Allocation all boils down to Owning, Loaning and Reserving.  Everything else is a variation on implementation of these three super classes.

Retirement portfolios need some Owning (for capital and income growth), some Loaning (for steady income and portfolio volatility dampening), and some Reserving (for dependable cash availability for withdrawals, and less reason to panic when the market is panicking).

The term “asset class” gets tossed around a lot and sometimes asset types that are merely subcategories of true asset classes are mislabeled as “asset classes”.  While the use of the term is certainly arguable, the three most basic asset classes are: (1) cash reserves, (2) loans made to others, and (3) ownership of something like stocks, real estate or commodities.  We think of them as “super classes”, because just about everything else falls under one of these as a subcategory (even derivatives).

Three specific examples of Loan, Own and Reserve are the 10-Year Treasury Bonds (Loan), the S&P 500 (Own) and 90-day Treasury Bills (Reserve).

They, like the super classes to which they belong, are substantially minimally or even negatively correlated over reasonable periods of time.

While stocks and bonds have periods of high correlation, such as in panics, where there may be a rush to cash for safety and liquidity; for the most part they react differently to different circumstances, making them good pairs, along with cash reserves in a portfolio where risk (volatility) control is an important goal.

For most asset categories really long-term data is hard to find, but for 10-year US bonds, US large-caps stocks (S&P 500 and precursors), and 90-day T-Bills; we have data back to 1928 as proxies for the Loan, Own and Reserve super classes.

Let’s see how those super classes behaved in total return, price return and income return in an annually rebalanced tax-deferred or non-taxable account from 1928 through 2014.

The portfolio we use here is 60% US large-cap stocks, 31% 10-year Treasury Bonds, and 9% of 90-day T-Bills. US large-cap stocks are the S&P500 and its precursors.

That is a specific modification of a generalized 60/40 portfolio to make room for a three bucket (9%) operating reserve for retirement accounts.  The reserve is important to create fairly high certainty of capital available for withdrawal for up to 3 years, which is helpful to avoid panic in a steep down stock or bond market.

There are very few periods where a balanced portfolio is down for more than 3 years, so the 9% 3-bucket reserve can help a retiree glide over a bear market without selling assets at fire sale prices to fund living expenses.  Selling assets at depressed prices in retirement is a good way to outlive your assets — and that is not a good thing.

In practice, the 60% in stocks would likely include different market-cap sizes, and some international in most cases; and the 31% in bonds would likely include different durations and perhaps qualities, and maybe some international; and the 9% in reserves (90-day T-Bills as proxy here) would probably consist of 3% in a money market fund (duration about 90 days),  3% in an ultra-short bond fund (duration about 1 year) and a short-term bond fund (duration about 2.5 to 3 years).

Figure 1 is a chart showing the annual total return of the 60/31/9 portfolio from 1928 (87 years), along with the three-year moving average of total return:

Figure 1: Total Return – 60 stock / 31 bonds / 9 reserve

There were some substantial dips on an annual basis, but the 3-year average was almost always positive, and where negative was mostly only mildly so.  Except for the Great Depression where the 60/31/9 declined over 14%, the worst decline was less than 4.5%

There were only 7 years of the 3-year average that were negative, and only two periods had back-to-back negative years: 1931-1932 and 1941-1942.  Two of the 7 down years had declines of less than 0.5%.

Specifically for individual years, there were 19 out of 87 years with a negative return (21.84%) of the time.

The periods of back-to-back negative periods were:

• 4 years from 1929-1932
• 2 years from 1940-1941
• 2 years from 1973-194
• 2 years from 2001-2002

The traditional 60/40 fund uses the S&P 500 index and the Aggregate Bond index.  That fund had total return less than negative 22% in 2008 (ref: Vanguard Balanced Fund VBIAX), whereas this 60/31/9 portfolio illustration uses Treasury debt for both the 31 and the 9.  Since 2008 was a year of panic, Treasury debt outperformed Aggregate Bonds.  This example portfolio declined 15.56% in 2008.

Both VBIAX and this example portfolio declined more than 22% and 15% from their intra-year 2007 peak to their 2008 intra-year bottom, but this memo is only about calendar year performance.

Figure 2 is a chart showing the price return separate from the income return for the 61/31/9 allocation.

Figure 2: Price Return and Income Return – 60 stock / 31 bonds / 9 reserve

As you might expect the income return is far less volatile and more reliable than the price return.  That is important to retirees who are drawing on their portfolios.

The brown line is the price return and the green line is the income return.  The dashed black line is the 4% return level that relates to the 4% rule of thumb for retirement withdrawals.

While total return had 19 negative years of 87, price return had 29  (33.33% of the time).  It was the income return that saved the portfolio from the 10 extra negative years.

The specific back-to-back negative price return periods were:

• 4 years from 1929-1932
• 3 years from 1939-1941
• 3 years from 1946-1948
• 2 years from 1973-1974
• 2 years from 1977-1978
• 3 years from 2000-2002

With regard to the 9% 3-bucket reserve, individual bonds are probably not a practical alternative for most retirees for a variety of reasons. Here are three low-cost Vanguard funds that could probably fulfill the objectives and uses of the 9% reserve.