Below is the analysis of a basic portfolio for a retired investor. It is a simple portfolio consisting of five asset classes including cash. The asset classes include U.S. equities, developed international equities, REITs, fixed income, and cash. I used TIPs for the fixed income asset class instead of long-term bonds such as BND or AGG.*
How well does the portfolio listed below match recommendations by Zvi Bodie in this video? What are the drawbacks to this portfolio? See comments below the screen shot. When you lock on to the Bodie web site, note the number of links on the left side for more information from Dr. Bodie.
* An almost identical portfolio is recommended in a very popular investment book.
Premium readers have seen portfolios that have higher projected returns and lower projected risks giving significantly higher Return/Risk ratios. In addition, we can create portfolios that are better diversified by adding a few more asset classes. Missing in this portfolio are emerging markets and commodities.
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The portfolio shown below is one designed for the investor in their 30s or 40s. Note the lower projected risk (11.2%) percentage that arises due to adding a number of asset classes to the basic four-factor portfolio. I used four years of data for this analysis so as to minimize the severe bear market of 2008 and early 2009. An inflation rate of 3.5% was assumed for this analysis.
While the projected return for the S&P 500 is a modest 7.3%, this portfolio falls short with a projected return of 6.0%. It is never a good idea to rely on a portfolio that will not keep up with the S&P 500, so additional tweaking is necessary to revive this portfolio to meet our expectations of bettering the market.
Premium Content readers will soon see a portfolio that projects a return 100 basis points higher than this portfolio and nearly 300 basis points lower risk. How is this possible? Check it out.
In this correlation matrix, we see AGG and VIPSX are the only two investments that bring significant diversification to the portfolio. AGG is the iShares Lehman Aggregate Bond Fund and VIPSX is Vanguard’s Inflation-Protected Securities. Instead of VIPSX, as recommended in the book where I picked up this portfolio, I would rather use TIP as my inflation protection investment.
Checking the above screen shot, you will note the Diversification Metric is 31% or shy of our expected diversification of 40%. The lack of low correlated assets accounts for much of this problem.
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The following portfolio holds the same four investments as the portfolio I analyzed last week for the young investor. It is a four-factor portfolio, only this time the percentages allocated to each asset class differ. This portfolio leans to the conservative side and as a result the projected return and risk are lowered. I suspect most mid-aged investors will find this portfolio too conservative. Note that the Diversification Metric (DM) is a disappointing 18%. We can do better by adding more asset classes.
Scroll down the page to see why this portfolio is much too conservative for a middle aged investor.
The portfolio planning report below assumes the investor is 45 years of age, will retire at age 68, has $240,000 saved, adds $1,000 per month to the portfolio, expects an inflation rate of 3.5%, and will live on $50,000 per year plus social security and any income from a pension. Note the 50 percent chance or running out of money eight years following retirement. Obviously, changes need to be made. Either one saves more, works longer, or alters the construction of the portfolio. Likely all three need to take place in order to lower the probability of running out of money before death.
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