How to Make Portfolio and Asset Allocation Changes
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 419. It's titled, How to Make Better Portfolio and Asset Allocation Decisions. The Money for the Rest of Us podcast has tens of thousands of listeners per episode. But in addition, over the years, we've helped close to 3,000 Money for the Rest of Us Plus members. Help us make better portfolio and asset allocation decisions.

help them invest with greater confidence, and manage their wealth. And we do that by providing market reports, tools, and other resources to make better portfolio decisions. As part of Plus membership, we have a weekly premium podcast episode called Money for the Rest of Us Plus. There's close to 400 of those episodes. In that weekly show, we share information about current investment conditions, financials,

financial market updates, portfolio trades, and we answer listener questions. Many of those questions have to do with asset allocation and portfolio decisions.

In this episode, we wanted to revisit four case studies that featured PLUS members that had questions. These were episodes that were released between February 2020 and April 2021. Instead of just playing the audio, I'm recording it fresh so I can provide updates and more context with what happened because those episodes were released during the heart of the COVID-19 pandemic. The first case study

Case Study comes from PLUS episode 287. It was released in February 2020, just when the coronavirus was being spread around the world, but we weren't really in severe

severe lockdown mode at that point. This member at the time was 47. He and his family live in the Middle East and they had a house in Seattle. It was a rental house, but they just got tired of renting it. They got tired of the turnover in renters. And so they sold the house in July 19 and they booked a large capital gain.

This member didn't have much investment experience. He described himself as a beginning investor and became a PLUS member just prior to selling that house in Seattle. He writes, For the first time, I find myself having to make a decision as to how to invest my money and realize I don't really know what to do. The house was our primary savings vehicle. As a PLUS member, he focused on the moderate model portfolio examples on the

the PLUS membership site. On there, we have 12 model portfolios that range from ultra-conservative to more aggressive. We have some role-based portfolios, and they're there to really give members some context, some examples, some inspiration to guide them in their investment decisions. So this member was focusing on the moderate portfolio, but then the money just sat for six months from the summer of 2019 to...

February 2020 when he wrote us about what to do. He said, despite having money to invest during a very hot market, I was afraid to do so. I now think in retrospect that it was probably a big mistake. The reason for this, I was constantly looking for a good entry point, despite intellectually knowing that this is probably futile. I kept thinking that the market was overheated and kept waiting. And although the market did dip slightly a few times most recently with the coronavirus effect, I

I was not able to get in in time before it swung back up again. He felt stuck. He hadn't invested. Now, the fact that he didn't invest over that six-month window wasn't a big mistake. From July 2019 through February 2020, the global stock market had gained about 10%. This member's family wasn't going to put 100% stocks, and their time frame is 20 years or more. And so that six-month window isn't going to make a big difference in

in the long term. Now, we know stocks will likely outperform bonds over the next two decades because not only do stocks have cash flow, but that cash flow can grow because of the earnings growth.

In that episode, I mentioned that cash yields were really low at the time. And at some point, just to save for retirement and to keep up with inflation, the member would need to invest. But how? First, we don't have to put it all in at once. We do regret management. The fear is if we put the money in and

and the market collapses, we'll just feel bad. And so, as I discussed in that episode, we put in a little bit at a time. We dollar cost average in just to get used to investing the money. If you've been in cash and you have a very large sum, doing it incrementally helps manage our emotions. It gives us experience of investing as we see what's going on.

At the time, February 2020, overall investment conditions based on our monthly investment conditions and strategy report was low neutral. And so it wasn't a time to be significantly underweight stocks in February 2020. There were times in 2008, 2011, 2000 where we've seen major drawdowns. But when we were recording this, we didn't know what was going to happen, how the pandemic would play out. And again, our timeframes 10 to 20 years.

Now, when I was small, five, six, or seven, my mother signed me up for swimming lessons, and I was just terrified of the water. I remember I flunked beginning swimming class twice because I was too afraid to jump off the high board.

I was afraid to jump in the 10-foot and swim across the pool. I would just jump on my instructor. So I was afraid of the water. But I started out not in the 10-foot water, but started out small in the 3-foot side of the pool and incrementally overcame my fear of swimming.

investing is the same way. If we just get in the water, little by little, invest our assets, that can help us overcome the fear and the uncertainty.

