Follow on TwitterLike on FacebookFollow on Google+Subscribe to RSS Feed

Asset Allocation using 10-5-3 Rule

Asset Allocation Source: stck.xchng Image: arinas74
Asset Allocation Source: stck.xchng Image: arinas74

There are any number of rules for investing out there. Many of them have to do with asset allocation. One of those rules that can help you determine what asset allocation could work for you is the 10-5-3 rule. The rule comes from a book by James O’Donnell, called The Shortest Investment Book Ever: Wall Street Secrets for Making Every Dollar Count. This rule is simple, providing an overall average annual return for three different investment classes: stocks, bonds and cash. According to the 10-5-3 rule, stocks are likely to get an annual return of 10%, bonds 5% and cash (as well as liquid cash-like investments) 3%. It is important to recognize that this rule is used for long-term investments. And by long-term, I mean over a period of at least 15-20 years. So we’re talking about a rule of thumb that can help you determine your asset allocation for the long haul; consider applying this rule to your retirement portfolio.

How you can use 10-5-3 to help you with asset allocation

10-5-3 is most helpful in terms of asset allocation when used in conjunction with the Rule of 72 (a lot of rules, eh?). This is a very basic rule that says if you divide the interest yield of your investment into 72, that will give you an approximation of how long it will take your money to double — if you leave it sitting there and do nothing. In the case of 10-5-3, here is how long it would take each of your types of investments to double:

  • Stocks: 72/10 = 7.2 years
  • Bonds: 72/5 = 14.4 years
  • Cash: 72/3 = 24 years

You can see where it becomes necessary to take long-range planning into account. Decide what your target goal is in terms of amount of money. If you want to retire with $1.2 million in 30 years (that’s actually my goal — I’m reasonably young), you can use the 10-5-3 rule to approximate an asset allocation that will put that money to work for you to help you reach your goals. In my case, my stocks can be expected to double four times, my bonds twice and my cash investments once. I’m going to start doing some more math here, but it’s going to be very simplistic. It’s just meant to give an overall idea of how this might work. It doesn’t account for the fact that I will add more money to my accounts every year, rather than letting them stagnate. Let’s say that I’ve got $60,000 in investments (which I would have, if I set aside $334 a month every year for the past 15 years — since I was about 15 and working). Here is one scenario:

  • $40,000 in stocks. This money will double four times in 30 years. After the first double, there would be $80,000, that $80,000 would double to $160,000, which would double to $320,000, which would double to $640,000.
  • $10,000 in bonds. This money doubles only twice: first to $20,000 and second to $40,000.
  • $10,000 in cash. This money doubles only once, to $20,00.

My total is around $700,000, after 30 years. But what if I change my asset allocation to something like this:

  • $50,000 in stocks. Doubles to $100,000, then to $200,000, then to $400,000, then to $800,000.
  • $8,000 in bonds. Doubles to $16,000, then to $32,000.
  • $2,000 in cash. Doubles once to $4,000.

Now the total is $836,000. Obviously, $60,000 just sitting in an account for 30 years isn’t going to get me to $1.2 million. However, you can see that using 10-5-3 helped me get $136,000 closer to my goal in the same amount of time. I would have to keep adding to my accounts in order to make my desired retirement, and that extra money, added in over the next 30 years, would be part of the doubling formula. 10-5-3 just offers an outline you can follow for a reasonably conservative long-term investment plan.

Drawbacks to the 10-5-3 investing rule

Any rule of thumb is merely a guideline. There are no hard and fast investing rules. And there is always the risk of loss. The 10-5-3 rule is no exception. First of all, these are long-term averages. This year, almost no investments are going to conform to the 10-5-3 rule. Market crashes are not reflected in the 10-5-3 rule, and if the market crashes again just before retirement, being heavily invested in stocks will wipe our your portfolio (which is why you should adjust asset allocation as you age). Additionally, the 10-5-3 rule doesn’t take into account the erosion of the value of your dollar due to inflation. And taxes aren’t considered here, either. Another issue about the future was brought to my attention by Arohan:

While the past historical return averages may hold in the future, it is also true that the past 100 years of US stock market returns reflect a nation with increasing productivity and young demographic. The future may indeed look very different as the country ages and productivity increases are not as significant any more (inventions of telegraphy, radio, internet, etc cut days from communication cycle, cars and highways saved significant amounts of time, while microwaves and washing machines enabled women the ability to participate in the work force and the men to help in the household chores. While we do not yet know what new ideas and products will come in the future, it is likely that the low hanging fruit of productivity increases has already been picked).

Going forward, the economy may not see the same level of production and growth that it has seen in the past. 10% annual returns for stocks (which seemed absurdly conservative in the late 1990s) may end up being wildly optimistic going forward. The 10-5-3 rule isn’t meant to be the final word. But it can be a useful tool to use when making long term investing plans.

Leave a reply