Opher Ganel, Wealth of Geeks
The stock market has taken a pounding in 2022, shaking the confidence of many soon-to-be retirees preparing to take the big jump into the post-work phase of their life.
According to S&P Global, the stock market has lost over 17% this year through August, as measured by the performance of the popular S&P 500 index.
With such volatility, it is prudent to reassess one’s asset spread ahead of a likely recession. Are you nearing retirement and wondering how much you should have invested in stocks?
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Your stock allocation for retirement
Asset allocation refers to the subdivision of a portfolio between different types of investments (e.g., stocks, bonds, cash, real estate, etc.). Research shows asset allocation has a far greater impact on a portfolio’s returns and volatility than the specific investments chosen (e.g., which specific mutual fund, stock, or bond).
How can you address market and sequence risks with a retirement portfolio partly in stocks? You must maintain proper asset allocation as you approach retirement, enter it, and live through it.
“Our investment philosophy is centered around the idea that we won’t be able to find excess returns in the long term by trying to time the market or pick stocks,” said Ian Weiner, CFP of Just Retire Now. “Yet we know that owning a diversified equity portfolio has generated the most appreciation over the long term since we’ve been tracking the data from 1926.”
“As simple as it sounds - our strategy is to have three to five years of expenses in low volatility assets (sometimes cash, depending on client risk tolerances), with the rest of the portfolio invested in diversified equity positions,” Weiner said.
Some asset classes are riskier than others, which usually corresponds to higher expected returns. Mixing assets that don’t correlate (i.e., when one zigs, the other zags) reduces your volatility faster than it reduces your expected returns.
There are various simple formulas for a stock allocation as a function of age, some more conservative and others more aggressive.
It’s impossible to define a single ideal asset allocation, except in hindsight. The best you can shoot for is the optimal asset allocation for you personally, which will change over time.
“The investment advice industry tends to focus on the stock/bond asset allocation mix as the most fundamental characteristic of an investment portfolio, but in fact it isn’t,” said Matt Smith, CFA, Founder of Concert Financial Planning. “Having reviewed and analyzed thousands of portfolios and models run by financial advisors across the US, I can tell you that one person’s 60/40 stock/bond mix may behave very differently from another person’s 60/40 stock/bond mix.”
“The deeper information, and the most crucial thing to get right, is targeting the right level of volatility in the portfolio, so you balance long-term growth goals with the ability to stay the course in times of market stress. The stock/bond asset allocation should simply be the byproduct of that more fundamental calculation.”
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Your ideal asset allocation
There are four crucial questions to ask that will help you decide your stock allocation:
1. What is your risk tolerance?
If losing 20-50% of your portfolio in a given year (recall that with bear markets, downturns of over 20% happen about every 3.6 years on average, while those exceeding 30% occur every 5.5 years) would see you head for the hills, locking in your losses, you shouldn’t be heavily invested in stocks.
2. What is your time horizon?
Making back bear-market losses usually takes many months or even years. This implies that you probably shouldn’t invest any money in stocks that you could need in the next few years.
3. How much growth do you need?
You don’t need to invest in stocks if you already have so much money that you could cover your expenses with a zero-stock portfolio. If you are just starting out, though, and need to make real gains, you may need the upside growth stocks can bring.
4. How flexible is your budget?
If most of your spending is fixed, a crash early in your retirement (if you hold most of your portfolio in stocks) will cripple your plan, as you need to cover your spending by selling stocks at exactly the worst time, when their prices are low. On the other hand, if most of your spending is discretionary, you can cut back when the market craters, reducing or eliminating such forced loss-selling.
“Asset Allocation, especially in retirement, is all about what makes sense to you, the individual - traditional rules of thumb don’t necessarily apply to everyone,” said Nick Covyeau, CFP, Owner and Financial Planner at Swell Financial. “It’s important to first determine how much you can afford to spend/draw down each year from your portfolio before diving into asset allocation.”
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The problem with accepted age-based allocation formulas
As the above-mentioned primer says, there are multiple age-based formulas for how much of your portfolio should be in stocks vs. bonds. Here are three (of course, for any age that gives a negative number, use 0%, and when your answer is over 100%, use 100%):
1. The percentage portion of stock in your portfolio should equal 100 minus your age (e.g., at age 65, you’d have 35% in stocks)
2. The percentage portion of stock in your portfolio should equal 120 minus your age (e.g., at age 65, you’d have 55% in stocks)
3. The percentage portion of stock in your portfolio should equal 90 and your age (e.g., at age 65, you’d have 70% in stocks)
Wade Pfau, professor of retirement income at the American College of Financial Services, makes some suggestions for how to ensure your savings can last you through your retirement.
Pfau reminds people to spend less than you think you can, in good times and bad. Pfau believes that due to lower expected returns in the coming years and decades, the 4% rule now has about a 60-70% chance of working, compared to its near-certainty back in the 1990s. Thus, he suggests reducing it to a “3% rule.”
When the market drops, reduce your spending as much as possible (e.g., that year, don’t take an expensive vacation, don’t remodel your kitchen, reduce gifting, eat out less frequently, etc.)
He also encourages the use of buffers such as cash, a reverse mortgage, or a whole life policy with cash value to cover expenses when the market suffers a downturn.
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The bottom line
As you approach retirement, figuring out your stock allocation is crucial and not intuitive. You have to consider the questions listed above and may want to find a local financial advisor who can help. Your answers will determine whether you should be more or less aggressive in your asset allocation.
