What Should Your Asset Allocation Be When You Retire?

Abstract

This paper intends to provide some guidance into what is an appropriate asset allocation strategy and draw down rate. We examine a number of commonly used strategies, these being the mean variance strategy, fixed asset allocation strategy and lastly a time varying asset allocation strategy. The overall findings are that the straight forward rule of a 4% real draw down is consistent with earlier studies. The simple allocation of 80% equities and 20% bonds seems to be a good rule of thumb. However, this approach has been criticised by some researchers as being suboptimal as the strategy is inefficient and there are embedded costs in this strategy that are wasteful. The simplistic 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 the stock market during bear markets. Having a high equity exposure during these times can substantially reduce ones capital. It therefore makes sense to adopt a flexible asset allocation strategy depending upon the relative attractiveness of equities, bonds and cash. We examine a number of TAA strategies and find that all out perform the static 80/20 strategy. The attractive feature of these strategies is that they may not generate as high returns when equities are performing well but they perform substantially better in down markets.