Forget the models for a moment. Most financial advisors will tell you that a 60/40 stocks and bonds split is the right way to go when planning asset allocation for retirement, but there’s a growing segment of experts who claim that number should be 75/25. Which is correct?
Both. And neither. The asset allocation process isn’t using a constant ratio that’s one size fits all. The ratio is determined by investor circumstances and market conditions. With bond yields historically low, the right move might be to increase the stock percentage. Or is it?
Where are you in your retirement journey? Folks in their twenties and thirties can afford to take more risk. Older workers need to be more conservative. Those who are already in retirement are faced with keeping a sufficient balance to maintain their lifestyle. So, let’s dive into asset allocation in retirement so you can learn everything there is to know.
Asset Allocation Recommendations From The “Experts”
If you subscribe to the Motley Fool, you’ve no doubt seen a number of related articles and “expert” analyses on retirement investing and asset allocations. The fool does not employ fools, and the Motley Fool generally publishes good information, though much of it is simple common sense.
One Motley Fool article from 2020 did a comparison of investment retirement returns from five model portfolios composed entirely of stock, no bonds. They tracked historical returns for 1, 3, and 5-year periods. The first four portfolios contained the following:
- Large Cap US Stocks
- Small Cap US Stocks
- International Stocks
The fifth portfolio was a mix of all four. It produced an average return of 13.1%, which ranked second behind the 14.3% small cap stocks returned. It also showed a five year worst return of 4.8%, proving that a mixed asset allocation strategy was better by far than any of the other portfolios.
Diverse Portfolios Are Good For All Phases Of Retirement Planning
Is it a big surprise that the diversified portfolio outperformed the others? Of course not. That’s the point we’re trying to make. Financial stability in retirement comes from having retirement investments that span a wide range of different industries and sectors.
The bond investments of a retirement savings account will take care of themselves. You’re not likely to take a loss on them and they won’t outperform inflation. They are roughly the equivalent of cash left in the bank for a rainy day. No portfolio volatility there. Treat them that way.
The stock investments are where asset allocation becomes important. It’s not about what percentage of your investment assets are in stock. Successful retirement planning focuses on which stocks or ETFs for retirement you are invested in. That’s where diversity becomes important.
Take international stocks as an example. Russia, China, and Brazil are currently classified as “emerging markets” due to economic instability and governmental policies. Emerging market stocks can have a high upside, but often take big losses also.
Small Cap US Stocks, on the other hand, have historically good returns and less risk. If you buy emerging markets, US small caps could be the “hedge” you need to prevent losses in your investment portfolio. Meanwhile, you still have a chance for big returns, which bonds don’t give you.
Viewing The Time Horizon 10 Years At A Time
This may seem short term in the grand scheme of things, but ten-year windows are easier to work with than thirty-year windows. Can you retire at 60 with $500k and still be financially stable in ten years? If you’re sixty-five and retiring, what does life look like before your seventy-fifth birthday? Those are typically active years.
The stock market historically returns a little over ten percent each year, so your investment portfolio will continue to make money, provided you don’t dip too far into the principal. If you have $1 million in diversified stock investments, you should pull in $100,000 a year.
Far too many retirees look at the stock-bond mix when they’re in their sixties and make dramatic changes. Why? Your level of risk isn’t dramatically higher just because you’ve gotten older. The stock market continues to perform at the same level. Why shouldn’t you?
Of course, there’s always the danger of a downturn or even a crash, but viewing investments and asset classes through a ten-year window typically allows the investor time to make adjustments when needed. It can also help with planning tax-efficient retirement withdrawal strategies.
Risk Tolerance Is A Financial Advisor “Catch” Phrase
Unfortunately, financial advisors usually view the investment time horizon as the number of years until retirement. They even assign a “risk tolerance number” to investors, based on their age and life circumstances. They use that number to come up with a stocks and bonds ratio.
On paper, this seems to make a lot of sense. It’s presented as a safe way to go, eliminating the possibility of big losses by using a more conservative mix of stocks and bonds. That type of reasoning is easy to sell, especially if clients are nervous about losses.
From a retirement-savings perspective, the bond yield on US treasury bonds was 1.15% over the past ten years. The average rate of inflation over that time was 3.10%. The S&P 500 had an average rate of return of 13.6%. Stop and think about that for a moment.
Now, go back to that financial advisor who tells you to shift more money into bonds to preserve your retirement savings because your risk tolerance is lower due to your age. Does it really seem like such a good idea now? Sounds more like you’d be throwing money away.
Bonds may be less volatile, but they don’t make you any money. Age is a number that your financial planner uses to decide on investment strategies. That’s what they get paid for.
Index Funds, ETFs, Annuities, And Social Security
In lieu of bonds, try investing in index funds or ETFs to mitigate risk during your retirement years. You can even combine the two and buy an ETF that tracks the index. The S&P, as we stated above, returned 9.3% over the past ten years.
Combined with any annuity income, which hopefully you set up during your working years, and social security income, the investment strategy suggestions we’ve laid out here should keep you comfortable in your golden years. Keep the returns high and you’ll never run out of money.