizon is 42 years to age 90 (Currently 48).
This length of portfolio sustainability would normally require a starting withdrawal rate of 3% or less. That is why I stress those critical seven years at the beginning. Again, I think it would really increase risk of failure if significant amounts of money were used up.
For me the following could be done in order of priority:

1) Living expenses cut in half to 1 ½% of portfolio<--wouldn't that be 2%?
2) Refocus undergrad to instate schools so yearly outlay reduced to $50k per year for all three kids
3) Get a job or start a business conservatively estimated at $60k income given skill set
4) Graduate schools paid for by kids with student loans

Conclusion: In isolation, the allocation to equities considering the “Ability to Take Risk” considering both the quantitative and subjective factors above is IMO 60% equities.
Good back ups, but be careful of putting yourself in a position to have to use them.

Ability to take risk in retirement is really all about how much of a loss can you sustain. At 60% stock, your losses based on the last three major bear markets would be about 45%-50% of what your equity allocation is, so ~30% portfolio loss. Obviously, lower withdrawal rates increase ability somewhat. And if these losses occur in the first years of retirement, they can be a game changer.
Willingness to Take Risk

I am the type of person who plans for the storms of life. As a result I always think about the “worst case scenarios” and thus this kind of thinking keeps me up at night. My Maximum tolerable loss is based on the level which I find myself needing sleeping pills and becoming just too irritable to be considered a nice person. That being said, using Swedroe’s Table as a suggested guideline, my Maximum Tolerable Loss is 15% and thus my Maximum Equity Exposure should be 40%.
Ok, that should work if coupled with the 2.5-3% WD.


Need to take Risk
My understanding here is that that if the need to take risk is low, a lower allocation to stocks is prudent. Another words, the marginal benefit of making more money is just not worth it.
Need is most useful for young investors with long time horizons. Young investors need to take some risk in the stock market and they also have a lot of ability, but need should never be the main driver of risk--it should never supersede ability and willingness.
In my situation, I can maintain my current standard of living, remain retired and send my kids through college with an average 4% Required Withdrawal Rate over the next 10 years and then reduced to a 2% thereafter.
You may be able to do it, but if the market does not cooperate, you could find yourself in a compromised situation for the rest of your retirement.
I have no desire to increase my personal standard of living. My approach here, (I and do not know if this is right or not because I just made it up) was to run Firecalc using a constant rate of assumptions but I kept lowering my equity % allocation as low as it could go without the success rate falling below 100%. My constant assumptions were as follows:
I don't know what firecalc is using for market returns, but the long term historical average is just above 10% and that is used in many scenarios; however, the estimated return on stocks over the next decade is currently ~6.5% nominal.


Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
YDNAL
Posts: 13774
Joined: Tue Apr 10, 2007 4:04 pm
Location: Biscayne Bay

Re: Equity/Bond allocation using ABILITY, WILLINGNESS &

Post by YDNAL »

sonowwhat? wrote:Under Swedroe’s methodology your allocation to equities should be the lower of the willingness, ability and need tests.

60% Ability to Take Risk
40% Willingness to take risk
30% Need to take risk

Therefore, my current equity allocation of 38% is too high and should be no more than 30%.

Am I approaching this correctly? Feedback please!
You are thinking too much.

1. Determine how much you need from your portfolio. You should know since retired December 2007.
2. Find out the % of number 1 to total assets.
3. Keep number 2 between 2%-4% by:
  • a. reducing 1.
    b. take more risk on total assets.
    c. a combination.
    d. always remain flexible.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
dbr
Posts: 35911
Joined: Sun Mar 04, 2007 9:50 am

Post by dbr »

pkcrafter wrote: I don't know what firecalc is using for market returns, but the long term historical average is just above 10% and that is used in many scenarios; however, the estimated return on stocks over the next decade is currently ~6.5% nominal.


