What's the Right Asset Allocation?

A new book can help us answer this age-old question

New research can help us with an age-old question: When constructing a portfolio, how much risk is too much? Especially today, with the market again near all-time highs, this is an important question.

You may be familiar with the so-called 4% rule, which is a guideline for sustainable portfolio withdrawal rates in retirement. Financial planner William Bengen first developed this research back in the 1990s, and over the years, he’s continued to examine the question from new angles.

When Bengen rolled out the first version in 1994, he made a simplifying assumption. In each of the scenarios he examined, he assumed the same asset allocation: 50% stocks and 50% bonds. That made sense because Bengen’s primary focus at the time was not on asset allocation but on withdrawal rates. In his new book, though, titled A Richer Retirement, Bengen considers other allocations. The results are extremely useful.

In looking at the full set of asset allocation options, Bengen found there to be an optimal range: Allocating between 45% and 75% of a portfolio to stocks led to the highest long-term sustainable withdrawal rates. Why? Allocations below 45% caused portfolios to lag behind inflation. Allocations over 75%, on the other hand, ran into trouble because they couldn’t recover from deep market downturns. But between 45% and 75%, Bengen found, an initial portfolio withdrawal rate of close to 5% would have been sustainable throughout a 30-year retirement.

This new data is helpful in two ways. First, it reinforces a point Bengen has always emphasized: that despite others calling it the “4% rule,” he himself never saw it as a rule. In his own work with clients, Bengen said, he regularly used 4.5%. And depending on other variables, such as the investor’s age, he felt that withdrawal rates could be even higher.

Another way this new research is helpful: It addresses a weakness in the traditional approach to asset allocation, which is that it tends to break down for higher net worth individuals.

Consider someone like Bill Gates. He could afford any asset allocation at all. If he held all his assets in bonds, the value of his portfolio would erode due to inflation, but because of its size, that erosion wouldn’t really affect him. For a similar reason, he could afford to keep everything in stocks. Market downturns would impact his portfolio, but never enough to affect his lifestyle.

While Bill Gates is an unusual case, I’ve found that this dynamic begins to apply even for “ordinary” millionaires. And while it might seem like a good problem to have, it does complicate the asset allocation decision because it means there’s no quantitative reason to choose one allocation option over another.

But with Bengen’s new research, investors now have a more tangible guideline. Even Bill Gates, the data tell us, should maintain an asset allocation within that 45% to 75% range.