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:
- 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.
- 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 %|
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
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.
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.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).