Paul
FireCalc estimates retirement success by tracking what would happen to the prospective retiree's outcome if retirement had been initiated in each of all actual historical periods beginning about a hundred years ago (one can check the actual data used) up to a year beginning 42 years ago (1969) in this case. There may be some recent revisions that allow extension to retirements starting more recently than that. Such a method of "historical periods" does not estimate returns or volatility of returns as such, so your question does not apply to FireCalc. Otar's calculator operates the same way, and Mr. Otar spends some time in his book discussing a preference for this over models that input estimates of mean and variation of returns.

A good suggestion is to try out a variety of models and especially to explore the sensitivity to a range of assumptions, especially allowing contingency for extra expenses.

I don't think a debate between 30% equities and 40% equities is a major decision factor as the dominating inputs to success of a retirement plan are the rates of withdrawal and the luck of historical experience. Between 30% equities and 40% equities there is probably no effect that offsets too high withdrawal and bad luck, nor safely low withdrawal and good luck. Even so, it is an effect that too low equities generally is a risk factor for long retirements, so there may not be a percentage in trying to push that factor as low as possible.

I think attention to some planning factors such as eventual conversion of assets to annuities should be in the considerations, though that would not be necessary if one finds oneself with lots of wealth and a low rate of withdrawal.

One thing for sure, over forty years a lot of things change and one must adjust. I would be wary of dispersing large fractions of assets early on.
john94549
Posts: 4638
Joined: Tue Jul 26, 2011 8:50 pm

Post by john94549 »

You are a bit too young to start retirement asset harvesting. Is your "retirement" by chance or by choice? I'd give serious thought to "career #2" as it were. FWIW, I was booted out at just about your current age and seriously contemplated retiring, i.e., throwing in the towel. I went on to found a solo practice and made so much I could actually retire ten years later and laugh all the way to the bank.
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

fwiw

Post by larryswedroe »

Glad you found the book helpful and yes you are approaching it right

IMO one should not exceed any of the three if your need to take risk is the lowest. With low marginal utility of wealth why not sleep well and cut the left tail risk down.

A way to improve your odds is to move to a lower beta/higher tilt portfolio which I have discussed many times here and if interested see Appendix A of The Only Guide for Right Financial Plan, which also goes into much more detail on all of the issues you discussed, sure you would find it helpful


Best wishes
Larry
etarini
Posts: 615
Joined: Sun Jan 24, 2010 6:46 pm

Post by etarini »

pkcrafter wrote:I would be very careful of spending down large amounts of retirement money on college expenses in those first seven years.
Another way to do it as you go forward would be to have them take out student loans. That way, you can still help them pay it off, but you may have some flexibility as to the timeframes and the amounts you pay, assuming they have jobs once they have to start paying down the loans.
There are many who feel that when kids have summer jobs to help pay for school, take out loans, etc., they have a more focused appreciation for why they're going to college. Or maybe not.

I worked in college, and I took out loans and paid them for many years, but then my parents offered to pay off the loans, which still had about one-third left. I was extremely grateful, because I hadn't expected it at all, but I realized that my parents had always wanted to help me and my brother, but it wasn't until after we'd gone through school that they were financially secure enough to do it.

Eric
Topic Author
sonowwhat?
Posts: 43
Joined: Sat Jan 02, 2010 10:39 am

Post by sonowwhat? »

pkcrafter wrote:
Later in your post you say you will begin 4% withdrawals and do that until 55 (for 7 years or 10 years?). The 4% rate is based on 30 years, but since you will reduce it substantially in 7 years you might be OK, but there is some risk.