In the episode, I mentioned if investment conditions turned red, maybe we pull back risk a little bit. And in fact, by early March, investment conditions had turned red and we reduced our allocation to stocks. The overall moderate portfolio, which this member was using as inspiration, has a neutral target of 60% stocks, 40% bonds. By early April, we had reduced that to

to 36% in stocks, including equity REITs. We followed the precautionary principle. We took preventive action in the face of extreme uncertainty.

Now, had that member invested it all at once in February 2020, he would have come out all right. It's been a challenging three years from February 2020 to almost February 2023. I'm recording this at the end of January. In fact, tomorrow when this episode will be released is February 1st.

2023. We had the pandemic, we had the major sell-off then, then we had the market rebound quickly, and then we had a very challenging 2022. Had the member invested it all at once, he would have done fine. The moderate adaptive model portfolios over that time frame returned 2.4% annualized.

The static portfolio, which doesn't make any adjustments, it's strictly made up of two Vanguard funds, 60% stocks, 40% bonds. It returned 3.5% annualized.

But had the member invested every month for the next year, did it incrementally, the adaptive models, had he invested like that, returned 3.5% annualized using dollar cost averaging, while the static would have returned 3%. So the reason why the adaptive did worse had you put it all in in February 2020 is because we pulled back risk and then gradually went back in as...

we got more clarity regarding the pandemic. And ultimately, that strategy, had the member invested incrementally, would have done better following the adaptive models versus the static, and partly that was due to the value tilt and some of the other allocations in that model.

I don't know what the member did. Hopefully, he was able to get those funds invested because his time horizon is 20 years and in the moderate model portfolio has an expected return of over 6% annualized, which is going to be better than inflation and certainly over the long term better than a cash yield. So that's one member getting invested incrementally.

Next member, this was an episode plus episode 306 that was released in July 2020. He wrote, I've listened to about 200 of your podcasts now and enjoyed them. And he and his wife plan on retiring. At the time, they were 55 and they wanted to retire in two to three years. And they don't have a defined benefit plan. They were invested in Vanguard Index Funds for their taxable accounts and Schwab for tax-deferred accounts. They had a fairly aggressive allocation. It was 80% to 90% aggressive.

across all of their accounts, about 10% to 20% in bonds. They were overweight value in small cap, and they were influenced by Paul Merriman. They had about 10% to 20% in non-US funds. The member said when the pandemic hit, and again, this is July 2020, about four or five months in from the more severe, more global pandemic, he said they sold some of their stocks to build up a cash position that would take care of two to three years of living expenses.

And his plan heading into retirement was to reduce risk over two to three years. But he said he sort of freaked out, understandably, given what was going on. But it really got him thinking what should be a proper asset allocation. He had been using our aggressive model portfolio as inspiration and was leaning towards 75% in stocks and income strategy, including REITs.

with about 15% to 25% in bonds and cash. And his question was, does using this aggressive model or this aggressive allocation make sense given their situation and goals? Now, they had some real estate investments and I wasn't ever quite sure what that percentage was. And that's where in these plus episodes, I'm not giving investment advice. This is by no means a

a comprehensive asset allocation financial review with specific recommendations. We're using it as a jumping off place to share investment principles. I'm also in my mid-50s. If I was retiring in two to three years, I wouldn't be comfortable with 85% to 90% stocks. If you get on the Plus membership, you can see my portfolio. I share my allocation and it is much more conservatively invested. Now,

Now, if this real estate portfolios that they have, if it's income generating, that can actually be used as a bond substitute. There's some stability there. And in the episode, I talked about other options to get really that safety first approach. So instead of being totally dependent on the stock market for the returns to fund retirement, even if you put away two to three years expensive, I'm comfortable having some stability there.

In the past, we've talked about immediate annuities, where we pay a one-time principal payment and then get income for the rest of our life. And what that does is it frees up the rest of our assets because we're covering much of our expenses through this guaranteed income source to invest more aggressively. Could be, in this case, the real estate served that purpose to allow for a more aggressive asset allocation. Another option is, is

is fixed annuities. And in that episode, I talked about fixed annuities, which are sold by insurance companies. They're sort of like CDs, but oftentimes certificates of deposits, but oftentimes the rates can be higher. I found it interesting. I shared some fixed annuity rates at the time for...

