You might be wondering what the right retirement asset allocation is if you are retired now or getting ready to retire. In fact, this is the second most frequently asked question I hear. (The number one question people ask me is, “How much money do I need to retire?”)
The conventional wisdom is that as you get closer to retirement your portfolio should become more conservative. But are conservative investments really the best investments to make for retirement income? On the face of it, this seems reasonable.
The older you are, the less able you are to make up for huge drops in value. Also, as you age, you’ll become more dependent on your investments to provide the income you need to live on.
So, as you become more dependent on your capital, some argue, you need to invest more conservatively. This way, you take less risk of losing your money and therefore, you safeguard your income better. There is truth in this argument.
But it does not mean that your money should mostly be invested in stable value funds (or bond funds) just because you retire. Lower risk investments are great. They can reduce risk and provide stability over the short run. The problem is, you’re still investing over the long run, and the fact that you retired doesn’t change that.
Don’t get me wrong. If you can afford to invest this way and still not outlive your income, that’s fine. But what if you invest very conservatively in order to feel good now…but it means you run out of money too soon? I’m not saying you shouldn’t be more conservative. I’m saying you should consider everything before you make that decision.
The proper way to implement retirement asset allocation is to consider the desired longevity of your money. Here’s what I mean.
Proper asset allocation is a function of how long you want your money to last – not how long you think you are going to last.
For example, if you are going to retire next year but plan on staying alive and retired for 25 years after than, your asset allocation should be that which provides the best return with the least risk based on a 25-year time horizon – not a one-year or a one-day time horizon.
As you get older, your investment horizon does indeed shrink. But the mistake is that people forget how long they are going to live and how long they need that money to work for them. They sometimes invest as if their investment time horizon is very very short when in fact it is much longer.
From a historical viewpoint, you take on more risk if most of your money is invested in bonds if your investment horizon is 25 years.
Bottom line? Your target retirement date is not a triggering point at which all your money must be invested as conservatively as possible. It’s not that simple.
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{ 3 comments… read them below or add one }
I think the right asset allocation is the key to everything. Picking consistent winners is a fools game in the long run.
Hi Neil, Just remember, it’s really important to start investing (even just a bit) sooner rather than later. Choose a modest asset allocation to start and then adjust as you go along. Research shows that 90% of portfolio returns come from the asset allocation decision.
PS This is a great post, it’s going in my link round up next week!
Asset allocation is quite important, not only from Bonds/Cash vs Stocks, but also from the different types of stocks and the different industries. However, the one allocation I am remaining firm is 80% stocks to 20% bonds/cash once in retirement years with the last 10 years of employment moving in that direction.