Episodes of market volatility are inevitable but impossible to reliably predict. Even for seasoned investors, these periods can be a source of unwelcome anxiety. To shield our clients from experiencing panicky feelings, Abacus crafts our client’s financial plans so that their life goals are achievable whatever the short-term financial weather.
And yet, reassurances can sometimes be hard to hear in the middle of a bear market. Fear can take the upper hand and provoke an almost overwhelming compulsion to sell. Sadly, the result is rarely beneficial and often quite harmful.
For that reason, we aim to place you in a portfolio whose volatility won’t induce panic in the first place. Ultimately, riding out the bumps in the investment road helps your plan benefit from the higher expected returns of a more aggressive portfolio.
How Abacus Portfolios Work
Every Abacus client portfolio is allocated between stocks, real estate, bonds, and cash. The process of recommending how much you should invest in stocks and real estate (which provide growth) versus in bonds and cash (which provide stability), is a mix of art and science.
Qualitatively, your advisor looks for clues about your risk tolerance in recommending an asset allocation. Were you invested during previous bear markets? How did you respond then and what is your perspective now? Have you had an extremely positive or negative investment experience in your past? What did your parents say, not say, or do when it came to money? In short, we want to understand your unique experiences and the perspective that has resulted from them.
Quantitatively, math drives our recommendation for your asset allocation. Stocks and real estate have reliably provided long-term growth – without which your goals would be much harder to achieve. Abacus’ allocation to stocks and real estate has an expected return roughly 5.5 times greater than that of the expected return on Abacus bonds and cash. That’s substantial! Let’s invest in those.
On the flip side though, we also expect in a very bad year, losses for stocks and real estate may be as much as 7.5 times greater than bonds and cash. So, we include high quality bonds and cash as a relatively stable store of value to fund near term financial objectives. In this way, you can avoid selling stocks and real estate assets that are temporarily down in value.
It is a trade-off. We don’t want to place more assets into bonds and cash than necessary and drag down long-term returns. We also don’t want to over commit to stocks and real estate if short-term unrealized losses must be locked in to fund a short-term financial objective.
Even More Diversification
Next, we establish a baseline minimum allocation to stocks and real estate. We look at both academic and industry research on the Sustainable Rate of Withdrawal. That’s financial advisor jargon for what is the maximum you can reliably pull from your portfolio, ensure your spending can keep up with inflation, and remain confident you’re not in danger of depleting your assets.
For example, research suggests for someone entering a 30-year retirement, allocating 50-60% to stocks and real estate and 40-50% to bonds and cash maximizes the sustainable rate of withdrawal. As such, many Abacus clients will start retirement with a 60/40 allocation and might drift down to a 50/50 allocation later in life.
When retirement is still over the horizon, your advisor will probably recommend allocating more than 60% to stocks and real estate, because there’s more time for the portfolio to recover from losses. But retirement is rarely life’s only objective. And not all pre-retirement expenses can be funded out of current income.
Saving for college, for example, may require disciplined saving and investment, may occur before retirement, and tends not to be as flexible on timing. Other typical examples could be a child’s wedding, a dream vacation, or buying a second home. You may not want to compromise on these objectives due to market fluctuations.
Your financial plan reveals when these expenses are likely to occur and is key to designing your portfolio’s asset allocation. How much will you need to withdraw from your portfolio over the next 3 years, over the next 10 years, and beyond 10 years?
Assets earmarked for expenses in the next 5 years should be exclusively in cash and bonds. Assets earmarked for expenses in years 6 to 10 should be split equally between riskier stocks and real estate, and less risky bonds and cash. Assets earmarked for expenses beyond 10 years can be entirely in stocks and real estate. Blend each of these ‘sub allocations’ together, and you have a rationale for your overall asset allocation.
History and the Future
How does Abacus derive these time frame driven ‘sub allocations’ of 0/100, 50/50, and 100/0? We do it by looking at historical market returns. We have found that, in most 5, 10, and over 10 year periods, this has been a sensible framework. There have been periods where a loss still would have resulted. But if we tuned the portfolio and planned it so that it always historically worked out, you may live a life that is more constrained than necessary. You only live once.
That is the framework for how an Abacus advisor recommends how conservative or aggressive your portfolio should be. And it leaves plenty of room for customization. Maybe your resources are more than adequate and your tolerance for market risk is quite limited. So long as your financial plan indicates adequacy, you can be more conservative than the framework might suggest.
Conversely, perhaps your resources are a bit short. Or if you have flexibility on the timing of major expenses, perhaps being a bit more aggressive makes more sense. Whatever your situation, an Abacus asset allocation is the result of a dialogue that is uniquely tailored to you.
