There is no exact science to optimal asset allocation over time, but any serious effort to address the subject must begin with the assumption of risk aversion. Why is that? Because to be useful, an asset allocation principal must address all of an individual’s or entity’s investible dollars, and any plan that risks leaving the investor destitute must be taken off the table immediately.
From this sensible precaution, a great many bizarre theories spring. What most fail to take into account is one of the most obvious risks that investors now face: the risk that they have not put aside enough money and will, therefore, be left without enough money in retirement. Everyone agrees this is a serious problem, from The Huffington Post to Forbes, yet still, typical asset allocation models never recommend more than 70% stock exposure (and never recommend options) even for investors with an investment timeline of 20 years or more. This is simply foolish, as the odds of bonds, cash, and precious metals returning more than stock over a 20 year period is astronomically low, while the chance that a typical investor will reach retirement age without enough money is extremely high.
Here then, is my effort to re-calibrate the entire system based on what we now know, which is that if you have less than $500,000 invested for a family of four, or less than $100,000 invested for yourself, the biggest threat you face is not the loss of your principle, but the loss of the opportunity you have to grow it. The true ideal asset allocation is suggested below for each possible time-horizon, along with one buy that should do well over that time period. Is there risk involved here? You bet. But it appears that a great many investors must now choose between the possibility of investment loss, and the certitude of investment failure.
Keep in mind that the suggestions below apply only to a theoretical investor; they may or may not be suitable for any particular reader.
This is the simplest time-horizon to allocate for, since whether you have 20 years in which to grow your wealth or 1,000 years, you want the investment with the highest total expected return, which generally means 100% growth stock. Here is why: 20 years is long enough for the market to have completed a large, generational cycle, which is the larger-scale version of what we typically describe as the “bull” or “bear” market cycle. As the time-horizon under consideration approaches the 20-year threshold, the chance of bonds or cash or any other investment outperforming stock becomes slimmer and slimmer to the point of insignificance. Most investors with this time horizon should invest their money in a broad-based stock fund such as SPY, which tracks the S&P 500, and let the magic of the market take it from there.
This is not to say that very astute investors cannot beat market returns, only that most who try to do so fail. If you count yourself among the very astute (and it is entirely possible that you should) you might want to push for higher returns by moving up to one third of your assets into a portfolio of hedged option strategies, such as the very popular covered-call strategy, or even bull-put credit spreads which, if you are interested, you can read more about here at InvestorsObserver.com, another website for which I write regularly.
10 to 20 years:
On a time-horizon of less than 20 years, there is a realistic possibility that a prolonged stock-market downturn could adversely affect the portfolio, and for this reason, cautious investors should add income producing stocks as well as some international exposure. I suggest another ETF, DEW, which invests in international high-dividend stocks.
Slide money from SPY to DEW at the rate of about 5% per year, so that you reach the ten year mark with about 50% invested in SPY and about 50% invested in DEW. Note that you are still 100% invested in stock, but this is not as foolish as it initially sounds. The chance of the market being down over a given ten year period is very small. It has happened, but not often. It is certainly not so common that, out of fear, you should throw away the possibility of achieving your real investment goals.
At this point, continuing to use hedged option strategies for about 25% of your money makes sense for some investors. If you are trading options with this time-horizon, be sure that you understand how to use options to increase your safety, and do not use them to gamble.
5 to 10 years:
This is, in some ways, the most difficult time-horizon to plan for. The market will probably be up… but it might not be. Rising interest rates are not likely to erode the value of bonds… but they might. The key here is to add a fund that introduces bonds for safety, but which continues to provide the potential for high returns. One excellent choice is PowerShares CEF Income Composite Portfolio ETF (PCEF). This fund of funds divides its assets between income-grade bond funds, high-yield bond funds, and option-leveraged income funds. In this time period, keep approximately one third of your portfolio in SPY, one third in DEW and one third in PCEF.
As before, continue to use hedged option strategies in a portion of your portfolio if you are comfortable with them.
2 to 5 years:
If your investment time-horizon is from two to five years long, the temptation may be great to push hard, but this is a period of high risk, when any loss of capital is most likely irreplaceable. Hence, it makes sense to add in a truly conservative ETF. One good possibility is iShares Barclays Aggregate Bond Fund (AGG), which invests in U.S. Treasuries of varying maturities. During this time period, have about 25% of your total assets in each fund, SPY, DEW, PCEF and AGG.
And yes, if you have the discipline and knowledge to use options for the additional safety they provide and not as gambling opportunities, then by all means continue to keep a portion of your portfolio in hedged option strategies.
Less than 2 years:
When you have less than two years to go, the key word becomes preservation. Hence, it is reasonable to add the counter-cyclical effects of precious metals into your portfolio. Keep in mind that as an overall investment strategy, buying precious metals is terrible, but they do tend to act as life insurance for your portfolio. If everything else in your portfolio fails, precious metals will likely rise. As with life insurance, obtaining the potential benefit is the last thing you ever want to happen, but as with life insurance, it is still worth planning for that worst-case scenario. Move about one fifth of your total holdings into GLD, an ETF that directly tracks the value of gold, while keeping a fifth in each of the other ETF’s described above: SPY, DEW, PCEF, and AGG.
Once again, keeping a portion of your portfolio in hedged option strategies makes sense for the most disciplined investors.