how and why asset allocation works

The first step in building a long term passive portfolio is deciding on your risk tolerance which means deciding on your split of equities/bonds.  To me, it’s not really deciding on the “risk” of your portfolio, but your tolerance for volatility (major swings in portfolio value).

We know that the markets go up over the long term but we also know that the market is moody and can swing aggressively in either direction (volatility).  Generally speaking, the higher your bond allocation, the less volatile your portfolio.  Sounds great, however there is a trade off – a higher bond allocation will also impact your long term returns.

Asset Allocation and Portfolio Returns

Let’s take quick look at how much bonds impact long term returns (spoiler alert – it’s not as great as you think percentage wise, but will make a difference over the long term.)  The portfolio below has an equity portion that is divided between US, Canada, and International, and a Canadian bond allocation.  These are the nominal returns over the past 30 years ending Dec 31 2015 (using a retirement advisor calculator):

  • 100% equities: 10%
  • 80% equities/20% bonds: 9.62%
  • 70% equities/30% bonds:  9.43%
  • 60% equities/40% bonds:  9.24%
  • 50% equities/50% bonds:  9.05%
  • 40% equities/60% bonds:  8.86%

As another example, according to Vanguard, which is essentially 100% US exposure, here are the returns from 1926-2015 (89 years):

  • 100% equities: 10.1% (years with a loss: 25 of 90)
  • 80% equities/20% bonds: 9.50% (years with a loss: 23 of 90)
  • 70% equities/30% bonds:  9.1% (years with a loss: 22 of 90)
  • 60% equities/40% bonds:  8.7% (years with a loss: 21 of 90)
  • 50% equities/50% bonds:  8.3% (years with a loss: 17 of 90)
  • 40% equities/60% bonds:  7.8% (years with a loss: 16 of 90)

So you may wonder why anyone would want bonds at all when the markets only go up over the long term.  Two main reasons:

  1. The first is psychological, some investors simply can’t tolerate (ie. sleep at night) a large swing to their portfolio value.  If you were 100% equities in 2008, you would have seen a 40% drop in your portfolio at one point.   Would you be able to stomach your $1M portfolio dropping to $600,000 and still hang on and not sell everything?  However, if you had 50% bonds, then you likely would have seen a 20% portfolio drop which is much easier to swallow.
  2. The second reason is that the closer you are to retirement and the withdrawal phase of your investment career, you want to reduce the market swings in your portfolio.  Withdrawing during a major trough, like a 100% equity portfolio in 2008, can do long term damage to a portfolio.  Bonds will help smooth out volatility as you get closer to retirement.

What Equity/Bond Split Should I Use?

So how much should you set to equity and bonds in a portfolio?  One rule of thumb is to have set your bond allocation low when you first start investing, but increasing as you age.

A popular method is to simply set your bond percentage the same as your age.  However, I like the idea of using the formula 115-age as your equity allocation.  This formula is a little more aggressive in your early years and becomes conservative as you age and get closer to retirement.  See the table below for my thoughts on equity/bond percentages as you age.


Age Stocks % Bonds %
0-20 100 0
25 90 10
30 85 15
35 80 20
40 75 25
45 70 30
50 65 35
55 60 40
60 55 45
65 50 50
70 45 55
75 40 60
80 35 65
85 30 70
90 25 75

From the table, you may notice that the equity portion of your portfolio continues to decrease until you pass away.  I’m going to suggest something a little different upon retirement.

If you follow the 4% withdrawal rule during retirement, it states that you can withdraw 4% of your portfolio every year (adjusted for inflation) for 30 years with a low probability of running out of money. The catch is that this rule assumes that you have a 50% equity/50% bond asset allocation during this phase.  If you plan on withdrawing up to 4% from your portfolio during retirement, then it may make sense to maintain at least 50% in equities rather than continuing to decrease equity exposure.

