Retirement 101: Asset Allocation and Risk Tolerance
Table of Contents
- Before we begin
- The who and the what
- What is retirement, anyway?
- Estimating your retirement number
- We need to talk... about investing
- Asset allocation and risk tolerance
- Setting up your portfolio
- Making it work
- COMING SOON - Keep on keeping on
- COMING SOON - What if something goes wrong?
- COMING SOON - The non-monetary side of retirement
- COMING SOON - OK, I've retired. Now what?
Asset: A piece of property or resource that you own and that you expect will provide increase in value over time (either by growing in capital value or providing positive cash flow).Allocation: To distribute according to a plan. To allot or designate.
Asset Allocation: The distribution of monetary value between various types of value-generating property. In other words, how much of your money do you put in each of the main types of investments?
In the context of long term investing, there are five main types of assets (or asset classes) that you will typically think about: Cash, Stocks, Bonds, Real estate, and Commodities (including precious metals).
Why does it matter? Why can’t I just pick one to keep it simple?
Each asset class has its own risk vs reward profile. Some assets are more liquid than others. And the value of each asset class tends to react differently to different market conditions.
- Cash is cash. One dollar is always worth one dollar. It’s perfectly safe unless our whole economy crashes. It’s highly liquid and just about the only thing you can directly use to pay for goods and services… But a jar of cash will not increase in value over time. Instead, its purchasing power goes down over time, due to inflation.
- Stocks have by far the best returns for their risks, in the long term. But they also tend to have much greater short-term volatility, meaning that although the overall trend is upward, there are a lot of little ups and down along the way.
- Bonds give you a lower return on your investment, but it’s a much smoother ride. Bond yields are not directly correlated to the stock market. So when the market is down, bonds generally won’t be–though there are some exceptions.
- Real estate values tend to track inflation, though there are short term bubbles (like the one we’re currently in right now in 2021) and there have been a few major crashes (like 2008). Real estate can also generate cash flow as a rental property. If you don’t want to manage owning investment properties, there are funds called REITs (Real Estate Investment Trusts) that you can buy and sell much like a stock or bond. One of the big upsides of real estate is that it may track inflation somewhat better than most other options, including potentially performing better in times of hyperinflation.
- Commodities are tangible goods like coffee, pork bellies, silver, and gold. While some day-traders attempt to play the commodities market for income, most long-term investors who choose to hold commodities hold precious metals as a hedge against inflation. Many choose not to bother with commodities at all.
We talked about how diversification in the stock market is the key to increasing the safety of your investments. When one stock goes down, there are others going up more than enough to make up for the loss. And since you can’t know with any certainty which stocks will go down, and which will go up, you need to own a broad, diverse group of stocks. The same can be true for asset classes.
Sometimes there is a dip in the stock market. And while the market as a whole is far more resilient than any given individual stock, it still sometimes takes a while to come back up. Remember how I mentioned that Trinity Study showed that their 4% withdrawal rate provided for successful retirements in 95% of their test cases? The 5% that failed did so because the market crashed right after the retirement period started.
The danger of that happening is called “sequence of returns risk.” If the market crashes during the early days of your retirement (early in your sequence of retirement returns) then you will be forced to withdraw funds while their value is low. Since you’re now retired and don’t have regular income, you can’t wait it out. This locks in a loss at a time that makes it much harder to recover enough to last through the rest of retirement. (Interestingly, crashes later on the retirement period didn’t have nearly as bad of an effect on the ending portfolio value. The big danger is during the first five to ten years of retirement.)
In order to avoid sequence of returns risk, it makes sense to have some of your retirement funds invested in asset classes whose values are not directly correlated to movements in the stock market.
On the other hand, if retirement is still more than 10 years away for you, there’s a good argument to be made that you should be primarily or even 100 invested in stocks. You have the time to wait out a recovery, and the long-term returns on the stock market are almost always better than any of the other asset classes.
What mix is right for you
In general, the farther away you are from retirement, the higher your ratio of stocks should be. If I had twenty years or more to go, I would choose to be in all stocks–though some studies have shown that having a small portion of your funds in bonds (10 to 20%) might actually increase your returns slightly over 100% stocks. (I’ve seen mixed results with this idea of having a small chunk of bonds, so in the interest of simplicity, I lean toward the 100% stocks school of thought).
Once you start getting to around ten years before retirement, it’s time to consider adding bonds into your mix. This will reduce your returns a bit, but it will help preserve your funds in the event of a downturn. Think of it as insurance against sequence of returns risk. Its a small price to pay to avoid a potentially retirement-ruining loss. The exact percentage to hold in bonds is hotly debated in the personal finance community, but anywhere from 40 to 60% bonds is probably fine. One simple way to do it is to start at 20 – 30% bonds at ten years out, and increase that percentage by two to five percent every year, aiming hit 60 or 70% in the year that you retire.
After you retire you may still want to consider adjusting your asset allocation. Since your sequence of returns risk gets lower the more years pass in your retirement, it becomes safer to move back toward a higher percentage of stocks. The reason you might want to do that is to take advantage of higher potential gains that stocks provide to help keep your retirement portfolio value higher though the rest of your retirement. This is part of a strategy called a “bond tent.” We’ll talk more about this and other ways to tweak your investments later on.
