In a comment on yesterday’s post, Aaron asked what a person’s portfolio should look like as he approaches and enters retirement. The question of what percentage of your portfolio should be devoted to each class of investment is known as “asset allocation.”
The most common answer given to the asset allocation question is, unsurprisingly, ”It depends.”
My opinion on that answer?
- Yep. It does “depend.”
- But that’s still a giant cop-out (and completely unhelpful).
You’ll usually hear that your asset allocation should depend upon your investment time frame (how many years until you need the money) and upon your “risk tolerance” (how comfortable you are with fluctuations in the value of your portfolio).
I absolutely agree that your asset allocation depends upon your time horizon. But…
I Think The Concept of Risk Tolerance is a Lie
(…kind of). Sure, if a particular person is going to have a heart attack as a result of a 30% drop in her portfolio value, yes, we want to take that into account.
However, I think financial advisors (and writers) use the concept of risk tolerance as a way to avoid telling the real truth. The real truth is that people need to have most of their money in equities, regardless of how uncomfortable that idea might make them. Think an almost-entirely-equity portfolio sounds crazy? Have a look at how JD from Get Rich Slowly described his financial position earlier today:
J.D. is a middle-aged blogger. He recently eliminated his consumer debt, and is only now beginning to learn about investing. All of his retirement money is in stock index funds (though one of them is FFNOX, which includes a small portion in bonds).
According to data from the Federal Reserve Bank of St. Louis, bonds offer a meager after-inflation return of 2-3%. (After-inflation returns for CDs are usually barely above zero–sometimes lower.) To be able to make her retirement nest egg last through 15-30 years of retirement on 2-3% returns, an investor would have had to save an absolutely exhorbitant sum of money.
The real truth? Most people simply do not save enough over their working years to be able to base their portfolios on debt. Without the income growth provided by equities, they’ll run out of money. For most people, the only solution to funding a multiple-decade retirement is to own equities and to have the courage not to panic when the market drops. (It’s sure to drop significantly at least a couple times over 20 years.)
The concept of risk tolerance says that it’s OK to put most of your money in debt investments if you’re uncomfortable with uncertainty. To some extent, it’s true: A primarily-debt portfolio does provide you with some “certainty.” Now, whether it’s the type of certainty that you’re seeking…
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{ 3 comments }
That makes no sense. The reason you move money to bonds is because you are about to use the cash. If at 65 you don’t have 65% of your money in bonds, and the market tanks (like it just did) you lose 40% of your portfolio. If only 35% is in equities, you only lose 17%.
Do you make less over time by buying bonds? It depends on the market at the time you are retiring
Hi Farhan. Thanks for stopping by and commenting.
I agree with you: If you’re about to use the cash, having debt investments (such as bonds) makes sense.
The point I’m trying to make, however, is that many financial advisors and/or writers recommend that people have a big portion of their portfolio in debt investments, simply because they’re not comfortable owning stocks (or stock funds).
To me, if the investor is years away from retirement, making such a recommendation is a disservice to the client/reader/investor.
Mike,
I agree with you here. I’m a financial planner and see this all the time in the industry. I’ve looked at the numbers a lot, and if you’ve got at least 20 years until retirement then you should have no less than 80% of your portfolio in stocks. Even during retirement you shouldn’t have less than 50% of your portfolio in stocks. Why? Inflation. If you have most of your money in bonds there’s a good chance you’ll run out of money because of your withdrawals and inflation.
My analysis all depends on you having saved 20-25 times the annual income you’ll need in your first year of retirement and assumes you increase your withdrawals by inflation every year. If you were to have a lot more than that saved up, then sure you could put it primarily in bonds. But as you noted, most people aren’t saving nearly enough as it is so they should have much more in stocks.
The key is education about how the market works and realizing how important it is not to panic. We also have to understand there is no easy way to make money in the stock market, and no one has the magic solution to making money on stocks every single day. If it sounds too good to be true…you know the rest.
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