Bernstein: Retirement Allocations for 3 Age Bands

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference, and I'm joined today by investment expert Bill Bernstein. Bill, thank you so much for being here.

Bill Bernstein: My pleasure.

Benz: Bill, your latest e-book is called If You Can. It has some great guidance for people just getting started in creating an investment plan. I'd like to start with some of the key pieces of wisdom that you have for maybe people in their 20s and 30s just starting out. What should their asset allocations look like and also what should their savings rates look like?

Bernstein: Well, I divide the age bands into three of them. One is the early one, the people or the person who is 20 or 30 or 40 years old. And then, there is a middle, where the person has significant assets but is still saving. And then finally, there is the distribution phase. And I start, logically enough, with the first phase. And from a strictly mathematical point of view, that person should be investing 100% their money in risky assets because their human capital is so much larger than their investment capital. If you're a typical 20- or 30-year-old person, you may have a couple of million dollars of human capital of future earnings over the course of your life. And if your $50,000 portfolio decreases by half or three quarters, it logically shouldn't affect you that much.

The problem with that point of view is that most young people are not terribly risk-tolerant, and the first bear market they run into often causes them to go off risky assets for the rest of their lives. So, I recommend a somewhat more conservative course until that person has encountered their first bear market, and then you see how you respond. If you bought more risky assets and you kept up with your plan, then by all means increase your equity allocation up from 50% or 60%, which is where I think you should start. If you panicked and sold, maybe you should only be for the rest of your life at 30% or 40% or until you learn to become more risk-tolerant.

The next stage that I deal with illogically enough is last phase, the distribution phase, because the person who is retired and has no more human capital left can't make up for a bear market. And if that person gets a particularly bad sequence of returns--that is, stock returns that are poor--early in retirement, then they may be in very deep trouble if they have an aggressive portfolio.

So, the concept that I talk about in the book is that of a liability-matching portfolio, which is a stream of [Treasury Inflation-Protected Securities] or an annuity or of at least short bonds, depending upon how much sheltered assets they've got, that will take them through retirement, which should be fairly sacred. And then, every bit of money they have on top of that can be invested in risky assets, which may not be very much since they may need every last dollar they have saved to retire.

The middle phase is the most difficult because that's where you've got to transition from being hopefully very aggressive to a more conservative portfolio. That's where I think that Wade Pfau and Mike Kitces have the right idea--that you start at a very low or a relatively low stock allocation and then work up. And the easiest the way to think about that and the way I rationalize their findings is simply to say that the size of your liability-matching portfolio, the safe part of your portfolio, falls in value as you age. You don't need as much when you're 80 as when you're 65 to see you through. So, naturally, the percent of stocks that you own are going to increase in that scenario, since the money you've got in risky assets really isn't for you; it's for your heirs and for your charitable bequests.

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Benz: You obviously know a lot about asset allocation. I'd like to discuss the role of international equities in investor portfolios. I noticed in the starter portfolio that you recommend for millennials you include equal allocations to U.S. and foreign equities. Is that something that you would recommend even for investors at later life stages?

Bernstein: The global-market basket of stocks, the global stock market, is not a bad place to start. And I think now it's 55% foreign, roughly 45% U.S. I don't think that that heavy of a foreign allocation is necessarily appropriate for most people. In the distribution phase, of course, you're spending in dollars. So, you've got to better match with the U.S. But even during the accumulation phase, most people are going to be investing inside of a sheltered environment, and they don't get the foreign tax credit on the withholdings. It's also more expensive to invest abroad as well.

And then, the final problem is the vehicles. This is a relatively small point, but total stock market or total global stock market funds tend to be, for some odd reason, a little more expensive in terms of their expense ratio. You're better off buying, let's say, a total stock market open end or ETF fund in the U.S. for 5 basis points and buying an international part for maybe 15 basis points rather than spending 25 or 30 basis points for the total product.

Benz: So, it sounds as though you're saying that the importance of having foreign diversification maybe that's more valuable when you're younger and that you want to step off that as you get closer to needing your money, as you get closer to spending your money?

Bernstein: I think that's the correct way to look at it. Now, there is another thing that we haven't talked about, which is that foreign stocks right now are at least moderately cheaper than U.S. stocks are. So, that's one reason that perhaps you should step your foreign allocation up. I think that, right now, a 40% or a 45% foreign allocation for the average investor is not inappropriate.

Benz: I'd also like to discuss the topic of how you set your emerging-markets allocation. One thing that you once said that has stuck with me is that the beauty of emerging-markets stocks is that periodically they get good and cheap. I'd be curious to hear if you think where they are now, do you think emerging-markets stocks are actually pretty inexpensive?

Bernstein: The point of maximum cheapness has probably already been passed. That was this year. But I think that emerging-markets stocks, now that they've fallen out of favor, are certainly a good place to go, and that should be a part of your total international allocation.

I think it's an interesting point that when you hear a lot of people talking about putting an asset class into an asset allocation and everybody is saying the same thing, that's generally a bad idea. Three or four years ago people were saying that the emerging markets weren't as affected by the global downturn and you should invest in those. Well, that turned out to be a bad idea. Now people are saying the opposite, and now I think it's a good time to invest.

Benz: On the flip side or in a similar vein, one deeply unloved asset class right now is precious metals, which was very much in vogue a few years ago. You think it's also a pretty interesting time to be looking at that asset class, too.

Bernstein: I do. It's a market that I've always been interested in. I've been following precious-metals equities for the past 25 or 30 years, and it's important to understand how this asset class behaves in the long term. It has very low long-term returns. If you look at Ken French's series, which goes back more than a half century, the return if you count the most recent declines probably comes out to be less than 5% per year nominal, which is 1% more than inflation over that period, which was 4%. So, it has gotten very low returns. It has bone-crushing volatility. Now, three times in the past 50 years, it's fallen in price by approximately 70%.

So, why do we even want to own this asset class? Well, it occasionally zigs. When the overall market sags, it does particularly well. When there is high inflation--and one of the reasons why it has done so poorly recently is that inflation hasn't turned up--it turns out that even with its high volatility and its crummy returns, adding several percent of it to your portfolio does improve its behavior. It improves its return and it improves its volatility as well; it lowers its volatility.

Three years ago, if you had had the temerity to suggest that it might not be a good thing to put in your portfolio because it was being talked up so much, you had your intelligence and your honesty and perhaps even your parentage questioned. Now, I think it's probably not a bad time to be adding it to your portfolio, if you don't have it there already. And if you do have it there, now might not be a bad time to increase your allocation.

Benz: Bill, thank you so much for being here. It's always a treat to hear your insights.

Bernstein: My pleasure.