Five factors for your asset allocation

When you think of your portfolio, visions of stocks, bonds and cash likely dance in your head. Generally, the mix of those investments is based on some measure of When you'll need the money

The conventional wisdom is that the farther you are away from your investment goal, the more risk you can take. While that's generally true, discussions of investment time horizon usually focus on one point in time, and that's usually when someone will retire. However, a retiree won't need all the money all at once. She'll take a bit out the first year — let's say 4 percent, since that's the safe withdrawal rate that most studies hover around (though there's plenty of debate about it) — but the rest will remain invested. Then she'll take out a bit the next year, and then a bit three years later, and so on… for decades. Retirement isn't a single financial goal, but a series of 30 or so (depending on life expectancy) progressively longer goals that must be met each subsequent year.

These goals must meet two criteria: 1) The money must last as long as the retiree does, and 2) provide income that keeps up with inflation. The implication is that retirees should still have money in stocks, since a portfolio dominated by bonds and cash would have trouble accomplishing both of those criteria.

The Reality of Risk

If you visit a financial adviser or use some kind of asset allocation software, you'll be asked a series of questions that will attempt to determine your risk tolerance. What this is really asking is how much of a decline you can stand before you panic and sell. However, thanks to the Great Recession, you already know the answer to that question. From October 2007 to March 2009, the S&P 500 fell more than 50 percent. Other sources of retirement income

You might be among the lucky minority that will receive a defined-benefit pension (i.e., a monthly retirement check for the rest of your life, courtesy of your employer). Or you might decide to purchase such a benefit yourself in the form of an income annuity. Maybe you own some property and receive rents every month. Whatever the source, a reliable stream of retirement income can factor into an asset allocation.

Retirees whose total retirement expenses are covered by a pension (or other income) can take more risk since a market downturn likely won't change their lifestyle or require them to go back to work. For those who rely on their portfolio for at least some of their income, they have to play it safer. Retirees should keep at least five years' worth of expenses out of the stock market. That might be safe enough for some investors, especially those who have a pension as a safety net. For those whose pension doesn't cover much, then the portfolio should be closer to a traditional mix of stocks, bonds and cash.

However, all this depends on how safe that income stream is. Just as bond issuers occasionally go bankrupt, there's a chance the company behind your “guaranteed” retirement income will go belly-up. Pensioners need to regularly assess the financial viability of their pension provider. Even many state and local government pensions are underfunded, to the tune of $3 trillion across all government plans, according to ratings agency Moody's. Just ask the pensioners of Detroit, who are currently facing potential cuts. Private pensions are backstopped by the Pension Benefit Guaranty Corp. (PBGC), but it only insures benefits up to a certain amount ($57,477 for plans terminating in 2013). Plus, the PBGC itself is underfunded by more than $20 billion. Government pensions are backed by the power to raise taxes, which will lead to some heated debates as more and more Boomers retire and strain government budgets. As for annuities, make sure the insurance company sending the checks is rated A or higher by Moody's, Fitch and S&P.

Your Human Capital

If you're still working, you're a living, breathing money machine. Every workday, you exchange your hours for dollars. Some experts think those dollars should be taken into account when you allocate the dollars in your portfolio.

Your ability to earn (and grow) a paycheck is known as your “human capital.” It can include your skills, education, network, charisma, and other traits that you can turn into a paycheck. But not all paychecks are created equal. Some are relatively stable and secure, others are more variable and unpredictable.

Finance professor Moshe Milevsky has written about this quite a bit, often asking this question: “Are you a stock or a bond?” (In fact, that's the title of one of his books.) If your job is safe and your income steady and reliable, you're more like a bond and can take more risks with your assets. On the other hand, if your job and compensation are very sensitive to the health of the economy, you might play it safer to mitigate the risk that your paycheck and portfolio are down significantly at the same time.

You also don't want too much of your human capital and your investment capital reliant on the same company, or even industry. This most obviously applies to workers who own company stock. One rule of thumb is that investors should have no more than 5 percent of their portfolios in one stock. But if that one stock is in the company that also puts food on your table, then even 5 percent might be too much since you don't want your paycheck and a large portion of your portfolio to disappear in case your company becomes the next Blockbuster Video, Circuit City, Lehman Brothers, or other company that once seemed on top of the world but is now gone or barely breathing.

Your Adviser Diversity

Your portfolio was built on a foundation of education, judgment and advice. Investments made it into your accounts thanks to the decisions of one or more people who think they know a thing or two about investing. One of those people may be a financial adviser, who recommended that you buy certain stocks or funds. Others could be the managers of the funds you own, who decide what the fund itself should own. Then, of course, there's you – the person who plays the role of portfolio bouncer, standing at the front door and deciding who gets to come in and who gets thrown out.

Here's the thing about people: They're not perfect… and that includes you (as smart and good-smelling as you are). Even the world's greatest investors make mistakes, and some turn out to be not as great as we all thought. The investing world is full of examples of once-great funds or fund managers who lost their touch — assuming they had it in the first place, and their “outperformance” wasn't really “dumb luck.”

To mitigate this “everyone's fallible” risk, make sure you're incorporating a diversity of analyses and opinions into your portfolio.

