What this article covers
Opher Ganel explains how to set your stock allocation as you approach and move through retirement, and why popular age-based formulas such as 100 minus your age break down later in life. Drawing on three financial advisors and retirement researcher Wade Pfau, he frames the decision around four questions: your risk tolerance, time horizon, need for growth and budget flexibility.
Key Takeaways
There is no single ideal asset allocation for retirement, only the right one for you
Asset allocation drives more of a portfolio’s returns and volatility than which specific funds or stocks you pick, but the best mix can only be known in hindsight. One advisor interviewed argues the real target is the right level of portfolio volatility, noting that one person’s 60/40 stock/bond mix can behave very differently from another’s.
Four questions set your stock allocation: risk tolerance, time horizon, need for growth and budget flexibility
With bear markets (losses over 20%) arriving about every 3.6 years on average, money you need in the next few years probably shouldn’t be in stocks. Retirees with mostly fixed spending are more exposed to a crash early in retirement than those who can cut discretionary spending, and risk tolerance should be weighed alongside your capacity to absorb losses and your need for returns.
Age-based rules like 100 minus your age break down in late retirement
At 65, the three common formulas put 35%, 55% or 70% in stocks, but at 90 they imply 10%, 30% or 0%, which makes little sense for someone with a $1.75 million portfolio and a life expectancy under 5 years. Wade Pfau suggests the opposite (a low stock allocation early in retirement that rises over time), plus spending less, cutting back in down markets and holding buffers such as cash.
Ian Weiner
Matt Smith
Nick CovyeauAre you nearing retirement and wondering how much you should have invested in stocks?
- In a previous article published on Wealthtender, I covered the importance (albeit unpleasantness) of good retirement planning, the 7 risks you face, the ideal (but impractical) solution, and offered a more practical approach.
- That approach requires investing in higher-risk/higher-reward assets like stocks.
- Unfortunately, such an approach requires you to face and mitigate market and sequence-of-return risks. A major part of how to address those has to do with figuring out your right stock allocation as you approach retirement.
How to Determine Your Stock Allocation as You Near Retirement
How can you address market and sequence risks with a retirement portfolio partly in stocks? The short answer is what was already alluded to above. Maintaining proper asset allocation as you approach retirement, enter it, and live through it.
Asset Allocation Basics: Highlights from OptimizedPortfolio.com’s Primer
1. Asset allocation means how you subdivide your portfolio between different types of investments (e.g., stocks, bonds, cash, real estate, etc.).
2. Research shows asset allocation is responsible for far more of a portfolio’s returns, and its volatility, than which specific investments you choose (e.g., which specific mutual fund, stock, or bond).
This aligns with the investment philosophy of Ian Weiner, CFP®:
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. 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, ~1926.
We also know that on average a correction, or greater than 10% drawdown from highs, has lasted on average three years, with the exception being the Great Financial Crisis, where equities took five years to reach new all-time highs. While things could potentially change in the future, we have a solid basis to believe that as long as we’re not forced to sell during a roughly three-year recovery period, the long-term price appreciation will be on our side.
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.”
3. Some assets 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.
4. There are various simple formulas for a stock allocation as a function of age, some more conservative and others more aggressive.
5. 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.
Matt Smith, CFA®, CFP®, CIMA®, CAIA®, Founder of Concert Financial Planning, agrees, saying:
Traditional approaches to asset allocation might involve picking a mix of stocks and bonds that become progressively more conservative with age, “risk tolerance,” or retirement date – essentially a ‘generic drug’ approach to picking one characteristic of the person and prescribing a dosage based on that limited information.
This approach may be completely fine for many people who don’t have serious financial issues or complex financial situations, akin to the common cold in medicine. However, for those who do have significant financial issues or complexity, getting the asset allocation dialed in appropriately can be incredibly powerful medicine.
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. 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 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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What Determines Your Ideal Asset Allocation in Retirement? 4 Questions to Ask
There are 4 crucial questions to ask that will help you decide your stock allocation:
1. What Is Your Risk Tolerance (and Your Capacity for Losses)?
As mentioned above, if losing 20-50% of your portfolio in a given year (recall that bear markets, i.e. >20%, losses happen about every 3.6 years on average, with >30% losses every 5.5 years) would see you head for the hills, locking in your losses, you shouldn’t be heavily invested in stocks.
Here, Smith points out:
When considering asset allocation between, e.g., stocks and bonds, the traditional financial advice industry tends to focus a lot on a client’s perceived “risk tolerance”. This can be misleading, however, when a person’s tolerance for risk is not taken into context with their capacity to absorb losses and their need for returns. If these three facets of a person’s situation do not align (i.e., high need but low capacity and tolerance), it is an indication that there is much to discuss beyond the investment portfolio.
2. What Is Your Time Horizon for Needing the Money?
Making back bear-market losses usually takes many months or even years. This implies that you probably shouldn’t invest in stocks money you’ll need in the next few years.
3. How Much Growth Does Your Retirement Portfolio Need?
If you already have so much money that you could cover your expenses from a 0%-stock portfolio essentially forever, you don’t need to invest in stocks (though you may still want to overweight stocks if you want to build multi-generational wealth for your family – and you wouldn’t be worried about a 50% loss because you have so much money in the first place that you could easily make back all your losses before they’d be locked in).
4. How Flexible Is Your Retirement Budget?
If most of your spending is fixed, a crash early in your retirement (if you hold most of your portfolio in stocks) would 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.
