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August 25, 2022
Diversification should be one of your retirement mantras. After all, if you have all your eggs in one basket, they’re more likely to all break if something goes wrong. That is why you want to try to achieve the right asset allocation mix for your particular situation. Continue reading for some rules of thumb as well as sample asset allocations to help you know if you are in the right ballpark (hen house) with your nest egg!
Financial planners have developed a couple of rules of thumb for different asset allocations over the last 50 years. They’re a handy mental shortcut for DIY retirement planning, but how good are they?
The investing landscape has changed significantly since the rules were first written down in the 1960s and 70s. Back then, you could get risk-free U.S. government bonds that would pay 10%. These days, the yield on the 10-year U.S. Treasury is around 3%.
At the same time, the stock market seems to defy gravity. From its low point after the crash of 2008-2009 to its peak in February 2020, the S&P 500 index of U.S. stocks grew 323%. If you had $100,000 in an indexed fund in February 2008 and you didn’t panic sell any during the crash, you’d have $423,000 in just 10 years.
Life expectancy has also zoomed up by 10 years since the 1970s when the rules first became popular.
Like all rules of thumb, most asset allocation rules have been contested since day one. Ralph Waldo Emerson famously said, “a foolish consistency is the hobgoblin of little minds.” In the case of asset allocation rules, there are lots of little details that make following the rules too closely dangerous.
The most famous rule for asset allocation in your retirement account is the Rule of 100.
The Rule of 100 says, subtract your age from 100 and the answer is how much of your retirement portfolio should be invested in riskier, high-growth investments like stocks. If you’re 25, 75% of your portfolio should be in stocks and 25% should be in safe assets like bonds. By the time you reach 75, the proportions should be reversed: 75% of your savings should be in bonds and 25% in stocks.
Fortunately for us (but problematically for our retirement), people are living longer, which means they have more time to work and grow their investments. Some financial planners modify the Rule of 100 for their clients to be the Rule of 125. If you think you’ll live for 25 years after retirement, you may not want to have 75% of your nest egg in bonds that only return 0.7% per year. The updated rule makes your sample asset allocation at age 75 a 50/50 split between stocks and bonds.
But just changing the math won’t fix the fundamental problems outlined above.
Another popular rule of thumb is the 60/40 Rule where 60% of your portfolio is in stocks and 40% is in bonds. This rule became popular after the turn of the century as more people became responsible for their retirement planning. One thing going for it is it’s easy to remember. And, it’s pretty easy to manage. If you look at your portfolio and one stock has changed the balance, sell some of it, and buy bonds.
The ideal asset allocation is constructed using your goals, time frame for potentially needing access to the money, and your risk tolerance. Again, asset allocation is key to being diversified and reducing exposure to any one sector.
The sample asset allocation above uses the following types of investments at different percentages, depending on your profile:
Fixed income investments are securities that pay a fixed amount of interest or dividends — so you know exactly what you are getting and when. Examples of fixed-income investments include bonds (treasure, government, agency, municipal and company), mortgage-backed securities, and certificates of deposit. Annuities are technically an insurance product, but they do provide fixed income and many retirees appreciate the assurances an annuity provides.
There is little risk with fixed-income investments because you know what you are getting, but the returns are not great.
All asset allocations need to include cash. This is the money you need to have on hand for expenses and emergencies.
But holding cash is for short-term needs. If you keep a large amount of cash in a high-interest account, you are not only not getting a good rate of return, you risk losing your purchasing power if inflation ticks up dramatically.
Large-cap stocks are shares in big corporations: companies with a market capitalization (total dollar market value of the company’s outstanding shares) of $10 billion or more.
Large-cap stocks are considered to be fairly stable, with less risk.
There is no one definition of a small-cap stock, but it is a general term used to describe companies with a market capitalization at somewhere between $300 million and $2 billion.
Small-cap stocks have historically delivered better returns than large-cap stocks, but they are also more volatile and riskier.
NOTE: Holding shares in one large-cap or small-cap company is riskier than holding an index of many different companies in either sector.
Any rule of thumb or sample asset allocation can become really complex when you start to apply it to your personal circumstances and as things change over time.
That’s why asset managers like Schwab and Vanguard allow you to invest money in your 401K in target-date funds that automatically rebalance your portfolio based on the date of its maturity.
If managing your investments on your own, you may want to create and maintain an Investment Policy Statement.
It may be a good idea to work with a Certified Financial Planner™ to determine your investment policies. Their expertise can be invaluable. Book a free discovery session with NewRetirement Advisors.
Basically, the rules are a shortcut calculation based on Modern Portfolio Theory. Harry Markowitz developed the theory, which was refined by Merton Miller and William Sharpe, all of whom won a Nobel Prize in Economics in 1990 for their work.
Modern Portfolio Theory (MPT) says you can increase portfolio returns by quantifying risk. The Rule of 100 assumes that your age is an approximate value for how much risk you can tolerate, so the younger you are the more risk you’re willing to take on to get better returns. The closer you are to retirement age, the less risk you can handle, so your portfolio shifts to “risk-free” assets, like U.S. Treasury bonds.
Robo-advisors like Betterment take away most of your ability to pick and choose what you want to invest in, giving you instead a list of goals and preferences to check. Their proprietary investing algorithm does the rest. But these solutions only address specific risks — the risk of investing too much money on one stock — not the systemic risk of market collapse or rising inflation.
The real risk of retirement savers is income risk, which includes systematic risks like inflation, market crashes and the loss of pension or social security income. Calculating those kinds of risks — and protecting yourself from them — takes a more comprehensive approach, like the kind offered by the NewRetirement Planner.
Diversification in retirement isn’t just about a defined contribution account and the rates of return. Diversifying your investments to create a retirement paycheck is also important.
Retirement is the time to shift your focus from just returns to income. Explore 18 retirement income strategies for lifetime wealth and peace of mind…
Some places to put earned income that aren’t stocks and bonds include:
Real diversification can also complicate your tax picture as you have more and different sources of income that are taxed at different rates to consider. A powerful tax calculator like the NewRetirement Planner is an essential tool for making the right decisions. Try different scenarios with different investments. See how your tax burden is impacted as you draw them down.
The problem with rules of thumb for asset allocation is that they are always just approximations. They don’t cover all the unique circumstances you bring to the table.
An advanced retirement planner will help you see and manipulate all the levers impacting your situation. It is the best way to model your various opportunities and set yourself up for success in retirement.
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