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Investing Specialists

Your Stock/Bond Mix Isn't the Only Thing That Should Change as You Age

Tweaking intra-asset-class exposures is also important.

If there's one matter upon which there's universal agreement in the realm of investing, it's that your portfolio's stock/bond mix should get more conservative as you age.

But what about the composition of those asset classes--should they change, too? For example, even though the equity component of a 34-year-old's portfolio will be larger than that of a 70-year-old, should the composition of those equity components look any different?

I've given a lot of thought to this question during the past year, particularly because of the varied pieces of advice being offered about bonds. On one hand the estimable author and investment advisor Bill Bernstein has said that you should just keep your bond portfolio short (that is, limit its interest-rate sensitivity). After all, he argues, it's there for ballast, not to deliver explosive returns, and the downside risk of rising interest rates dwarfs the potentially higher yields you'd pick up by venturing into long-term bonds.

But let's face it--Bernstein and people like me have been saying that for a while now, and for much of the past several years, there has been a definite opportunity cost to staying short. Long-term bonds have outperformed short-term bonds over every longer-term trailing period; during the past five years, the long-term bond category has generated twice the return of the average short-term vehicle.

From this I've concluded that there's no one-size-fits-all answer to what the composition of your bond portfolio should look like--or your equity portfolio, for that matter. It really depends on who you are. If you're close to needing the money you hold in bonds--say, to fund your living expenses in retirement or fund tuition after your 16-year-old graduates in two years--by all means keep your bond portfolio short and safe, and hold some cash, too.

But if you're many years from retirement, you have less of a reason to be defensive. Yes, your bonds are there to reduce your portfolio's overall risk level, but there's no reason that sleeve of your portfolio has to have no risk whatsoever. You have time to ride out the inevitable bumps that come along with investing in riskier fixed-income assets like long-term and junk bonds.

The same logic holds true, albeit to a lesser extent, for the equity component of your portfolio. Landmark research by Eugene Fama and Kenneth French points to the notion that small-value stocks outperform larger, more growth-oriented companies over time. Based on that research, it's sensible for a young person to have a portfolio that tilts toward these names--even though they'll have periodic "off" years like they experienced in the late 1990s. A senior might also maintain a slight tilt toward small-value stocks; after all, if the portfolio is constructed correctly, she might not need that money for another 10 years. But such a tilt should be subdued, at most, because she'll have fewer years to make up for lost ground if small-value stocks go into a prolonged slump.

Of course, if you have a finite amount of time to devote to your investments, getting the big-picture stock/bond split right should occupy the lion's share of your attention, because that will have the biggest impact on your portfolio's risk/reward profile. But if you have the time and inclination to fine-tune your intra-asset-class exposure, here are some guidelines on how those allocations might change as the years go by. Figures 27-28 of this document, put together by my colleagues at Morningstar Ibbotson Associates, neatly sum up some of the key themes.

Long-Term Bonds: Decrease as You Age; Increase Short- and Intermediate-Term
The rationale here syncs up with the concept I discussed above: The closer you are to needing to spend your money, the more important it is to steer a larger share of your bond portfolio to safe, liquid assets.

For example, in Morningstar's Lifetime Allocation Indexes, the 2040 Moderate Index (geared toward investors with moderate risk tolerances with anticipated retirement dates around 2040) includes a less than 10% bond weighting. Of that, only an infinitesimal stake is in short-term bonds and the biggest position is in long-term bonds; the thinking is that such a young investor would be able to pick up a higher yield with long bonds and wouldn't be so bothered by the short-term effects of interest-rate increases.

By contrast, the 2015 Moderate Index allocates the largest share of fixed-income assets to intermediate-term bonds and also includes a larger allocation--in absolute terms and as a percentage of fixed-income assets--to short-term bonds. Long-term bonds are still there--in fact, they're roughly 25% of the bond portfolio--but they've shrunken as a piece of the pie.

Foreign Stocks and Bonds: Decrease as You Age; Increase Dollar-Denominated Exposure
The same general logic holds here, too, particularly if you hold international investments that are denominated in foreign currencies. That currency exposure can bring a valuable diversification benefit when you're in the accumulation phase, and that in turn can enhance your portfolio's return potential. But given that you'll eventually spend what you've accumulated--and likely do so by forking over U.S. dollars--you'll want to make sure that you're increasingly locking in your gains by reducing your exposure to foreign stocks and bonds as the years go by. For example, the 2040 Moderate Lifetime Allocation Index devotes 17% of its bond portfolio to foreign bonds, whereas the 2015 Moderate Index steers 12% of its bond weighting there. On the equity side, the 2040 index has more than a third of its equity holdings in foreign securities, whereas just one fourth of the 2015 Index's stocks are foreign.

Small-Cap Value Stocks: Decrease as You Age
As I noted above, there's a body of data that points to small-cap stocks, especially value names, outperforming large caps and growth names over time. But smaller-cap value stocks can and do undergo bouts of short-term underperformance, as in the late 1990s, when they underperformed the S&P 500 by an enormous margin. Their volatility, as measured by standard deviation, has also been higher than the broad market's over the past decade, even as their returns have been more than twice as high.

Taken in aggregate, those data points are a solid argument for maintaining a tilt toward small-value stocks when you're in the accumulation phase, then gradually neutralizing the exposure as you age. The 2040 Moderate Index has roughly 14% of its total equity position in smaller stocks, roughly five percentage points of which is in small-value names. The 2015 Moderate Index, by contrast, takes overall small-cap exposure down to about 10% of equity assets, though that position still skews a bit toward the value side of the style box. (For comparison's sake, the Dow Jones Total Stock Market Index has roughly 9% in the small-cap row of the style box, and is equally distributed across investment styles.) Of course, the extent to which you might neutralize such a bet depends in part on your time horizon for your stocks. If you are amassing assets that you don't expect to have to tap in your lifetime, you could reasonably have more "tilts" in your portfolio than someone using the "last breath, last dollar" model.

TIPS: Increase As You Age
The preceding points all discuss market exposures that you should lighten up as you age, with an overall goal of reducing your portfolio's risk level. But where should you be adding? In addition to adding to your portfolio's overall fixed-income stake, Treasury Inflation-Protected Securities are an area to consider increasing as a percentage of that pool. The reason is straightforward: If you're still in your working years, you have the potential to receive raises and cost-of-living adjustments, and those help offset the bite that inflation can take.

But when you retire and turn to your portfolio to fund at least part of your living expenses, the purchasing power of the money you take from that portfolio is apt to decline unless you take steps to offset it. Enter TIPS, which some academics have called the only risk-free asset because of the inflation adjustment you receive on your principal.

Morningstar's Lifetime 2040 Index has a tiny stake in TIPS--less than 10% of the overall fixed-income weighting, but the TIPS position in the 2015 Index consumes close to 20% of the bond stake. This article takes a closer look at optimal TIPS weightings for retirees. Commodities are also often posited as a way to beat inflation and could arguably take a bigger position for retirees, but the Lifetime Allocation Indexes maintain fairly static weightings across age bands, in part because of the fairly high absolute volatility of commodities investments.

A version of this article appeared Nov. 7, 2011. 

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