More about...Investing, Planning, Retirement

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Derek @ MoneyAhoy.com
Derek @ MoneyAhoy.com
7 years ago

I’m one of those folks that folded and dumped a lot of stock in the 2008 crash! After such a big mistake, I am slowly trying to train myself to get back into stocks (namely market index funds).

Hopefully this time around I’ll be able to stick with the swings more and pickup additional stocks as we go down.

I’m trying to keep the 30-year outlook in the front of my mind and not worry about daily gyrations!

Michael @ The Student Loan Sherpa
Michael @ The Student Loan Sherpa
7 years ago

I think the 30 year outlook is definitely the way to do it. Its just hard to stay the course after you have taken a serious beating like we did in 2008.

rjack (Mr. Asset Allocation)
rjack (Mr. Asset Allocation)
7 years ago

Actually, the 2008 crash was one of the best things that ever happened to me, because I followed my asset allocation strategy and bought more stocks. It’s the main thing that allowed me to retire early.

Derek @ MoneyAhoy.com
Derek @ MoneyAhoy.com
7 years ago

Rjack,

I wish I would have been there with you! I totally screwed it up and probably lost out on ~5-10 years of retirement because of the bad choices!!!

Thomas | Your Daily Finance
Thomas | Your Daily Finance
7 years ago

I would also think that other things could be considered outside of the stock portfolio when it comes to your allocation as well. Say you have 100k in stocks, 20k in savings account, real estate, and side hustles making money. Its easier for that people to take more risk possibly in the market knowing that all around they are diversified. When people look at allocation it should be a total picture of their financial situation and not just want is invested in stock in my opinion.

Matt Becker
Matt Becker
7 years ago

Great stuff here. I’ve taken those “risk tolerance” surveys and I honestly can’t believe that they have much value. You really have to live through a crash to know how you’ll react. Hopefully people remember their feelings during 2008 and don’t let the run-up over the last few years completely cloud their judgment. One thing that people often fail to recognize is that there is real long-term risk with stocks. When you look at 30 year periods, the thing people focus on is that the returns are always positive. But the difference between a 6% annual return and a 10%… Read more »

EMH
EMH
7 years ago

When the stock market tanked, I was still buying stocks. The only reason I did so was due to my age. I felt like I had time on my side. If I was 55, instead of 35, then I would have probably freaked out and sold the stock as well. The time horizon is a huge factor for me. I don’t know if this is the smartest thing, but I have two different Target Date Funds with different companies – Schwab and T. Rowe Price. I don’t like to put all my eggs in one basket but I worry that… Read more »

Jay
Jay
7 years ago

I bought heavily into Las Vegas Sands and Ford Motors in late 2008 and early 2009. I thank my lucky stars I had the courage to make those purchase$.

Jake @ Common Cents Wealth
Jake @ Common Cents Wealth
7 years ago

There are a few great tips here. It’s so common that people plan their asset allocation based on the year they want to retire when in reality, they’ll only take out a small portion that year and for the 30 years following. I also thought the metaphor of whether your job is a stock or bond is a valid one as well.

mike
mike
7 years ago

Pensions- They are joke right now. 3 Trillion is a very conservative # of how much they are underfunded. If you were to look at all Pensions in the U.S. they are probably close 20 trillion to 50 trillion underfunded depending on calculation methods used. Many promises were made that can’t be kept and the taxpayers will revolt if they jack taxes up more because they don’t have anymore wiggle room to be paying for other peoples pensions. Stocks-Most people underperform any returns including indexing because they try to time the market or just from fear of losses. Every study… Read more »

ARCpoint Labs of Herndon
ARCpoint Labs of Herndon
7 years ago

People often forget that their investments for the future (college savings, retirement, etc.) have to keep up with inflation. And the money still has to be there far into the future for when you will need it. Good advice.

Mike@WeOnlyDoThisOnce
7 years ago

Pensions vary widely, especially when you’re in the private sector. Good information here.

rosarugosa
rosarugosa
7 years ago

Robert,
We need a small army of people with your wit and wisdom teaching financial literacy to young people before they go out into the world! I was able to stay strong through the recession with my “ostrich strategy” of not looking at my 401K until it was almost over. And I do smell good; thanks for noticing 🙂

Theegooch
Theegooch
7 years ago

Not bad info. I would like to point out that people trade work for money, not hours. if I come to work and just sit at my desk I won’t get paid for it.

And don’t forget to continue live life and save for retirement. There are things in life that are best experienced when you are young and fit, and there is no guarantee you’ll live another day. so, I say take a balanced approach between saving, spending, and giving.

Kirk Kinder
Kirk Kinder
7 years ago

I especially like Robert’s point about your job being a stock or a bond. This plays into how big your emergency fund should be. If you are in a sales position, you may need a year’s worth of expenses, but if you work for the government, three months should suffice.

Along those lines, you don’t want too much company stock. Robert is right that this is way too much risk.

Krishanu
Krishanu
7 years ago

As usual, Mr. Brokamp tackles a complex issue with knowledge and humour, which ends up being a fantastic post. Thank you for pulling me back to GRS, time and again.

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