Examples of Asset Allocation

Using ETFs

So how does this look in a real portfolio?  Lets build a relatively simple globally diversified portfolio (more ETF portfolios here) with four ETFs.

  • Canadian Index: XIC
  • US Index: VUN
  • International Index: XEF
  • Canadian bond index: VAB

Say that you’ve decided that you are comfortable with a 60/40 equity/bond portfolio.  In this example, you would buy:

  • 20% XIC
  • 20% VUN
  • 20% XEF
  • 40% VAB

As another example, if you are in retirement and need a 50/50 equity/bond portfolio, the portfolio could look like:

  • 16.67% XIC
  • 16.67% VUN
  • 16.67% XEF
  • 50% VAB

Using Mutual Funds

Some may shun mutual funds for their high fees, but there are some pretty good low cost solutions out there.  In fact, I have built our children’s education fund around low cost indexed mutual funds with TD (e-series).  Generally, our asset allocation close to the 75% equities/25% bonds (using 4 index funds @ 25% each).  You can read more about our RESP strategy here.

An even easier solution is to purchase a balanced fund that has an asset allocation that matches your requirements.  Basically you deposit into one mutual fund (rather than 4) and it rebalances for you (more on rebalancing below).  A product that looks promising are the Tangerine mutual funds.  They have a selection of balanced funds with a fairly low MER of 1%.

Using a Robo Advisor

Another recent solution is to use a Robo Advisor.  This online service will pick ETFs based on your (risk) profile and rebalance based on your asset allocation.  The fees are approximately 0.5%-1% plus the MER of the ETFs.

Sticking with your Asset Allocation – Rebalancing the Portfolio

Since the stock/bond markets go up and down every year, you will notice that your percentages will get out of whack frequently.  That’s ok and completely expected.  Easiest solution, at least for me, is to rebalance your portfolio with new deposited money annually (side note: no need to rebalance if you use a single balanced mutual fund or a robo advisor).

Say that the previous year was a bull market which would cause your equity portion to increase greater than your bond portion.  In this case, I would add money to bonds and less to equities to maintain the 60/40 split.  If the portfolio is large compared to any new annual deposit, then it may require that you sell positions to restore balance in the portfolio.

For specific calculations for your particular situation, Moneysense created a nifty spreadsheet that will help you with rebalancing your portfolio.

Final Thoughts

In a nutshell, asset allocation is important.  How important? Studies show that it can account for up to 90% of lifetime portfolio returns (compared to market timing and stock selection). If you are squeamish about your portfolio value jumping up and down from one year to the next, then holding a healthy dose of bonds will help alleviate some of the moodiness of the market.

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  1. The Financial Tech on February 20, 2017 at 12:39 pm

    Great article, I am working on my invesment plan and always wonder about the bond I should have in it. The 115-age is easy to understand and make sense. I should have around 10% of it.
    Would you recommend VAB over VSB and ZAG ?

    • EngPhys on February 20, 2017 at 4:48 pm

      VAB and ZAG are very similar. ZAG has a slightly lower MER and a slightly higher allocation to corporate bonds, which means a higher yield, but either choice is good. VSB is short term bonds, so only use it if you want to use the money in the next couple of years or if your are worried about the fund losing money in the short term due to rising interest rates. For a long term investment, the aggregate bond indicies (ZAG and VAB) would be better, but would have higher volatility due to interest rate changes.

  2. Joe on February 21, 2017 at 3:41 pm

    1%-2% difference on long term returns over 30 years make a huge difference.

    100,000 @ 10% over thirty years $1,744,940
    100,000 @ 8.86% over thirty years $1,276,585

    • Greg on February 21, 2017 at 7:27 pm

      It’s not ideal to blindly rebalance to a predetermined ratio of stocks:bonds using an Age-X type strategy. The free preview of the book describes and compares several strategies, and Age-X type strategies are some of the weakest. The better strategies tend toward holding on to stocks if they have gone down and selling stocks when they have gone up, according to fixed in advance rules (not attempting to time the market).

