Asset Allocation by Age

How many investing textbooks and websites out there recommend that, when it comes to asset allocation by age, you should roughly own your age in bonds? Hundreds of thousands. It’s one of the most basic rules of thumb.

How many times have I advised the same to friends?!

Only… according to this research this is the complete opposite of what you should be doing!

If you go through the paper you’ll see 3 asset allocations backtested side by side for 40 year working lifetimes over real historical data:

    Traditional: Begin with 80/20 stocks & bonds, transitioning to 20/80

    Fixed: Stay 50/50 the entire time (the average of Traditional)

    Contrarian: Begin with 20/80, transitioning to 80/20. What?! Never! Danger!!

But as you can see in the paper, Contrarian results in not only a larger average nest egg at retirement, it even beats Traditional when you hand pick the worst cases!

I couldn’t believe that this wasn’t some artifact of data mining, so I decided to repeat the experiment myself a different way.

I looked up the 85-year average return (μ) and standard deviation of returns (σ) for two USA indexes: one for stocks, one for bonds. I got this:

USA Total Stock Market
USA Short Term Gov’t Bonds

Next, I programmed Matlab to generate normally distributed returns with the above characteristics and just compared the 3 asset allocations’ performance over about a bazillion 40-year periods (rebalanced annually) to see what $1 grew to. Stand by for my beautiful console output:

asset allocation by age

…and there you have it. Contrarian (far right) equals or beats Traditional (far left) at every decile. And interesting how well 50/50 performs on the low end. I threw in min and max too but I wouldn’t pay too much attention to them. They’re the tail ends of the distribution and change every time you re-simulate (sometimes Traditional wins, in this case it lost).

How could we possibly explain this? It’s easy, actually. The Contrarian approach puts you more into stocks when your nest egg is bigger. More money at (systematic) risk means a higher return. Sure, your portfolio might get whacked right before you retire, but it’s grown to such a large value that you still end up coming out ahead!