Is the withdrawal method you are going to use begin with 4% and increase by an inflation adjustment each year? If so, the early years can be critical to success. For instance a significant drop in the market in the first 5 years can ruin plans if adjustments are not made immediately.
and dbr wrote:
One thing for sure, over forty years a lot of things change and one must adjust. I would be wary of dispersing large fractions of assets early on.
I am little nervous with all the comments regarding early year draw downs which could jeopardize success. I wish Firecalc would have some sort of interim period or year by year spending inputs instead of just a single number. But I just figured the approach of putting in a 4% withdrawal starting withdrawal rate and then using the Ty Bernicke appraoch that after age 55 reduces withdrawals by 2-3% per year until age 76 would approximate my situation. I actually thought I was being conservative. I would appreciate any thoughts on using Firecalc more effectively or another Monte Carlo simulator that is a bit more flexible. Also, I thought Firecalc handled inflation. I kept the inflation assumption at 3%. Is this correct.

Larry Swedroe wrote:
A way to improve your odds is to move to a lower beta/higher tilt portfolio which I have discussed many times here and if interested see Appendix A of The Only Guide for Right Financial Plan, which also goes into much more detail on all of the issues you discussed, sure you would find it helpful
Still trying to wrap my head around the tilt portfolio, but I am still reading. You have a remarkable gift for simplifying the application of where one should be in terms of just more than age and risk tolerance. Cannot wait to finish reading, but this whole debt downgrade has got me distracted for now.

john94549 wrote:
You are a bit too young to start retirement asset harvesting. Is your "retirement" by chance or by choice? I'd give serious thought to "career #2" as it were. FWIW, I was booted out at just about your current age and seriously contemplated retiring, i.e., throwing in the towel. I went on to found a solo practice and made so much I could actually retire ten years later and laugh all the way to the bank.
retirement is by choice. I might start working again once all the kids leave home but as of now I am enjoying them in these final years while they are at home.
FireCalc estimates retirement success by tracking what would happen to the prospective retiree's outcome if retirement had been initiated in each of all actual historical periods beginning about a hundred years ago (one can check the actual data used) up to a year beginning 42 years ago (1969) in this case. There may be some recent revisions that allow extension to retirements starting more recently than that. Such a method of "historical periods" does not estimate returns or volatility of returns as such, so your question does not apply to FireCalc. Otar's calculator operates the same way, and Mr. Otar spends some time in his book discussing a preference for this over models that input estimates of mean and variation of returns.
Not sure I follow your logic. If I am achieving 100% success rate, then isn't the only assumption I am making is that the next 42 years will not be worse than any other 42 year period in the past. Now that I wrote this, maybe thats not so far fetched. But for planning purposes, isn't making such an assumption being relatively conservative?

pkcrafter wrote:
I don't know what firecalc is using for market returns, but the long term historical average is just above 10% and that is used in many scenarios; however, the estimated return on stocks over the next decade is currently ~6.5% nominal.
Yea but at a 100% success rate wouldn't I be looking at the lowest 42 year rate of return therefore it definitely would be less than the overall average. Be nice if Firecalc would spit out what the range of returns it used in its calculations given the inputs.

Everyone who responded, thanks for the insightful comments. They are really helping.
Topic Author
sonowwhat?
Posts: 43
Joined: Sat Jan 02, 2010 10:39 am

Post by sonowwhat? »

I am not sure if individual holdings make much of a difference in this discussion of choosing an overall mix, but here are my investment allocations.

Cash & Equivalents 2.4%
Equites 37.95%
Bonds 59.66%
Total 100%

TAXABLE
Bond Funds (37%)
19% Vanguard Intermediate-Term Investment-Grade Fund Admiral Shares
18% Vanguard Total Bond Market Index Fund Admiral SharesVBTLX

Cash & Equivalents (13%)
0.2% Cash
13.0% CD (Matures NOW and must figure where to reinvest)

Equity Funds (41%)
33% SPRTN TOTAL MKT INDX FID ADVANTAGE CLASS
8% SPARTAN INTL INDEX FID ADVANTAGE CLASS

HIS IRA (All Bond))
5% Vanguard Total Bond Market Index Fund Admiral SharesVBTLX

HER IRA (All Bond))
0.4% Vanguard Total Bond Market Index Fund Admiral Shares
529 COLLEGE PLANS
4% Balanced Managed Allocation Funds




