Asset Allocation: Fixed Income

On 02/07/2011, in Asset Allocation, by Jordan Wilson

Fixed income is the second core asset class.

Here we can start to look at percentage allocations when investing.

Again, the investor profile will determine the appropriate amount to invest in fixed income.

Within the profile, the phase of one’s life cycle and the investor’s risk tolerance are keys.  

Fixed Income Recap

Fixed income normally includes bonds, debentures, notes and preferred shares.

Fixed income is generally higher risk and higher return than cash equivalents. But it has a lower level of risk and expected return than common shares.

People who desire a constant stream of income liked fixed income.

What about the suitability of fixed income for those in the different phases of the life cycle?

Fixed Income for Accumulators

Not Really Suitable Investments

The logic goes that Accumulators tend to be young, with extremely long investment horizons. As a result, they can better absorb the fluctuations of higher risk and higher return investments than those in other phases of life. Because of this, Accumulators tend not to emphasize lower risk fixed income in their portfolios.

I agree with this logic.

Unless extremely risk averse, Accumulators should not invest heavily in fixed income assets.

But Do Not Exclude Completely

But that does not mean they should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.

For example, consider a few current inter-asset correlations.

From the website Asset Correlations, as at February 4, 2011, the 1 year correlation between U.S. Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.32; U.S. Mid Cap Stocks −0.31; U.S. Small Cap Stocks −0.30; EAFA Stocks -0.26; Emerging Market Stocks -0.26.

If you recall our discussion of correlations, combining two assets with negative correlations is very beneficial in reducing portfolio risk.

For a refresher on diversification and asset correlations, please review here and here.

When we look at alternative asset classes, we shall see that fixed income can also enhance diversification. Consider the latest 1 year correlation between U.S. Bonds and: Commodities −0.24; U.S. Real Estate 0.12; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.

And do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between U.S. and Emerging Market Bonds is only 0.05. So there is value in diversifying within the asset class.

The Magic Number

I believe that Accumulators should include a percentage of investable assets in fixed income. For diversification if nothing else.

But I do not personally believe that most Accumulators should invest more than 50% of their investable assets in fixed income. I likely would not recommend 50% in fixed income even after backing out one’s cash equivalent component. That is because the time horizon is so long that investing in riskier assets, with higher long-term expected returns, makes more sense.

For the generic Accumulator, I might recommend somewhere between 5%-25% in fixed income. This assumes someone with a moderate risk tolerance and whose cash component, as a percentage of total wealth, is roughly 20%.

It also assumes that the fixed income itself is diversified. Something that should be done when investing in any asset class.

Where you fall in this range will depend on your risk tolerance and amount invested in cash.

Fixed Income for Consolidators

Consolidators are older, but still have lengthy time horizons in which to invest. Consolidators should have some wealth accumulated and their investments in cash equivalents will reflect this. Perhaps 5-10% of total assets will be in cash.

Not the Best, But Not Bad

Because of the relatively long time frame, fixed income should not dominate the portfolio. Rather, the focus should be on investments with greater capital growth potential.

Same as with Accumulators.

Becomes Better With Age

As the time to retirement shrinks, Consolidators should increase their allocation to fixed income. This will solidify previous accumulated portfolio gains and begin to generate stable income flows for retirement.

But not too much, as we shall see below.

The Magic Number

For the generic Consolidator, 10%-30% allocated to fixed income may be appropriate. The increase from the Accumulation phase simply reflects a reduction in necessary cash equivalents to about 5%. The suggested allocation also takes into account that Consolidators often invest in alternative asset classes.

One’s risk tolerance will determine the appropriate allocation.

If you are extremely risk averse a higher percentage allocated to fixed income may be appropriate. It is your portfolio. You need to be comfortable with your investments. Because it is also your (potential) ulcer.

Finally, the extent that you invest in non-traditional investments (e.g., derivatives, commodities, venture capital, etc.) will impact your ultimate allocations.

The wider you spread your investments, the less that is usually allocated to any one class. How you diversify your portfolio will depend on your investment knowledge, comfort level, risk preferences, asset correlations, and the like.

Fixed Income for Spenders

Spenders are usually individuals at retirement age. Employment or business income has ceased and Spenders need to live on their pensions and savings.

Spenders are generally risk averse. This reflects the reduced time horizon for surviving asset volatility.

Because of this, Spenders traditionally invest primarily in fixed income and cash equivalents.

Now We Are Talking

These asset classes provide the stability, consistency, and liquidity Spenders want.

So many Spenders invest 80-90% of their wealth in cash and fixed income.

However, the trade-off for low risk investments is a low return.  And that is a problem.

Too Much of a Good Thing

Today, many people retire between 55 and 65. Yet many retirees now live until at least their 80s. That means Spenders may need to live off their savings for at least 25 years. Maybe more.

That is a long time to survive on investments with low returns.

With longer lives (and investment time frames), Spenders should strongly consider maintaining a portion of assets in investments with potentially higher returns.

I would suggest that investors do not allocate 80% to cash and fixed income. Keep a portion in equities and other asset classes with better expected returns.

The Magic Number

For the generic Spender, at retirement perhaps 30%-40% in fixed income is suitable. That would assume about 10% in cash equivalents at that date.

As one continues to age, additional assets should shift into cash and fixed income instruments.

Personal factors need to be taken into account. Theses include: health situation; family history of death age; wealth accumulated; cost of living; prevailing interest rates.

If you expect to live until 110, you need to plan for that in your investing and drawdowns.

If your accumulated wealth is high, you can take a safe investment path. But if you have not saved enough for retirement, you may want or need to try and generate greater returns with riskier assets.

If interest rates are low, your level of income will also be low. If it is insufficient to cover your mandatory costs, you may also need to try to boost returns with higher risk investments.

So where you are at retirement will play a significant role in your actual asset allocation.

And, as is always the case, your personal risk tolerance will also play a part in the allocation. Both at retirement, as well as how you reallocate during your retirement years.

Most Spenders should have relatively low risk tolerance. This reflects the lack of other income on which to live and the reduced investment time frame.

But some Spenders may be extreme and want almost everything invested in safe investments. They will sacrifice some income in order to sleep well at night. Other investors with higher risk tolerances may ignore the shorter time horizon and still want a significant portion of their assets in less stable investments.

Next, equities.

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