The Only Asset Allocation Guide You’ll Ever Need

Tyler Gardner (0:00)

So forget obsessing over whether your stock fund should be Vanguard or Fidelity, or whether your bond fund should be intermediate or long term. Those choices, dare I say, don't actually matter. It's the allocation of percentages that drive your returns, your risk, and your ability to stay the course when things get ugly. Hello, friends. This is Tyler Gardner welcoming you to another episode of Your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing. So let's get started and get you one step closer to where you need to be. I want to start this week's episode with a quick thought experiment. Imagine two investors. Investor A has a portfolio that jumps 20% one year, then 0% the next. Investor B has a portfolio that climbs a steady 10% each year. On paper, both average the same return, 10%.

But after two years, Investor A has $120. Investor B has $121.

Some of you may have seen this example before, and for others, it might be new. Regardless, it's crucial we start this week's episode here. Because in this particular example, after one year, that $1 difference doesn't sound like much, but let's think long term. Over decades, it compounds into thousands, even millions of dollars. And the point is this. The average return you get is not the same as the return you actually get. The even more pressing point is this. Just because you crushed the stock market this year doesn't mean you're going to crush it long term, nor does it mean that your allocation strategy is sound or genius.

Because volatility drags you down. And the number one enemy of long term wealth, especially in retirement, isn't missing the big winner. It's suffering the big loss. Remember, if you lose 50% in one year, you don't need a 50% gain the next year to break even. You need 100%.

Let that sit with you for a moment, as I take a sip of my new favorite Jamaican coffee from the Woodstock Farmers Market, cleverly called Jamaican Me Crazy. No, they're not sponsoring me, but it is dang good coffee. They're very clever over there, and they have exceptional cookies too. This example, not the cookies, is why asset allocation matters. We're not looking for the asset class with the flashiest year. The hot stock, the crypto moonshot, or whatever Uncle Bob is raving about at Thanksgiving. What we're really after is a mix of assets that don't all win or lose at the same time. The jargony academic terminology we need to know here is called non or negative correlation. I've talked about this before. It just means that if one asset class responds to macro or micro trends by going down, hopefully we have invested in another asset class that responds to those same trends by going up. We need to focus our attention on gathering pieces in our portfolio that offset each other, so the portfolio as a whole compounds steadily even when individual pieces wobble. And the data backs this up. A classic study by Brinson, Hood, and Beebauer found that more than 90% of portfolio returns come not from stock picking or market timing, but from asset allocation itself. And not just asset allocation throughout your life, but the initial asset allocation that you choose. Meaning, if you spend one hour doing this well, in all seriousness, that hour will and can define 90% of your ultimate returns in life, regardless of what happens in the world. In other words, your long-term results are driven far more by how you divide the pie than by which toppings you constantly obsess over. Again, there's a reason that in any Wall Street movie ever, the top brokers are always mentoring the new person by telling them that stock-picking is a fool's errand. I will extend that to picking one thing inside an asset class is almost irrelevant versus how you divide the entire pie across asset classes. That's what matters most. And here's why we're talking about this now. In the listener survey I sent out, and a massive thank you to all who filled it out, by the way. I got about a thousand responses, and you all are amazing for offering what this show can do better and what you want to see. And the link is still live in the show notes if you didn't get a chance to fill it out. I asked you all what you wanted to hear most about. And asset allocation was absolutely consistently one of the top things you wanted covered. Which makes sense. It's the unglamorous but essential backbone of investing. So, I'm proud of all of you for whatever that's worth, for wanting to hear more about this relatively dry topic. And I'm happy to cover asset allocation, and in typical fashion, because it's a dry topic, we're going to try our best to have some fun with it. Because if you ever take life too seriously, you're missing out. Start here. Asset allocation isn't a horse race. It's more like a Thanksgiving dinner. Aunt Karen swears mashed potatoes beat stuffing. Uncle Bob won't shut up about cranberry sauce, and cousin Chris will only eat the dark meat, and you've placed him last in line to get food, because he's been known to take it all and leave none for the rest of you. But the truth is that people love Thanksgiving dinner because you have options and you get to mix and match, and it works as a plate. Hence why so many sandwich shops have created the Gobbler, or whatever they want to call it these days. And, quick sacrilegious side note, am I the only one that doesn't like any food that's served at a traditional Thanksgiving? I continue to be blown away that we're still pretending that any of that food is good. If I just lost you, I'll do my best to get you back with what follows. If you prefer another image other than Thanksgiving to understand asset allocation, think of Noah's Ark. You don't load up on giraffes just because they look cool and have long tongues that can eat the food out of your car. You bring two of everything. That way, when you one day find dry land again, you're not the one explaining extinction to the grandkids. Enough of my rambling. Here's the roadmap for today's episode. First, we're going to take a tour of all the major asset classes, warts, and all. Second, we're going to walk through three practical allocation strategies that you could actually follow, depending on your tolerance for risk. And third, we're going to bust one of the biggest myths in retirement investing, the conventional glide path of shoveling your money more and more heavily into bonds as you age. Honestly, I think that's 100% backwards. And come on, y'all knew I was going to say that. And, as always, a quick favor before we jump in. If you've been enjoying the show, leaving a review on Apple Podcasts really helps more people find it. And it helps me know what's connecting with you. I read every one, and I appreciate all the support you've shown for the show, and how I can continue to make it better for you. All right, let's open the gates and take a stroll through the zoo of asset classes. Everyone behave, each asset class has its quirks. Some are majestic, some are smelly, and some will absolutely bite you if you're not careful. Starting with number one, stocks, or the star quarterback that we all know and sometimes love. Everyone loves it when they're winning. Stocks are the charismatic, occasionally cocky quarterback of your portfolio. They've historically delivered the highest long-term returns about 7% annually post-inflation in the US market over the past century. But they also throw spectacular interceptions at the worst times. See the.com bust, the great financial crisis, and yes, March 2020, when the S&P fell 34% in 33 days. The key with this asset class, stocks will build your wealth, but they'll also test your stomach lining. And that's why for textbook asset allocation, we tend not to put them on the field alone. If you want to dig deeper here, check out Burton Malkiel's A Random Walk Down Wall Street, or John Jack Bogle's The Little Book of Common Sense Investing. Both argue that stocks work best when you buy broadly, cheaply, and for the long haul. AKA, what I've been preaching for years, and yes, I got it from the best. Number two, bonds. The responsible accountant. Bonds are like that accountant friend who insists on splitting the dinner bill down to the penny. They're relatively stable, predictable, occasionally boring. Historically, long-term US treasuries return around 5% a year. That's nominal. But that average hides the fact that bonds can, and do, get hammered by inflation. Think of the 1970s. Or rising interest rates. Hello, 2022 I hit on this back in episode 7, title Should I Invest in Bonds? And if you want a deeper dive into my thoughts on bonds and investing in bonds, check out episode 7, titled Should I Invest in Bonds? So, why do people bother with bonds? Because bonds are not in your portfolio to beat stocks. I need to repeat that because it is the biggest myth conception that I hear daily from many of you. Bonds are not in your portfolio to beat stocks. They're there to soften the blow when stocks fall. Let's see our initial example where we started the show of 10% 10% returns versus 20% 0%.