    • FT on February 21, 2017 at 8:41 pm

      Great point Joe and something that I should have worded differently in the article. I have another article about the long term effects of a high MER and came to the same conclusions. A 1.7% reduction in MER (or difference in returns) results in a 60% larger portfolio size.

  3. Greg on February 21, 2017 at 7:28 pm

    My reply to Joe above was meant to get general comment, not a reply. D’oh!

  4. SST on February 26, 2017 at 11:43 am

    Why does the portfolio split equites between Canada/US/Int’l but use only Canadian bonds? It also makes no mention of the type of assets, e.g. 5-yr bonds? 20-yr bonds? Municipal? Corporate? MBS? Small or large cap equities? Not only that but exactly which International markets/funds are being assumed from 30 years ago? Weak calculator.

    Over the last 35 years, same calculator, a 100% CAN bond portfolio returned 9.43%; 100% CAN equites 9.27% (but with much more volatility).

    (Also no use in posting 89-year returns when most of us won’t even be alive for 89 years.)

    There’s also no mention of WHY these returns occurred. Holding bonds in the future may provide a measure of stability but math dictates they won’t provide historical returns, forcing the split against equities even greater.

    Some modern theories state a retirement portfolio should start with a higher bond-lower equity mix and increase the equity portion over time. Thus, a simplistic long-term static portfolio calculation is, at best, entertainment.

    “Withdrawing during a major trough, like a 100% equity portfolio in 2008, can do long term damage to a portfolio. ”
    Sensationalism. 2008-style troughs are exceptionally rare. Those kind of drawdowns also decline in power as a person advances through retirement; higher damage the first year of retirement, very little damage the last year of retirement. The DIY asset allocator doesn’t have a lot of experience thinking in probabilities.

    • Greg on March 3, 2017 at 4:35 pm

      The Bonds first strategy (always sell bonds before selling any stocks) is actually one of the best strategies by many measures on historical US, UK and Japan market data as well as bootstrap simulations using those data sets. But it almost inevitably leaves you with 100% in stocks late in life, something many would be very uncomfortable with.

      Straying too far from 50%/50% stocks/bonds at the start of your retirement puts you at much higher risk of running out of money. You need stocks for the long term growth but also need to avoid selling stocks when they are down early in your retirement. It isn’t so much a quick 2008 type dip and recovery that is the worst problem, it’s more multi-year scenarios in market performance, interest rates, and inflation that cause you to run out of money, and they aren’t so rare.

  5. APF Blogger on February 26, 2017 at 11:40 pm

    Thanks for the great post. Asset allocation is clearly VERY important. One stat I read recently (Peter Berstein?) is that on 90% of returns can be attributed to asset allocation (as compared to say, picking the right stock). That blew my mind, and is further encouragement for people to consider shifing towards low-fee baskets like ETFs. I have gone that route and my new money is being invested through a robo-advisor, as there are some significant advantages to these platforms, including:
    -they help you stick with your asset allocation (mentioned above)
    -simplicity and automation: once you set up automatic transfers, there is really nothing you need to do or pay attention to on a regular basis
    -diversification across a variety of assets classes
    -the fact that there are no transaction fees when I make purchases (this means that I monthly purchases don’t cost me a cent)
    -automatic reinvestment of dividends, and
    -automatic re-balancing
    Thanks again for the excellent post. A very important topic!

  6. Patrick on March 6, 2017 at 5:32 pm

    It looks like those in the retired age bracket with a high bond allocation are going to lose a bundle if they are using bond ETFs , now that we are in rising interest rate period. If they are using laddered bonds held to maturity they will be better off, but then again its hard to beat a dividend aristocrat. IMO, people get asset allocation all wrong. When you are young, you should invest in solid dividend payers, and see what happens 47 years later- they will be throwing off so much cash in dividends you won’t know what to do with it. Here is a link to dividend re-invested returns…

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