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Age-based Bond / Stock Ratio

Age-based models for determining the bond/stock ratio in an investment portfolio are a popular strategy for managing risk and optimizing returns over time. The principle is to allocate a higher percentage of your portfolio to bonds as you age, reducing exposure to the more volatile stock market. This model aims to decrease portfolio volatility as you near retirement, protecting your nest egg from market downturns. Historically, bonds have been less volatile than stocks, providing a safer investment as you age.

However, this approach simplifies the patterns of human capital dynamics and overlooks the volatility of your human capital and its dependency on other assets, such as rental income and stock plan compensation, varying risk tolerance, financial goals, and market conditions.

Evaluate the stability and volatility of your human capital, including job security, income variability, and other financial commitments. Incorporate other income sources and assets into your investment strategy. For example, if you have stable rental income, you might afford a higher allocation to stocks. By integrating these elements, you can create a more robust and personalized investment strategy that better matches your unique financial situation and goals.

A common rule of thumb is to subtract your age from 100 (or 110) to determine the percentage of your portfolio that should be in stocks. For example, if you are 30 years old, 70% of your portfolio should be in stocks and 30% in bonds. This approach aims to balance growth potential with risk management, as bonds typically offer more stability and lower returns compared to stocks.

Assuming an 80/20 stock/bond split, the next step is to determine the allocation between US and international (ex-US) stocks. Vanguard recommends a 60/40 split; the volatility-minimization evidence under geographic diversification above is flat across roughly a third to half of the equity sleeve, so precision here is wasted — what matters is not sitting near zero.

The stock/bond allocation depends not only on your retirement horizon but also on how close you are to your capital accumulation target and your personal temperament. If a market crash tempts you to sell stocks, it may indicate a need to shift more towards bonds. What matters most is having a plan you will hold to, regardless of market fluctuations.

However, focusing solely on bonds and stocks overlooks the potential benefits of diversifying into other asset classes. Including a variety of asset classes can improve portfolio performance and reduce risk through diversification.

So, consider whether to invest in additional asset classes. real estate investment trusts (REITs) behave like a third asset class,103 so let’s include a small investment in REITs for diversification. Since REITs are stocks, they will be part of our stock allocation. We’ll allocate 5% of our total portfolio to REITs. The 5% is a convention — large enough to register, small enough that being wrong about it cannot hurt; nothing in the data distinguishes it from 3% or 8%.

Our model portfolio looks like this: 75% stocks, 20% bonds, 5% REITs.

Applying the 60/40 US/ex-US split, we get:

If your choice of funds is limited, such as in a 401(k) or HSA, and does not include a total U.S. stock market fund, you can replicate the total U.S. market using the Institutional Index Fund (which tracks the S&P 500) and the Extended Market Index Fund (which tracks the remainder of the U.S. market, S&P Completion Index). Hold them 80/20, matching the capitalization split above. This results in:

This allocation aims to closely mirror the performance of the total U.S. stock market by combining the large-cap exposure of the S&P 500 with the mid-cap and small-cap exposure of the Extended Market Index.

For international investments, the split is between developed and emerging markets. Vanguard Total International Stock ETF (VXUS) is essentially a combination of Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets ETF (VWO), as they all track FTSE Russell indices. Compare the expense ratios — VXUS(.08%), VEA(.06%), VWO(.08%) — and note that VEA is the larger component of the blend. You can replicate VXUS by purchasing approximately $3 of VEA for every $1 of VWO, reflecting the market capitalization ratio of developed to emerging markets. While the fee saving is insignificant, the split allows rebalancing between these classes.

For an 80/20 stock/bond ratio without a separate REIT sleeve, the allocations would be:

Total: 38.4% + 9.6% + 32% + 20% = 100%

To either of the above, add a money-market fund for cash reserves (such as Vanguard Federal Money Market Fund (VMFXX)), if you don’t have a savings account that earns a high interest rate. This is a simple, institutional-grade, low-cost structure. Historically, such passive index strategies have a high probability of outperforming actively managed portfolios. If you meet the investment minimum, prefer Vanguard’s Admiral Shares to the Investor Shares. They contain the same holdings, but have a lower expense ratio.

Debt (such as a mortgage) is a negative bond (section “The Mortgage as a Negative Bond”): a principal payment earns a guaranteed return equal to the loan’s after-tax interest rate, just as a bond coupon would, and it shrinks a negative position where buying a bond grows a positive one. That does not mean a borrower needs no bonds. Net the two only when the arithmetic says to — prepay when the after-tax mortgage rate exceeds the after-tax yield on a bond of similar duration, and hold the bond when it does not (section “Prepay or Invest? Compare the Right Two Things”); a 3% mortgage against a 4.5% Treasury is a positive spread, not a reason to be bond-free. And keep the part of the bond sleeve that does a job prepaid principal cannot: it can be sold to rebalance into a drawdown or to fund spending, while equity locked in a house cannot.

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