Nick Covyeau, CFP®, Owner and Financial Planner at Swell Financial, says:
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. 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.
Personally, I’m a fan of the “buckets approach” where we assign different risk profiles to different segments or time horizons of a client’s life. This means money you expect to need sooner should have a more conservative risk allocation than money assigned to be spent later. Simply put, we take risk where it’s appropriate to and don’t take risk where it’s not.
Legendary advisor and coach Nick Murray famously championed a portfolio holding two to three years’ worth of living expenses in cash to be able to sustain a market correction, while keeping the rest of the portfolio entirely in equities. Though I disagree with that approach personally, the idea behind it works.
This idea of not disturbing your long-term assets during a time of market volatility allows for greater investment success and long-term appreciation.
“If investors can have a conservative portion of their account, in addition to some personal savings in cash to cover living expenses, they can keep the rest of their portfolio invested in the market where it can keep growing.”
Why Age-Based Rules Like 100 Minus Your Age Fall Short in Retirement
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%):
- Have in stocks a percentage equal to 100 minus your age (e.g., at age 65, you’d have 35% in stocks)
- Have in stocks a percentage equal to 120 minus your age (e.g., at age 65, you’d have 55% in stocks)
- Have in stocks a percentage equal to double the difference between 90 and your age (e.g., at age 65, you’d have 70% in stocks)
However, none of them make sense beyond a certain age.
For example, if you retired at age 65 and made it (with your $1.75 million portfolio intact) to age 90, does it really make sense to have 10%, 30%, or 0% in stocks, respectively?
According to the Social Security Administration’s actuarial tables, at age 90, Americans have a life expectancy of under 5 years. If you have a $1.75 million portfolio and need about $70,000 a year to complement your Social Security benefits, you don’t need any allocation to stocks, but there’s virtually zero risk that you’ll outlive your money even if it’s 100% in stocks!
Also, the first glide path (100 minus age) would struggle to provide the growth you need for decades in retirement, while the second and third expose you to high sequence risk.
Wade Pfau, professor of retirement income at the American College of Financial Services, suggests an opposite approach to solve this dilemma, “… you could have a low stock allocation early in retirement but increase it over time…”
While this approach reduces your sequence risk early in retirement, it does so at the cost of missing out on the more-likely appreciation you could gain from stock exposure during those years.
3 More Ways to Reduce Sequence-of-Returns Risk
Whether you follow Pfau’s contrarian advice or not, he offers three other ways to combat sequence risk:
- 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.)
- Use buffers such as cash, a reverse mortgage, or whole life policy with cash value to cover expenses when the market suffers a downturn
The Bottom Line: There Is No Single Ideal Asset Allocation
Figuring out your stock allocation as you approach retirement is crucial, and not intuitive. You have to consider the 4 questions listed above.
Your answers will determine whether you should be more or less aggressive in your asset allocation.
And what’s right for you may be very different than what’s right for me. However, if you’d like to know my personal approach, I cover it in detail in my next piece.
Frequently Asked Questions
What is the ideal asset allocation for retirement?
No single asset allocation is ideal for everyone, and the best mix can only be identified in hindsight. The goal is the optimal allocation for you personally, which depends on your risk tolerance, time horizon, need for growth and budget flexibility, and which will change over time.
Does the 100 minus your age rule work for retirees?
Age-based formulas (100 minus your age, 120 minus your age, or double the difference between 90 and your age) give a starting point but stop making sense at older ages. The 100-minus-age glide path may not provide enough growth for decades in retirement, while the more aggressive formulas expose retirees to high sequence risk.
How can retirees reduce sequence-of-returns risk?
Retirement researcher Wade Pfau suggests a low stock allocation early in retirement that increases over time, although that approach can mean missing out on likely stock gains in those years. He also recommends spending less than you think you can (a 3% rule rather than the 4% rule), cutting spending when markets drop, and holding buffers such as cash to cover expenses during downturns.
What is the bucket approach to retirement investing?
The bucket approach assigns different risk levels to money based on when you will need it, so funds for near-term spending are invested more conservatively than money meant for later. One advisor interviewed keeps three to five years of expenses in low-volatility assets with the rest in diversified stocks, so clients aren’t forced to sell during a market recovery.
Is risk tolerance enough to choose a retirement asset allocation?
Not on its own. One advisor interviewed says risk tolerance should be considered together with your capacity to absorb losses and your need for returns, and that targeting the right level of portfolio volatility matters more than the stock/bond split itself. Another advisor stresses first determining how much you can afford to draw from your portfolio each year.
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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.
About the author
Contributing Writer, Wealthtender
My career has taken some unexpected turns, from earning a PhD in experimental high-energy physics, to conducting cosmic-ray research in Antarctica, to supporting NASA projects and programs, to running my own consulting business. I also run several other small businesses and help my wife run her Marriage and Family Therapy practice.
Those experiences taught me to question assumptions, think critically, and recognize that real-world decisions of any significance rarely have simple answers that apply to everyone. Today, I bring that perspective to writing about personal finance. Drawing on my analytical background, business experience, and research, I explore financial decisions, challenge conventional wisdom, and help readers understand the tradeoffs that can affect their financial well-being. To complement my own research and experience, I also weave insights from financial professionals into my articles, drawing on their expertise and real-world experience helping clients navigate financial decisions and challenges.
At medium.com/@opher-ganel, you can read more of my articles and subscribe to receive email notifications when new ones come out.