Portfolio design and rebalancing is both a science and an art. Understanding the science is akin to understanding the physics of why a spinning ball hooks and bends. The art is the execution of the science such as when you are actually playing soccer or golf. It is the execution and follow-through that produces the desired outcome.

Science of a Bond Allocation

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.

A stability allocation helps you have enough money to meet your withdrawal needs by dampening the volatility of stock returns. However, having too much in bonds means that you might not have enough growth and end up running out of money.

An appreciation allocation helps you have enough growth in your portfolio to compound your savings to meet your financial goals. However, having too much in stocks risks having to take money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover.

An all-bond or all-stock portfolio can be projected and the difference between them measured, but the value of not running out of money when making withdrawals cannot be measured. That is why the optimum asset allocation is priceless.

One standard deviation of 7-year stock market movements is all positive. For this reason, we recommend having 5-7 years of your withdrawal needs invested in bonds. This way, you likely won’t have to sell your stocks when the market is down.

When it comes to college planning, setting the asset allocation for your child’s 529 plan can be difficult to decide. When they are younger, college is just a distant financial goal and the volatility of a 100% stock portfolio provides helpful appreciation. However, as they approach college, the volatility of the markets may jeopardize the success of the plan.

That being said, if you keep in mind the goal of having seven years of safe spending in bonds, then the asset allocation is easier to set.

Let’s assume that our bond allocation returns 3% per year over inflation and my child is spending a variable amount from our portfolio over the next seven years.

The money we need to spend within the next year needs to be 100% represented in my bond allocation because it won’t have a full year of growth.

The money we need to spend one year from now though will have one year of growth. Because over the next year, it should grow by 3% real return, I only need 97.09% of the year two expenses represented in my bond allocation. This is 1 divided by 1.03 raised to the one year of growth, 97.09%

For the third year, the assets will have two years to grow before I need to spend the money. This means, I only need to have 94.26% of the year three expenses in my bond allocation. That is 1 divided by (1.03)^2 years of growth.

In this way, the formula for calculating the necessary allocation for any given year is:

1 / (1 + real return)^(number of years)

For a 3% real return, the bond allocation table is:

Years Until You Spend It	Necessary Bond Allocation
1	100.00%
2	97.09%
3	94.26%
4	91.51%
5	88.85%
6	86.26%
7	83.75%

 

Investments with a time horizon of seven years or longer are probably best put into stocks, as one standard deviation of average 7-year stock market movements is all positive.

Example: A 15-Year-Old’s 529 Allocation

Here’s how you could use this table. Let’s imagine that you own a 529 plan for your 15-year-old child who is planning to go to college when they turn 18 in three years and then spend down the account for the next four years.

Your projected expenses look like this:

Age	Projected Expense
17 and younger	$0
18	$30,000
19	$30,000
20	$30,000
21	$30,000
22 and older	$0

 

To determine how much to allocate to Bonds, you can multiply by the necessary bond allocation and then sum like this:

Years	Age	Expense	Necessary Bond Allocation	Bond Allocation
1	15	$0	100.00%	$0
2	16	$0	97.09%	$0
3	17	$0	94.26%	$0
4	18	$30,000	91.51%	$27,454
5	19	$30,000	88.85%	$26,655
6	20	$30,000	86.26%	$25,878
7	21	$30,000	83.75%	$25,125
			TOTAL	$105,112

 

This would suggest having $105,112 allocated to bonds for this 15-year-old.

Sometimes it is difficult for parents and grandparents to have a more conservative portfolio for their children’s college education than for their own retirement. The difference is that the money will be needed sooner and faster than longer term and slower paced retirement needs.

With expenses up and coming, it makes sense to have the money staged ready to be spent. It does not matter that the child is only 15 years old. They will be spending those assets within the next seven years.

This type of planning can also be helpful if you have over funded the 529 plan. Imagine that your child’s 529 plan has $210,224. If only $105,112 needs to be allocated to the bonds, the remainder can be allocated to stocks.

Having over funded a 529 plan is not necessarily a bad idea since any excess funding can be saved for future schooling or future generations.

Example: A 13-Year-Old’s 529 Allocation

Taking the same example, imagine that your child is just 13-years-old and has 5 years until going to college at age 18 rather than 3 years. The next seven years of withdrawals would look like this:

Years	Age	Expense	Necessary Bond Allocation	Bond Allocation
1	13	$0	100.00%	$0
2	14	$0	97.09%	$0
3	15	$0	94.26%	$0
4	16	$0	91.51%	$0
5	17	$0	88.85%	$0
6	18	$30,000	86.26%	$25,878
7	19	$30,000	83.75%	$25,125
			TOTAL	$51,003

 

At age 13, only the first two years of college are within our seven year window. This would suggest that only $51,003 should be put into more stable bond investments.

Art of a Bond Allocation

You can see from these examples that as college expenses approach, you’ll want to add more and more bonds to the 529 allocation. However, taking money out of stocks when stocks are down is harmful to the plan whether you do it seven years in advance for a bond allocation or right before you spend it.

This is where the artistry of asset allocation comes in.

It is best to adjust your asset allocation to be more conservative when the markets are doing well. That means that making this important adjustment is the most helpful when it is the most difficult.

In contrast, after stocks have suffered a large loss isn’t a good time to make this adjustment either. If you sell your stocks at relative lows to buy bonds at relative highs, you are locking in your stock’s losses. Unfortunately, when stocks are down, most investors long for the stability of bonds and thus are inclined to make this troublesome mistake.

Adding more Stability to an asset allocation isn’t an easy issue. It takes science to know how much bonds you need. It takes artistry to gradually adjust your asset allocation over time.

Photo by Ben White on Unsplash