In the long term, the most important factor that influences the returns of your liquid portfolio is the percentage of stocks and bonds you own.
In this post, we will focus on liquid asset classes: stocks and bonds. ICash is also an asset class, but I will discuss it in another post about budgeting and saving.
Age method
To determine the percentage of stocks that you should keep in your portfolio, you may consider a widely adopted rule of thumb. It is based on your age and it suggests subtracting your age from 100. The result is the percentage of stocks that you should own in your portfolio. The rest of the portfolio should be allocated to bonds.
As life expectancy has increased, some people started to suggest subtracting your age from 110 or 120. Since stocks have higher financial performance in the long term, a higher allocation to equities will enable your portfolio to grow faster
The age-based method may be the quickest way to determine your asset allocation to stocks and bonds. The basic concept is that stocks in the long term perform better than bonds, however, their value fluctuates more in the short term. When you are accumulating wealth, you want more stocks. When you retire, you will likely own more bonds to be on the safe side.
Target Date Funds method
Another approach that you may use is to look at the glide path of Target Date funds. The glide path describes the progressive reduction in stock allocation as investors get closer to their retirement date.
Target Date funds are designed for people who want to retire at a specific time. Often their name will include the target retirement year, such as 2065. They use the intended retirement date as the main variable to determine the fund portfolio’s asset allocation.
If you research the glide path of Target Date funds, you can substitute their target date with your intended financial independence date. Based on the number of years that you have left, you will obtain a sample stock/bonds allocation.
The example above comes from Schwab. It explains how they calculate the stock to bond allocation before and after retirement.
You may also invest in a Target Date mutual fund that will build a portfolio on your behalf if you don’t feel comfortable building a portfolio on your own. Personally, I am not a fan of Target Date funds. They tend to charge higher fees than portfolios that you can build on your own. High fees will affect the value of the portfolio in the long term. These funds are also one-size-fits-all funds, and that is not what I look for.
Can I have a 100% stocks allocation?
The age-based and Target Fund allocation guidelines are a good start for many people. And if you are new to investing, you should definitely consider them.
But in my view, they are slightly too conservative. They are designed for people that seek a conventional retirement at around 65 years old. At that age, people’s wealth must be safe because it is hard to re-enter the workforce even if they need to do so.
A 100% stocks or even a 90% stocks/10% bonds allocation are very risky. They should be only considered by investors who are more familiar with the stock market.
Yet they are possible if you don’t need the money for at least 10-20 years and if you have the option to return to the workforce in early retirement. A portfolio with a 100% stock allocation can and will fluctuate significantly. At some point, it may even lose 50% or more of its value. But in the long run, it will have higher returns.
Since this website is about financial independence and early retirement, it is designed for people who want to retire sometime between 30 and 50 years old. I am not advocating that readers (you) should have a 100% stock allocation, but early retirees may consider taking more risks with a smaller allocation to bonds compared to standard guidelines. If at the target retirement date the portfolio is not sufficient for retirement, they may still re-enter the workforce and work more years.
My allocation
Personally, I decided not to own any bonds until I am 10 years away from my target early retirement date. Even though bonds would reduce my overall portfolio volatility, I have no need to withdraw the money for more than a decade. I also plan to reach financial independence when I will still be able to work. That is my worst-case scenario.
I know that there will be times when my portfolio will lose a lot of its value. While I am writing this post, the uncertainties around the 2022 Russian-Ukrainian war and increasing interest rates in the USA have significantly reduced the value of my technology stocks. But after years of investing, I have learned how to assess my risk tolerance when the market takes a downturn and not to panic sell. So I am comfortable taking more risk at this stage. I have also structured my savings to have a small emergency fund to cover unexpected expenses. This way I don’t need to sell my investments when they are down in value if anything comes up.