Searching for the Perfect Portfolio – Part 5

search4In the previous parts we have looked in detail how various portfolio allocations might affect our retirement income. In each cases we started with a portfolio that has values USD 600k five years before the planned early retirement date. But unless you have 600k in hand, we need to earn it somehow. Let’s see how to get there!

In this part we’re gonna talk about the wealth accumulation phase. Unless you have a big load of cash to start with, this phase will be long, and you will need to appreciate every little progress on the way. This is where I am at the moment and I am expecting this phase to last for about 10-12 years (of course depending on Mr. Market plus the amount we can save each month it can be longer or shorter). Let’s see what could be the best portfolio allocation during this period (I am only going to check equities and bonds here, disregarding real estate, gold, antiques, baseball cards etc.).

Historically (which is never a guarantee for the future, just ask our Japanese friends) equities offer the highest long term returns. This return on average (taking both bubbles and market crashes into consideration) is yearly 6.8% above inflation. It sounds reasonable that a portfolio in the wealth accumulation phase should consist solely or at least mainly equities. Bear in mind that this might mean a bumpy ride on the way; just have a look at the charts in any of the previous part of this series. But there is no big reward without a risk. The below graph clearly shows this:

stockbond

source: www.mymoneyblog.com

As you can see a higher return comes with a higher deviation. It is also interesting to see the increasing deviation when increasing the bond ratio from 80% towards 100%. One more reason to diversify even the safest assets! Also note that as you move towards a 100% stock portfolio, the curve gets flatter, meaning that you go for a bit higher return, but what you also get is a much higher deviation.

It is also interesting to check the below chart from Credit Suisse:

stockbond2

It shows the best, worst and average return of the various portfolio allocations. Note that from around 80% equity weight onward the risk increases more than the return.

How much risk you are willing to take in exchange for higher returns is totally up to your individual risk tolerance. I personally think that in the wealth accumulation phase you need to take more risk and go for at least 70-80%, or potentially even 100% equities.

These studies take a fixed portfolio ratio allocation into consideration. But would it make sense to keep a certain percentage of bonds in the portfolio solely for the purpose to reallocate it to equities when the market crashes? This is what I will check in the next part.

You can find the other parts of the Searching for the Perfect Portfolio series under the below links:

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  1. Mustard Seed Money October 10, 2016
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