Revising Our Asset Allocation Models

As we move forward with The AAII Way for creating a personal investment plan, we are revising the AAII Asset Allocation Models. The equity weighting in both the moderate and conservative investor models are being reduced to dampen the volatility of their returns. As I’ll explain, the changes will improve the trade-off between risk and return. The existing aggressive investor model is staying unchanged, though we’ll suggest some options for substitutions on how to fill its equity allocation.

The most notable change is for the moderate investor model. It is moving from a 70% diversified stock weighting to a 60% diversified stock weighting. The bond weighting is increasing from 30% to 40%. This change brings the moderate investor model’s equity/bond exposure in line with the well-established 60/40 allocation benchmark.

In its most simplified form, the 60/40 allocation is 60% large-cap stocks and 40% bonds. There are various compositions of the model, but most stick with the basic 60/40 mix. AAII’s moderate investor model uses a mix of stock categories for the equity portion and intermediate- as well as short-term Treasuries for the bond portion. This diversifies the portfolio, reduces the duration (sensitivity to interest rate changes) on the bond side and gives a nod to the short-term cash needs investors may have. The revised mixture is 20% domestic large-cap stocks, 15% domestic mid-cap stocks, 10% domestic small-cap stocks, 15% international stocks, 30% intermediate-term bonds and 10% short-term bonds. The bonds can be Treasuries, investment-grade corporate bonds or municipal bonds.

There a few reasons for the change. The 60/40 allocation is a well-established benchmark. It has held up well against a variety of more complex allocation strategies. For retirees, the 60/40 allocation tends to work well with the well-established 4% withdrawal rule. Even at retirement periods of 40 years in length, portfolios using the simplified version of 60/40 don’t run out of money 87% of time. (For retirement periods lasting between 15 years and 35 years, the success rate of a retiree not outliving their portfolio ranged between 100% and 93% with this allocation.) A variety of models center around it, from Nobel laureate Harry Markowitz’s and the late John Bogle’s use of a simple 50% stock and 50% bond allocation to the very long-running Vanguard Wellington fund’s (VWELX) allocation of 60% to 70% in stocks and 30% to 40% in bonds. (The Vanguard Wellington fund was founded in 1929 and is one of the oldest mutual funds still in existence.)

The 60/40 allocation is also easier to follow. This is extremely important because the optimal strategy is the one you can stick to no matter what the market is doing. One of the reasons investors bail on their investment strategy is because the level of volatility is too high. While we can make the argument of volatility being the price of higher returns, psychological and financial tolerances vary. Not all investors can tolerate higher levels of volatility to realize higher returns. Just tweaking the equity and fixed-income weightings of AAII’s moderate investor allocation resulted in a better risk/return trade-off for many investors.

Over the past 20 years, the revised moderate investor model would have realized an annualized return of 6.1%. This compares to a 6.6% annualized return for the existing moderate investor model (which, as a reminder, is a 70/30 allocation). The standard deviation of annual returns—a measure of volatility—was 10.1% for the 60/40 mix versus 12.4% for the 70/30 mix. Put another way, volatility was reduced by more than two full percentage points in exchange for a 0.5-percentage-point reduction in annualized return. This is a good improvement in risk-adjusted return. (The returns were calculated using benchmark indexes for each component of the models for the period of 1990 through 2020.)

Some of you may be concerned about the higher exposure to bonds given the current interest-rate environment. Between 1940 and 1959, there were 13 calendar years when intermediate-term government bonds realized a gain of less than 2%. During eight of those years, returns were less than 1%. A simplified 60/40 portfolio (large-cap stocks and intermediate-term bonds) realized a 9.9% annualized gain during this period. The 60/40 mix also enabled a retiree to have far more wealth at the end of 1959 than they started with in 1940 even after withdrawals were accounted for.

As I explained last week, the role bonds play in a portfolio is to provide diversification, dampen the volatility of portfolio returns and provide cash flow. Those of you who are nervous about interest rates can consider laddering individual bonds, using defined-maturity bond funds or buying CDs with different maturities. Any of these would allow you to maintain the basic allocation framework, though CDs will not offer any appreciation of capital.

AAII’s Aggressive and Conservative Investor Allocation Models

The aggressive investor allocation model remains unchanged. It calls for a 90% allocation to stocks and a 10% allocation to cash. The suggested breakdown is 20% large-cap stocks, 20% mid-cap stocks, 20% small-cap stocks, 20% international stocks, 10% emerging market stocks and 10% intermediate bonds. An alternative would be to use AAII founder James Cloonan’s Level3 approach or to use one or more of our model portfolios (Model Shadow Stock Portfolio, Dividend Investing, Stock Superstars Report and VMQ Stocks) for the stock portion. The bond portion is essentially a proxy for a low-volatility buffer. It could be substituted by cash-like assets to fund near-term goals and cash flow needs. Cloonan, for instance, suggested that retirees keep two to four years of planned withdrawals in cash or cash equivalents. 

The conservative investor model is being made less volatile. It is currently 50% stocks/50% bonds. The mix is being lowered to 40% stocks/60% bonds. The new suggested weighting is 20% large-cap stocks, 10% mid-cap stocks, 10% international stocks, 40% intermediate-term Treasuries and 20% short-term Treasuries. We removed the small-cap stock exposure to reduce volatility, increased large- and mid-cap international equity exposure for diversification purposes and doubled the exposure to short-term bonds. The change reduced annualized returns by about half of a percentage point (to 5.3%) while cutting the level of volatility by nearly two full percentage points (to 6.1%). The 40/60 mix held up well for retirees following the 4% rule, with the portfolio lasting for a full 35-year period 86% of the time.

Asset Allocation Models and My Portfolio

The current allocation models shown on AAII.com will be revised to reflect these changes. We will also be updating the Diversification Analyzer in My Portfolio to reflect the changes as well. (My Portfolio is our portfolio tracking tool launched earlier this year. Many AAII members are already using it; if you have yet to, consider doing so today.) The tables below show the different iterations of each allocation model, with changes to weightings highlighted in blue.