For example, New York Life, they're AA+. So in July 2020, you could get a five-year multi-year guaranteed annuity or fixed annuity for 1.6%. That's what it was paying. Now they're paying 4%. Lower rated and

insurance companies, not risky ones, but just lower rated. So New York Life's AA++, I guess. If we look at B++, they were paying 3.1% for a five-year fixed annuity at the time. Now it's up to 5.5%. Oftentimes, banks, their yields on CDs are lower than what we can get with fixed annuities. And the reason why is the model is different. Banks offer CDs, they offer...

on savings accounts as a way to backstop their loan portfolio, to balance their accounting books. And it's an accounting exercise, a regulatory exercise. But the idea is to lend out at a higher rate

and then the cost of their funds needs to be lower than that, and the difference is the net interest margin. Whereas insurance companies, one of the main points is the actual product itself. To sell fixed annuities, and then they invest the assets primarily in bonds. Upwards of 75% are in bonds, and the idea is that they can...

They can earn more on their investment portfolio than they pay out on these annuity products and other insurance products. And so they keep the spread that way. It's a different approach, a different business model. And because of that, oftentimes insurance companies pay higher amounts on fixed annuities than what banks will pay on certificates of deposits. Now, it's not always the case. It just depends on the environment.

Now, I'm not sure what the member did. Did they go ahead and invest like the aggressive adaptive model portfolios on Money for the Restless Plus, or do they steer more toward some type of fixed annuity, look at immediate annuities to get that guaranteed income source? I don't know. Had they, though, put all the money in the aggressive portfolio

portfolio, a more aggressive allocation, from July 2020 until the end of January of this year, 2023, that portfolio, adaptive aggressive portfolio, returned 7.2% annualized, and the static returned 6.3% annualized. So he would have done all right. Now, there would have been a period there, the maximum drawdown during that period, which the

really was last year, beginning of 2022 through October 12th, the adaptive aggressive model portfolio fell 20%, and the static comprised of the two Vanguard funds fell 24%. This would have been, and like for many of us, when we consider a portfolio, if we're retired or not, seeing that drawdown helps us to

decide whether we're comfortable with the risk. Now, this member was selling during the pandemic, raised two to three years of expensive, but had he invested more aggressively, having seen that 20% drawdown and the aggressive portfolios, the potential worst case maximum drawdown like we saw in 2008 is

is close to 50%. And that's where I get uncomfortable seeing a retiree invest with their portfolio that aggressively unless they have some other source of income, be it a divine benefit plan, an annuity, to withstand the volatility so they're not forced to sell their stocks in a panic or even forced to sell to fund their spending.

Those aggressive portfolios, given the sell-off in 2022, they've not recovered. So they sold off 20%. But even from October through the end of January, we've had a strong rebound, but the static portfolio is still down 12%. The adaptive model is down 7.8%.

Overall, the adaptive models, the way we've structured them, tend to be a little less volatile than the static models just because we have additional asset classes. We're willing to reduce equity or stock exposure when investment conditions are red.

And so overall standard deviation of the adaptive portfolio has been 14.3% versus 16.5% for the static version. So we don't know what happened, but hopefully he did rely or the couple relied more on some type of safety first approach, getting some type of guaranteed income source to complement the more aggressive portfolio.

The next case study then is from Plus Episode 310. It was released August 2020. At the time, he'd been a Plus member for a couple years, but it procrastinated, really hadn't done anything, hadn't looked at his asset allocation or the portfolio tools. People join Plus membership for different reasons. Sometimes they just like to listen to additional content, listen to the Plus episodes, get

get more familiar with our investment philosophy, and then after a year or so might decide, I'm going to use the tools and decide how I should adjust their portfolio. This member is primarily buy and hold and forget investors, he describes it, and was invested primarily in stock mutual funds.

