How to invest for retirement (or: how to construct a core asset allocation)

Want to know how to construct a diversified portfolio for retirement that will give good returns over the long haul but takes little effort to maintain? Many financial advisors would pitch their services at such a request and recommend a costly portfolio of mutual funds. Meanwhile, your friends and neighbours might tell you to put it in ETFs and perhaps even in a two or three-fund “lazy portfolio“.

In this article I discuss an approach that sits somewhere in between: a lazy portfolio of 3 bond and 4 equity ETFs which can be combined to form your total desired asset allocation and needs rebalancing at most once a year.

The reason I use more funds than just the standard all-market stock and bond ETFs is that by adding in several specific ETFs I avoid missing large market components that could drive positive returns going forward:

  • The Vanguard Total World Stock ETF is called Total World, but in reality is very US centric as it consists for 52% of US stocks given their overbearing market cap. The US market has historically performed extremely well, but some diversification is probably needed and many analysts see better prospects in foreign markets at current valuations
  • The Vanguard Total Bond Market ETF is a misnomer too, as it consists for 64% of bonds backed by one single issuer, namely the US government. Those are critical to have in your portfolio, but since their yields are pretty meagre and interest rates are going up, adding some other type of bonds in the mix needed

By adding a few more specific ETFs which for instance cover emerging market equity or non-US bonds, I can create just enough detail to capture the bulk of the market.

An appropriate asset allocation between bonds and equities by age

When investing for retirement, the standard rule used to be that a person’s equity allocation should be roughly 100%-age. So a 40 year old should invest 60% in equities, a 50 year old 50%, and so on. That meant that an average person nearing retirement at 65 would have a portfolio with 35% equities and 65% bonds. The logic is that younger people have more time to ride out the waves of the market, while older people do not want to see half their retirements wiped out by a 2008 style crisis.

As secular stagnation became all the hype over the last decade, while populations aged and expected returns were lowered across the board, many started to suggest that 100%-age might not do, and that allocation should be lifted to 110%-age or even 120%-age. Personally I would suggest to go to the middle range of that and stick to 110%-age.

Portfolio construction: combine with themes

Most of the portfolios discussed on this website deal with specific themes. These range from themes that have a longer horizon before their value becomes apparent, such as investing in frontier markets or water, to others which deal with specific events that can play out, such as a hard Brexit.

Those themes will be a good addition to your portfolio and may one day come to form the bulk of it. But when constructing a portfolio, the starting point and first two building blocks should probably be an equity and a fixed income allocation.

You can invest your assets into below portfolios based on the 110%-age in equities rule. You can then handpick themes that you feel convinced by and replace some of the bond or equity portion – depending on the theme’s risk levels – with it.

The components of the Core Bond portfolio

CategoryNameIDTERAlloc %
All worldVanguard Total Bond Market ETFBND0.05%40.0%
World ex USVanguard Total International Bond ETFBNDX0.12%35.0%
EM LCSPDR Bloomberg Barclays Local Bond ETFEBND0.40%25.0%

The Core Bond portfolio comes down to having approximately 36% US exposure, 14% in Europe, 8% in Japan and 2%-3% in markets like Brazil, Mexico, Malaysia and Indonesia. It consists of three main components with expense ratios of between 5 and 40bps.

  • The Vanguard Total Bond Market ETF. broad exposure to the US investment grade bond market. Has an overall duration around 6 years and consists of thousands of bonds. US Government securities in the form of mortgage-backed bonds or regular US Treasuries are 64% of that.
  • The Vanguard International Bond Market ETF. Global investment grade bond exposure (capped at 20% per issuer) at a duration of 7.2 years. Creates exposure mostly to Europe and Asia-Pacific.
  • SPDR Bloomberg Barclays Local Bond ETF. Creates exposure to debt of local currency bonds in emerging markets

The components of the Core Equity portfolio

CategoryNameIDTERAlloc %
All worldVanguard Total World StockVT0.10%35.0%
EMiShares MSCI Emerging Markets ETFEEM0.69%30.0%
FrontieriShares MSCI Frontier 100 ETFFM0.79%10.0%
World ex USVanguard Total International Stock ETFVXUS0.11%25.0%

The Core Equity portfolio is built up from four components, and breaks down to roughly 17.5% US exposure, 12% Europe, 10% China, 7% Japan and 6% Korea. TER ranges from 10bps to 79bps. The specific components are:

  • Vanguard Total World Stock ETF. Thousands of stocks that are 52% concentrated in the US. Apple forms nearly 2% of its entire holdings.
  • iShares MSCI Emerging Markets ETF. Heavy in IT and financials in places like China and South Korea
  • iShares MSCI Frontier 100 ETF. Argentina, Vietnam, Kuwait and Morocco. Countries with significant idiosyncratic risk, which also adds diversification benefits
  • Vanguard Total International Stock ETF. A global stock ETF that excludes the US, to better capture Japanese and European stocks

Combined Risk and return characteristics 

Strategy% Equity / % BondYieldVolVaR2008-2009 Scen2010+ Scen
Core Equity100% / 0%2.1%10.5%-14.2%-12.8%+137%
40 years to retirement85% / 15%2.2%9.1%-12.6%-11.4%+118%
30 years to retirement75% / 25%2.2%8.3%-11.4%-10.5%+106%
20 years to retirement65% / 35%2.2%7.5%-10.4%-9.5%+93%
10 years to retirement55% / 45%2.3%6.7%-9.3%-8.6%+80%
Core Bond0% / 100%2.5%4.2%-6.6%-3.4%+11%

The tail risk (VaR or Value-at-Risk) of the bond portfolio is -6.6%. Meaning that in 95% of all 1 year periods, your return will be better than that. The tail risk on the equity portfolio is -14.2%. The numbers above show that risk is not linear, as a 45% addition of bond holdings to an otherwise all-equity portfolio, captures some 64% of the risk reducing properties of bonds.

Core Bond Portfolio Characteristics (Full Look-Through, From USD Perspective)

  • Dividend yield: 2.5%
  • Ex-ante predicted volatility: 4.2%
  • 1 year 95% Value-at-Risk: -6.6%
  • Scenario: 2008 Lehman Brothers default period: -5.8%
  • Scenario: Interest rates +100bps: -4.1%
  • Scenario: 2008-2009: -3.4%
  • Scenario: 2010 onwards: +11%

Core Equity Portfolio Characteristics (Full Look-Through, From USD Perspective)

  • Dividend yield: 2.1%
  • Ex-ante predicted volatility: 10.5%
  • 1 year 95% Value-at-Risk: -14.2%
  • Scenario: 2008 Lehman Brothers default period: -18.5%
  • Scenario: Interest rates +100bps: +3.2%
  • Scenario: 2008-2009: -12.8%
  • Scenario: 2010 onwards: +137%


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Categories: Themes

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