Other things to consider
Aside from time-to-retirement, here are a few other things to consider about yourself and your circumstances that can help you decide how to allocate your assets.
- Internal Risk tolerance – Your attitude about risk can play a huge part in how you invest. I’ve said it before and I’ll say it again: Most people who lose money in the stock market do so because they panic and sell while the market is at or near the bottom of a dip. It can be very hard to stick with it and stay in the market during a deep dip, but it is absolutely critical to your success that you do! If you know you’ll have a hard time with that, it’s probably better for you to hold a higher percentage of bonds to help your portfolio avoid the lowest of the market low… even knowing that by doing so your portfolio will also not reach the market highs.
If you’re the kind of person who feels a strong desire to sell off everything at the slightest sign of a downturn, then you might want to increase your percentage of “safer” bonds. Likewise if you’re the kind of person who will be checking your balance every few hours and feeling stressed about every up and down of the market. Conversely, if a small dip in the market gets you excited about being able to buy more stocks at a discount, then your risk tolerance is probably pretty high and you will probably want to lean toward having more stocks and fewer bonds.
- Lifestyle flexibility – If you have the ability to “tighten your belt” when the market dips, then you can afford to take a bit more risk. If your planned retirement spending includes lots of travel, gift-giving, and expensive hobbies, then you’ll have room in your budget to cut back if there’s an early downturn. However, if your retirement budget is detailed down to the last cent and you can’t afford for it to change at all, then you’ll want to mitigate some of that risk. This is most important during retirement, but also plays a role leading up to retirement.
Taking a big risk in your asset allocation leading up to retirement can lead to higher sequence of returns risk. Once way to mitigate that risk, other than moving some of your investments to bonds or other safer asset classes before retirement, is to be flexible during retirement. When the market drops, if you’re able to move to a lower cost of living area, in a smaller house, and eat rice and beans for a few years, you’re more likely to weather the storm. If that doesn’t seem reasonable to you, then you’ll want to move your allocation to a higher percentage of safer investments before retirement.
Help! My asset allocation has changed all by itself! What happened? What do I do?
Daniel is contributing to a 401(k), and has his contributions set up to match his asset allocation. Every payday, a certain percentage of his paycheck gets directed to his 401(k). And that amount gets further split: 80% goes to stock-based index funds, and 20% to bond-based funds. After a year of this, Daniel checked in on his account. He is surprised to discover that instead of a nice 80/20 split, his stock funds account for 75% of his portfolio, and his bonds are at 25%. What happened?
As we talked about earlier, stocks and bonds grow at different rates, and their respective markets are not directly correlated. Daniel’s stocks had a less than stellar year, and his bonds did better than expected. So even though his contributions were split at 80/20, their ending values had changed due to changes in their respective markets. This is actually great news! It means Daniel now has a chance to practice the age-old wisdom of selling high buying low.
When market movements cause you asset allocation to get skewed, it’s time to rebalance. It easy. In Daniel’s case, he will sell a portion of his bonds and use the money from that sale to buy more stocks. In fact, in many 401(k) accounts it’s even easier: you just click the “automatically rebalance” button and let them do the work for you.
Rebalancing is good not only because it beings your portfolio back in line with your intended asset allocation, but also because it causes you to automatically sell the funds that are currently doing very well and buy more of the ones that are currently struggling.
That may feel counterintuitive to many people. Why would you want to buy struggling funds? And why would you want to let go of your winners? First, to be clear, we’re not intending to buy something that is struggling on its way down to bankruptcy. No, we’re buying strong funds that we believe have a long future of growth ahead of them, that just happen to be down at the moment because of market conditions. And we’re selling funds that are high because that’s how you lock in your earnings! Remember: Buy low, sell, high. It makes sense until it’s time to do it, but it sure can be hard to sell your “winners”!
Target Date Funds
If all of this talk about asset allocation and rebalancing has you feeling overwhelmed and unsure, there’s good news. For a very reasonable fee, there are funds that will handle all of this for you. These are called Target Date Funds, because they are set up to provide a good asset allocation based on your target retirement date. If you plan on retiring in 2035, you just put all of your retirement contributions into the 2035 Target Date fund and then forget about it for the next 14 years. Vanguard or whoever operates the fund you chose will take care of everything.
The downside is it’s a one-size-fits-all sort of thing. You won’t have the flexibility to play around with your percentages if you feel like trying to do more of your own research and optimize for your own situation. That being said, you aren’t locked into the Target Date Fund forever. You may choose to start out that way, and then later on, when you’re feeling more confident and want to tweak things yourself, you can always sell your target fund position and re-allocate however you want. This is especially good in a 401(k) or IRA because you don’t pay taxes on any earning when you sell within a retirement account.
Think about your timeframe and risk tolerance. If you feel like you have an average risk tolerance and you want a hand-off, easy-button option, skip to the shortcut below. Otherwise…
- Choose one to three broad stock market index funds, with low fees, that give you diversified exposure to a mix of domestic and international companies–leaning heavily toward domestic for most people.
- Choose one to three broad bond market index funds, again with low fees.
- If you really feel like it, choose one or two REITs to add real estate exposure to your portfolio… But it’s not really necessary, especially while you’re just getting started
- Write out your list like this:
Fund Name/Ticker % of portfolio
If you feel like you have a relatively average risk tolerance, choose a Target Date fund. You’re done! There’s nothing else to choose.