I had to laugh. He also shared the allocation for his 91-year-old mother, has about just over a million in assets, and she was invested 87% in stocks. Her living expenses is covered through a pension. So that's an example of somebody that is able to live with a pension, Social Security,

And so the investment portfolio can be incredibly aggressive because essentially it's used to build up the estate to pass on to heirs or charity or whatever they decide to do with it. This couple, though, were invested in 11 stock mutual funds. They were primarily growth-style funds, Fidelity, T. Rowe Price. There was a number of sector funds, and it had done incredibly well. Over the previous five years, it had returned 12% annually.

annualized, but he recognized the expense ratios were high and tilted toward the growth style investing. And he was trying to convince himself to pull back from growth and invest in some more passive index funds or ETFs. He said he was just having a difficult time moving completely away from a strategy that had worked very well for him.

That's understandable. When something works, it's difficult to shift those assets out. And the way to do that is not to do it all at once and to continue to invest some in that strategy. In his email, he wrote, I'm not sure that I've totally sold on broad index only. It seems like some riskier stock sectors might provide a greater return with not a lot more risk potentially.

Now, I have some active or at least one active microcap growth fund. It's Momentum Manager. It's Driehaus Microcap Growth Fund. I've had it for a number of years now, and I keep it because they've been very, very good stock pickers and have outperformed any relevant index. But they do, like many growth strategies, momentum strategies can get some big drawdowns.

And so one way to approach this would be to allocate to a core inexpensive index fund and then complement that with these active mutual funds that have...

have been good to you and have done well. This obviously can also be complemented with some type of stable income source, be it a fixed annuity, immediate annuity, etc. This is if you're retired. If you're not retired, if you're young, you can just keep that more aggressive allocation because you have the human capital to withstand any major drawdowns. What I did, though, is one of the tools that we have as a resource that we actually use to manage or

or to track the performance of our models is YCharts. YCharts is a tool used primarily by financial advisors. We're not financial advisors, but we use them mainly because they're one of the few sources we have found that we can provide a dynamic model portfolio and it'll actually track performance. But as part of that, I went ahead and made a model out of the 11 mutual funds and the weights that this member owned just to see how it would have done from...

August 2020 through the end of January 2023, had he just kept that same allocation. And the reality is it wouldn't have done as well as investing in a broad index fund. Look at the allocation, mostly U.S., some sectors, and so probably the most appropriate index would be the S&P 500 index, a measure of large cap U.S. stocks.

This member's portfolio, or at least the allocation in August 2020 with those mutual funds, from August 2020 through January 2023, returned 1.7% annualized compared to a return of 21% annualized for the S&P 500 and a more global stock market would have done around 11% annualized.

If we look at how much it sold off during that time, the biggest drawdown was only 12%. So it wasn't like there was a big loss. But we've seen value come back. And in the last three, four months, we've actually seen non-U.S. meaningfully outperform U.S. But those active funds lagged broad-based index funds by 2%.

10% to 18% over that time frame. And any strategy switches. Any strategy can go through these long periods of underperformance. But after that significant outperformance, now we've had a period of underperformance. And that's why having a core of passive index funds or ETFs, and then they can be complemented by other more niche strategies.

Our final case study is from a member in Bosnia. And in this case, he and his family had just sold a family business. This is from Plus Episode 337, released April 2021. And he was working on

an asset allocation. They had just sold a family business and they were, his parents were in the 60s, he and his sister in their 30s. They started another business that was just really just getting going. And so they netted about $5 million and they were hoping...

to seek safety and wealth preservation with a 10-year time horizon, but they wanted to generate income of 3% to 4% a year and some growth. Now, they also had a situation where tax rate in Bosnia on dividends is 10%, on capital gains is 13%, but there's an additional 15% tax rate on investment earnings from outside of the country, which is unfortunate. But his question is how to go about designing

a target asset allocation. On the Plus site, we have a number of tools for doing that. We have a template, a spreadsheet template, so that members can put their existing allocation and their existing holdings that categorize it by asset class, and it'll show here's the expected return, the range of the returns, and the potential drawdowns for that. We have found spreadsheets just easier to use than some of the other tools out there. But there's

There's also a spreadsheet for just sort of modeling, like what is a 90% stock portfolio, 10% bond portfolio? What's the expected return of that? And that's really another role of the model portfolio is we can compare, now here's what a conservative portfolio is yielding, the expected return versus a more aggressive. And any resource you have just to be able to compare different allocations helps us to assess our comfort. Is the return enough? But what's the potential drawdown risk?

