While you’re still in your early working years, asset allocation is (relatively) easy. For the most part, it’s OK to have as much in stocks as you’re comfortable having. If you’re not bothered by the volatility that comes from a 90% stock portfolio, then having a 90% stock portfolio is probably just fine.
In retirement, things get a lot trickier. Why? Because once you start selling your investments, volatility takes on a whole new significance (one which cannot be avoided, no matter your psychological makeup).
When you’re still working, the appropriate response to a bear market is to simply refrain from “selling low.” Once you’re retired, that’s not an option. You need cash to pay your bills, and if it has to come from your investments, it has to come from your investments–no matter how poorly the market has done recently.
As a result, if your portfolio is invested too aggressively, a poorly timed bear market (i.e., one at the beginning of your retirement) can be crushing because you’ll be forced to sell a large portion of your portfolio at precisely the worst time.
On the other hand, with life expectancies as long as they are, you can’t simply ditch all your stocks in favor of CDs and bond funds the day you retire or you’re likely to be overrun by inflation a little more than a decade into retirement.
So What to Do?
While recently reading Investing in an Uncertain Economy for Dummies*, I came across what I think is an excellent way to approach asset allocation in retirement. Martha Schilling (the author of the chapter in question) argues that you should essentially have 3 separate portfolios:
- A liquid, stable portfolio (high yield savings, money market, etc.) that includes any money you’ll need to use for expenses in the next 2-3 years,
- A conservative portfolio (short-term bond funds, for example) that’s intended to fund your expenses 3-10 years from now, and
- An equity-oriented (though still conservative) portfolio that will be used to fund your expenses more than 10 years from now.
She then suggests that you:
“Think of your investments as having a waterfall or cascading effect. As the pool at the bottom gets drained, you pour out a little from the top-growth tier into the mid-term pool, which overflows into the pool on the bottom.”
Functionally, it’s not terribly different from the typical recommendation that investors gradually shift their investments out of stocks and into bonds and CDs in retirement.
What I like about this approach though is that it’s easy to understand. It’s a common sense, concrete way of answering the question of retirement asset allocation.
*Frequent commenter and occasional guest poster Dylan Ross is one of the authors. If you’re looking for a comprehensive reference guide to investing, I highly recommend the book.
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{ 8 comments }
Mike,
First an observation, assuming a 4% withdrawal rate that portfolio works out to:
8-12% cash
12-40% bonds
48-80% equities
Doesn’t 80% equities seem pretty aggressive for a retiree? A 12%,40%,48% portfolio seems pretty reasonable… I’m pretty aggressive so I would probably choose 12%,28%,60%.
In a bear market would you try to avoid selling any of the equities portion? It seems to me that you would try to wait it out- draining the cash and bond reserves, and taking dividends as cash BEFORE selling any equities. I realize this will increase the %equities and thus the volatility over time. However, you should be able to wait out at least a 13 year bear market (longer with redirected dividends) . That seems an excessively long time for a bear market. At that point the economy would be collapsing anyway so you really would need guns, ammo and a food rather than an investment portfolio ;->!
-Rick Francis
Rick: My understanding was that Portfolio #3, while equity-oriented, would still be fairly conservative (specific allocation depending upon age, but perhaps something like a 60/40 stock/bond split), thereby leaving the overall portfolio with far less than 80% in stocks.
As to your question re: which investments to sell during a bear market during one’s retirement, I don’t have a fully-formed opinion on what I think is necessarily the best approach. I’d be interested to hear other people’s thoughts on the matter.
Rick,
Yes, these numbers seems aggressive for a retiree. But that’s based on the assumption that what we are doing these days is better. Is it?
I’ve been arguing for a new approach, although my idea has nothing to do with asset allocation.
Mike,
Thanks for clarifying portfolio #3- If #3 is 60/40 split that really limits the equity portion… the maximum % equities is 48% with the most aggressive mix.
Mark,
I’m not sure that keeping fixed % allocation in all market conditions is the best plan either. However, is there really a systematic system that is superior to rebalancing with fixed allocation %es? It seems one would need a reliable way to know that the current market is over or under priced, and that is a tall order!
Rob,
I suspect you would suggest PE10 to rate market pricing, but do you have a formula for % equity allocation as a fn of PE10?
-Rick Francis
I don’t agree with the premise that “it’s OK to have as much in stocks as you’re comfortable having” in the accumulation stage. So I also don’t agree with the advice (which follows from that premise) re how to invest in retirement.
There are special risks in retirement. So I do think it makes sense to go with somewhat lower stock allocations when new money is no longer coming in.
However, the biggest risk both in the accumulation stage and in the distribution stage (retirement) is ignoring valuations (investing passively). The historical data shows that there is little risk in investing heavily in stocks during retirement so long as valuations are reasonable. And reasonably priced stocks will generally bring in far higher returns than the alternative asset classes. I think you are giving up a lot if you elect to go with a low stock allocation in retirement just because you are not willing to look at valuations.
Rob
I had always planed to follow Vangards asset allocation policy that they use for their target date funds, but this does seem like a good alternative.
Does Schilling have a blog or website by any chance?
Brian: Martha Schilling’s website is here: http://www.schillinggroupadvisors.com/
It appears to be pretty static though. I’m not seeing a blog anywhere.
You could use your withdrawals to rebalance. So when the market is plummeting, you mostly cash out your CDs. During market bubbles, you mostly sell stock.
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