Everyone has heard that stocks are risky. If you want to be conservative and not lose money in the market, bonds are the way to go. But what if holding bonds in your retirement portfolio is a greater risk than holding stocks. Most people think of risk as volatility. For purposes of this post, let’s define risk as the chance of running out of money towards the end of your retirement.
In Warren Buffet’s annual 2013 letter he discusses the direction that he has given in his will for how to handle money left for his wife, found below.
Excerpt from 2013 Annual Letter
“What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit … My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals— who employ high-fee managers. Buffett [2013, p. 20]”
When I read this advice, I was initially a bit taken back given how contrary it is to popular asset allocation advice. I’ve always heard that your stock allocation should be 100 minus your age. The remainder would be bonds. Another popular asset allocation is 60% stocks and 40% bonds, which we’ll explore later in this post. But having read all of Warren’s annual letters he has always ignored volatility in favor for the highest return over a long-time horizon. The thought process is that a portfolio that is down 20% in any given year but returns an annual return of 9% over a 10-year period is more attractive than a portfolio that returns a consistent 7% every year with little volatility.
Testing Warren’s Advice
I came across an excellent research piece “Buffet’s Asset Allocation Advice: Take it…with a Twist” by Javier Estrada who is a professor of finance at the IESE Business School in Barcelona, Spain. I recommend reading it for yourself. Javier creates 8 different portfolio’s ranging from a 100% stock and 0% bond allocation to 30% stocks and 70% bonds. Assumptions of the analysis are an initial investment of $1,000, a 4% annual withdrawal rate adjusted each year for inflation, a retirement period of 30 years, and he begins his back testing in the year 1900 which allows for 86 30-year periods. He defines a failure as running out of money at year 30.
| Allocation | 100/0 | 90/10 | 80/20 | 70/30 | 60/40 | 50/50 | 40/60 | 30/70 |
|---|---|---|---|---|---|---|---|---|
| Failure | 3.5 | 2.3 | 2.3 | 1.2 | 0 | 1.2 | 3.5 | 12.8 |
| Average | 3,232 | 2,638 | 2,116 | 1,661 | 1,267 | 930 | 647 | 423 |
| Best 5% | 10,882 | 7,820 | 5,529 | 3,943 | 2,837 | 2,161 | 1,613 | 1,196 |
| Worst 5% | 20 | 42 | 58 | 86 | 93 | 38 | 1 | 0 |
The first number in the above chart is the stock percentage, thus the first column is 100% stocks and 0% bonds. As you can see the failure rate is in a tight range from 0 to 3.5% in the 100% to 40% stock allocation scenarios. The 30% stock allocation jumps to a 12.8% failure rate, disproving the common misconception that bonds have less risk. What is most interesting is the upside potential of the various scenarios. The average line in the chart provides what the average amount of money remaining after withdrawals at year 30. Looking at the average portfolio value at the end of 30 years the 90/10 split is twice the amount of the 60/40 allocation. While the 60/40 asset allocation is the only scenario with a 0% failure rate, if one is willing to accept a little more risk to a 2.3% failure rate, they have the potential to double their upside. This amount at the end of year 30 will either be a larger inheritance to leave loved ones or additional income if your retirement extends more than 30 years.
To further explore the upside and downside potential Javier provides the average amount in the worst- and best-case scenario in the top and bottom 5% probability ranges. In the worst 5% range you would have 42 dollars in the 90/10 split and 93 in the 60/40. Only one year’s difference of living expense given the 4% withdrawal adjusted for inflation based on the 1,000-initial value. The surprise is on the upside. In the best 5% range your upside in the 90/10 split is 7,820 compare to 2,837. That’s a difference of close to 100 years of living expense.
Can Buffet’s Advice be Improved?
Javier improves on the 90/10 split one step further. In years when the stock market is down, why not withdraw money from bonds? Withdrawing money from bonds while stocks are down will give stocks time to recover. Rationally, the idea seems like it will work and that is exactly what Javier proves. The Twist as he calls it, requires a retiree to compare the stock return year over year. If stocks have done worse than the previous year, then withdraw the 4% from bonds and do not rebalance. If stocks have done better, then withdraw the 4% from both stocks and bonds in a ratio sufficient to maintain the portfolio at a 90/10 split. Below is the comparison of how this improves the performance of the portfolio.
| Scenario | 90/10 | Twist | 60/40 |
|---|---|---|---|
| Failure | 2.3 | 2.3 | 0 |
| Average | 2,638 | 2,726 | 1,267 |
| Best 5% | 7,820 | 7,919 | 2,837 |
| Worst 5% | 42 | 110 | 93 |
The failure rate stays the same at 2.3 but every other metric improves. The only negative that a retiree needs to accept is the 2.3% failure rate verse the 0% of the 60/40.
Conclusion
Unsurprisingly Warren Buffet’s advice to his wife is both simple and effective. The additional work on the part of the retiree described as the twist has shown on historical data to improve performance. Either the 90/10 or twist variation would prove to be satisfactory, but more importantly Javier’s work has shown that holding a high percentage of bonds may prove to be riskier than the common perception.