Now, as markets sell off, the expected returns can change. And this is what's interesting about this case study. At the time, they were looking at the moderately aggressive model portfolio. And before tax, it had a 10-year expected return of 5% and a range of 2.4% to 7.1%. It was about 72% in stocks and

and stock-like strategies like REITs at the time. Now markets have sold off, valuations are lower than they were, and so the expected return of that model now is, over the next 20 years, is 6.6% annualized. So another 1.6% potential annualized with a range of 3.3 to 8.2%.

The other good news is the yields are higher. Now it's actually possible to get a yield closer to 3% between the bonds and the dividend yields that you couldn't do three years ago. And that's where expectations change over time, which is why I find it helpful to revisit periodically what the expected return is for

for different portfolio mixes so that we can set our expectations. There are times when expect returns are higher because valuations are lower and yields are higher. And that's kind of a period where we're in now. And so expectations are higher for our portfolios.

One of the other questions then this member was looking for was seeking some type of protection to buy put protection. He had recently read Nassim Nikola Taleb's book, The Black Swan, and this member was looking at some type of protective puts. But at the time, and I priced it out in the episode, the cost to protect against a loss, I believe it was like greater than 10%, was 3% to 4% per year. And

And that's where it can get really challenging in terms of trying to protect against the downside. If we use straight up put options, they can be very, very pricey. And so I have found it more helpful is just to choose an allocation where we're comfortable with the maximum drawdown. Now, recently, and I'll probably talk about this in another episode in the future, but I had a call with a financial advisor and we were talking about

the innovator outcome-based ETFs, which is ETFs that provide some downside protection. In this case, protection, I believe it was against the first 15% of losses, but then you were exposed to losses greater than 15%. And then there was a cap on the upside. And they can get really complicated because they have caps, you're not getting the dividends, and then you get partial protection on the downside. And

And we had a lengthy discussion because he was using them in his practice. And my biggest challenge is how do you model that out in terms of the potential loss greater than 15%? And he sent me a bunch of studies that he did, which will be helpful. And I'll look through and we'll certainly revisit that. But to date, I have not found a solution to protect against the downside and still capture sufficient upside. Perhaps...

The Innovator Series, outcome-based ETFs can do that. We've actually had, have referred to them in prior episodes, but it's something I certainly want to take a look at. But straight up buying put protection is expensive. It's better to choose an asset allocation where you're comfortable with the maximum drawdown. Better yet, if you're retired, to get some type of safety first, guaranteed income source, so then you're not so exposed.

when we get a major sell-off in stocks. And 2022 was unusual in the fact that, well, not unusual, it was actually somewhat, I won't say it was welcome, but it certainly was a good exercise in realizing our risk tolerance. We saw at times drawdowns of more aggressive portfolios of close to 30% in 2022. Now that's not 50% like we saw in 2008, but it was enough to call

cause investors to worry a little bit. But ultimately, as we think about these four case studies, some takeaways are doing some incremental dollar cost averaging can be helpful when we have a large sum of money that we're trying to get to work.

The incremental approach also is appropriate if you've been in a strategy that's worked well and are trying to pull back risk to do that gradually and use a core satellite approach where you have a core index strategy and you have satellite, perhaps more niche or more aggressive funds or ETFs surrounding that.

The third takeaway is the recognition that investment conditions change. Expected returns change. And so periodically revisiting our asset allocation and return assumptions helps us to better model out our future and to set reasonable expectations.

And finally, having some resources to compare against, having some type of models to look at, not necessarily to replicate exactly, but to use as guidance or jumping off points can be very helpful. When we have surveyed PLUS members, 94% feel they now better understand financial markets and economic trends. Nine out of 10 feel that membership has helped them make better investment decisions, and 87% feel more confident in their

investing. This is by no means an ad for Money for the Rest of Us Plus, but it's a resource we have and we're excited about and members are excited about. I believe seven out of 10 refer Plus membership to friends and family. And so if you want more guidance, want more resources, Plus membership is there. You can learn more at moneyfortherestofus.com. If that's just not something you're interested in right now, that's no problem also. We'll continue to provide free week

weekly podcast, as well as investment guides and other information to help you become a better investor. This episode has been for general education. We've not provided specific investment advice even to the members that we profile. This is simply general education on money, investing, economy. Have a great week.