What Should Your Asset Allocation Be When You Retire?

Abstract

This article provides guidance about an appropriate asset allocation strategy and drawdown rate. The article examines a number of commonly used strategies, namely, the mean-variance strategy, fixed asset allocation strategy, and a time-varying asset allocation strategy. Overall findings are that the straightforward rule of a 4% real drawdown is consistent with earlier studies. The simple allocation of 80% equities and 20% bonds seems to be a good rule of thumb. This approach has been criticized, however, by some researchers as being suboptimal because the strategy is inefficient and the imbedded costs in the strategy are wasteful. The simple nature of the strategy does not take into account mean reversion of stock prices and can suffer from extreme downside risk as illustrated by the poor performance of stocks during bear markets. Having a high equity exposure during these times can substantially reduce capital. It, therefore, makes sense to adopt a flexible asset allocation strategy depending on the relative attractiveness of equities, bonds, and cash. A number of TAA strategies are analyzed and all outperform the static 80/20 strategy. The attractive feature of these strategies is that they may not generate as high a return when equities are performing well, but they perform substantially better in down markets.