Thanks again for all the input.
dbr
Posts: 35911
Joined: Sun Mar 04, 2007 9:50 am

Post by dbr »

sonowwhat? wrote:
One thing for sure, over forty years a lot of things change and one must adjust. I would be wary of dispersing large fractions of assets early on.
I am little nervous with all the comments regarding early year draw downs which could jeopardize success. I wish Firecalc would have some sort of interim period or year by year spending inputs instead of just a single number. But I just figured the approach of putting in a 4% withdrawal starting withdrawal rate and then using the Ty Bernicke appraoch that after age 55 reduces withdrawals by 2-3% per year until age 76 would approximate my situation. I actually thought I was being conservative. I would appreciate any thoughts on using Firecalc more effectively or another Monte Carlo simulator that is a bit more flexible. Also, I thought Firecalc handled inflation. I kept the inflation assumption at 3%. Is this correct.


My comment is generic and not technical. Forty years is simply too long a time to take into account all the personal and financial events that can occur and therefore as an attitude one should be prepared to adjust. This may be a gratuitous comment that need not have been offered.



FireCalc estimates retirement success by tracking what would happen to the prospective retiree's outcome if retirement had been initiated in each of all actual historical periods beginning about a hundred years ago (one can check the actual data used) up to a year beginning 42 years ago (1969) in this case. There may be some recent revisions that allow extension to retirements starting more recently than that. Such a method of "historical periods" does not estimate returns or volatility of returns as such, so your question does not apply to FireCalc. Otar's calculator operates the same way, and Mr. Otar spends some time in his book discussing a preference for this over models that input estimates of mean and variation of returns.
Not sure I follow your logic. If I am achieving 100% success rate, then isn't the only assumption I am making is that the next 42 years will not be worse than any other 42 year period in the past. Now that I wrote this, maybe thats not so far fetched. But for planning purposes, isn't making such an assumption being relatively conservative?

This comment was in answer to pkcrafter who was asking about the estimates of return used in FireCalc, where the answer is that it doesn't operate by starting with estimates of investment returns. I didn't post any logic, just a description of the method of analysis used by FireCalc. You are correct that the assumption is that the next 42 years are assumed to be a single random sample from the same experience of which the 42 year periods in the past that FireCalc looked at are samples. Also note that if, for example 70 periods were looked at, 100% just means that all 70 periods succeeded. If one period would have failed the success rate would have fallen to 69/70 = 98.6%, so 100% in FireCalc is not like asking for a 99.999% sort of reliability estimate. A perspective is that trying to assign distinctions between 100% successful retirements, 99% successful retirement, 95% successful retirements, 90% successful retirements, and so on is probably not a meaningful exercise.


Yea but at a 100% success rate wouldn't I be looking at the lowest 42 year rate of return therefore it definitely would be less than the overall average. Be nice if Firecalc would spit out what the range of returns it used in its calculations given the inputs.


The essence of the logic of how FireCalc works is to look at the effect of the order in which returns occur in the different historical periods. That is information that is far more detailed and relevant than just a statement of range of returns, but I don't know that the actual data can be extracted from the program. It is possible to extract a table of the portfolio value year by year for each trajectory examined, but that includes not only the return but also the effect of the withdrawal that year.

One should note that in a Monte-Carlo simulation that would accomplish the same end as FireCalc, the logic would be to apply a return each year which is a random sample of a proposed distribution of returns. Such a distribution might be specified by its shape, (such as Normal, but could be other than that) and specification of the parameters that are sufficient to define the distribution (Mean and standard deviation work for some, but there are one parameter, two parameter, more than two parameter distributions, and also distributions that don't have a standard deviation, and so on.). There has been a current thread in how to construct MC simulations in which regression to the mean, or serial correlations, have somehow been introduced. That is not easy stuff. FireCalc, of course, phenomenologically includes any serial correlation of returns by simply looking at actual histories, which is why the method appeals. A criticism s that the the periods studied in FireCalc are overlapping and not statistically independent. In reality one is only sampling about three independent 30 year periods in 90 years of FireCalc and two 42 year periods in 84 years of FireCalc periods. As a result the range of uncertainty that should be applied to estimates obtained in FireCalc is going to be pretty large.


