A reader recently wrote in with a particularly important question. I suspect there are many readers with situations similar to this, so I thought it would be worth addressing here for a broader audience.
The reader explains that he is 5-10 years away from retirement. His concern, rightly, is that with bonds likely to be a loser or poor performer in the immediate years ahead, he doesn’t know what to do in order to take steps to protect his portfolio from risk. He wants to gradually reduce exposure to the stock market, but recognizes that shifting that money to bonds as he would have in the past is likely to result in losing ground to inflation.
The immediate answer would seem to be to utilize the Dynamic Asset Allocation strategy! Alas, he goes on to explain that roughly 75% of his investments are locked up in his company 401(k) account, where that isn’t an option. The other 25%, which is in IRAs, he has already moved to DAA (he’s using the fund to automate this). He wishes he could move some or all of the 401(k) money to that strategy, but can’t until he retires. His 401(k) options are the typical mix of a dozen or so stock funds, some target-date retirement funds, and the usual assortment of bond, money market, and stable value choices. Bottom line, as he sums it up, "So with a 401(k) plan with these types of options available, if I (and others) want to reduce our exposure to stocks, are there any reasonable options?"
It’s a great question. This is the financial repression the current Federal Reserve policies have created. Keeping interest rates low is great for some, primarily borrowers (including our government at the front of that list), but is misery for those trying to responsibly balance risk as they save toward retirement. This is a huge problem, not just for individuals, but for pension systems and other institutionally pooled investments that rely on decent fixed-income returns to at least outpace inflation.
Naturally readers in this situation can utilize SMI’s Portfolio Tracker to maximize their retirement plan earnings. But that’s more a tool for making sure you get the most out of the allocation you have — it doesn’t really offer much help for the problem here, which is figuring out how to balance or shift between asset classes. DAA is definitely the best tool in our toolbox for that specific task, but can it help us when limited to the options within a typical 401(k) plan? I believe it can. It may not be optimal, but the "secret sauce" to DAA is the timing with which it moves us between asset classes. This is much more important than the specific vehicles we use to represent those classes.
True, in a case like this one, some of the asset classes may be missing (most commonly gold and real estate). But typically, at least four of the options will be represented within a 401(k) plan fund menu. It’s a rare plan that doesn’t have at least one fund in each of the following classes: US stocks, International stocks, Bonds, and Cash (Money Market). In this type of situation, my suggestion is to do as this reader has already done and allocate significantly to DAA outside of the restricted plan. Then, with whatever portion of the restricted account that the person would allocate to DAA if they were able, follow a modified DAA approach.
That approach would still use the signals from regular DAA, but would then apply them to the closest available option within the 401(k) plan. For example, if DAA said to be in US stocks and Foreign stocks, I would buy the US and Foreign stock index funds within my 401(k) plan (assuming those are offered, as they typically are). If those aren’t offered, I’d buy the broadest US stock and Foreign stock funds available to me.
What happens when a category is recommended but there’s no fund option available for it? This may have been the case lately, when Real Estate was recommended (some plans offer a real estate fund of some type, but others don’t). This gets a little trickier. The more aggressive approach in this scenario is to allocate the available money between the two choices you do have. In other words, instead of splitting that money three ways, you’d split it half and half between US and Foreign stocks. A more conservative approach would be to default to cash with the final third instead.
This isn’t a perfect solution, but it should help steer around most of the major downturns in the stock market, which is the main goal people have for re-allocating stock market money to bonds as they approach retirement. Even if that’s all this accomplishes — roughly identifying when to invest significantly in stocks, and when to run away from them — it would be quite valuable.
I’m not trying to complicate things for anyone, so don’t misunderstand this as a new recommended approach. It’s simply a work-around for people who have the lion’s share of their portfolio locked up within a company retirement plan, without the option to follow DAA or Upgrading as designed. The more optimal approach is to divide the portfolio between DAA and Upgrading and follow them exactly as described each month. But if you don’t have that option with a significant portion of your portfolio, you may find using DAA’s signals to be more appealing than blindly re-allocating from stocks to bonds and hoping those new bond investments don’t lose money as interest rates rise.