Everyone who responded, thanks for the insightful comments. They are really helping.
Topic Author
sonowwhat?
Posts: 43
Joined: Sat Jan 02, 2010 10:39 am

Maybe Another Option Then

Post by sonowwhat? »

dbr

I really appreciate your feedback. It is almost over my head but in a nutshell I think you feel that backing into the lowest equity allocation using Firecalc with fixed assumptions to still achieve a 100% success rate is not quite as conservative as one would think. Given that I am early retired, using such long periods normalizes the return under any time frame and also does not account for "life situations" that can occur under such a long time frame. I can understand now what you are saying.

I am analytical though and it helps me to approach the problem of equity/fixed income allocations analytically if possible. That being said, are there other models that I can put in some conservative assumptions into, including front loaded early withdrawals that may help me back into the "NEED" side for holding equities.

Thanks again
dbr
Posts: 35911
Joined: Sun Mar 04, 2007 9:50 am

Re: Maybe Another Option Then

Post by dbr »

sonowwhat? wrote:dbr

I really appreciate your feedback. It is almost over my head but in a nutshell I think you feel that backing into the lowest equity allocation using Firecalc with fixed assumptions to still achieve a 100% success rate is not quite as conservative as one would think. Given that I am early retired, using such long periods normalizes the return under any time frame and also does not account for "life situations" that can occur under such a long time frame. I can understand now what you are saying.

I am analytical though and it helps me to approach the problem of equity/fixed income allocations analytically if possible. That being said, are there other models that I can put in some conservative assumptions into, including front loaded early withdrawals that may help me back into the "NEED" side for holding equities.

Thanks again
\

My favorite recommendation for discussion of this problem would be here:

http://bobsfinancialwebsite.com/

Bob is a poster on this forum.

Here is his link on withdrawal strategies:

http://bobsfinancialwebsite.com/withdrawlinks.html

Here are some calculators that do this problem recognizing that models are models and always subject to uncertainties:

http://www.i-orp.com/
http://www.retirementoptimizer.com/
http://www.esplanner.com/
http://www.flexibleretirementplanner.co ... ntSim.html

There are others. If you have an account at Fidelity, you can use their retirement planner as well.

The following discussion may also be interesting:

http://www.efficientfrontier.com/ef/998/hell.htm
http://www.efficientfrontier.com/ef/101/hell101.htm
http://www.efficientfrontier.com/ef/901/hell3.htm
http://www.efficientfrontier.com/ef/103/hell4.htm
http://www.efficientfrontier.com/ef/403/hell5.htm

I should add that the calculators listed above, and FireCalc, answer the problem Dr. Bernstein is addressing, noting, however, some of the comments in hell4.

Dr. Bernstein posts here from time to time as does Mr. Otar.

None of this is to imply that you should actually be alarmed as you appear to have a solid position and a rational attitude toward the issue.
dickenjb
Posts: 2941
Joined: Tue Jan 05, 2010 1:11 pm
Location: Philadelphia PA

Post by dickenjb »

FIREcalc does allow you to vary spending by year, you have to make a donation to unlock that capability. Also try Fidelity Retirement Income Planner.
pkcrafter
Posts: 14901
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Post by pkcrafter »

sonow, points that were made are something you need to be aware of, but common sense and the ability to adapt when necessary can go a long way to improving your odds of success. The only point I might emphasize is avoiding high withdrawal rates in the early years--4% is somewhat high at your age.

Also suggest you read Bob's website. There are at least two other withdrawal methods that are worth looking at. One is called floor and ceiling, and that's worth researching. Vanguard did a paper on it too. Basically, it's a combination of the usual 4% WD and fixed percent of portfolio value WD.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
Post Reply