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Fine-Tuning Your Stock-Bond Mix

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

Investors looking to get going on their asset allocation have a few places to start. They could look at the asset allocation of target-date funds, use online calculators; they could rely on some simple rules of thumb.

But customizing and personalizing the asset allocation to your specific situation is where the pencils really need to get sharpened.

Here with me talk about some of those swing factors in asset allocation is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, there are several potential swing factors you might want to consider in how you're customizing your asset allocation. Today, we're going to talk about deciding whether you should hold fewer equities or more equities. We divided it into some different life stages.

So, let's start with some of the younger investors, the accumulators. What things should they think about as they are deciding whether they should bump up their equity exposure a little bit or hold off on it a little bit?

Benz: Well I think for those folks, they want to think hard about the chances of income disruption in their lives. So, of course, there is that standard prescription that we should all have the three to six months worth of living expenses set aside in an emergency fund, and that's great advice, but if you are someone with a realistic chance of income disruption or maybe you're one of the many people who's already been laid off, you definitely want to make sure that you have additional assets set aside to meet your living expenses if you quickly cycle through those three to six months, and you find you still need more.

So, if you are a tenured college professor, probably not as much of a need to worry about that income disruption, but if you are a freelancer or someone who works on a commission-only basis, it's all the more important to think about making sure that you have relatively more in bonds than that person who is really relying on quite a safe stream of income while they are working.

Stipp: So, I know some experts have talked about thinking [in terms] of [whether] you are a stock or a bond, based on your job. So, the college professor is probably more like a bond…

Benz: ... Exactly ...

Stipp: ... Who's got a fixed salary that they know is going to be there, whereas the freelancer might be more like a stock; they could have great times or they might have times where the market has just really dried up for them.

Benz: Right, that's the Ibbotson concept and it so useful really in terms of evaluating this decision of what you need your pre-retirement asset allocation to look like.

Stipp: Okay, so let's fast forward a little bit, and let's say that you've been saving for retirement for a little while, and you're kind of moving into that pre-retirement mode, where you're assessing how much you have saved and whether that's going to work for you or not.

When I'm looking at those bottom-line numbers and gauging, "do I have enough to retire?" how should that affect my willingness to maybe add more equities or the need to maybe subtract some equities.

Benz: It's a really important question and here, I would definitely urge people to look at a variety of retirement income calculators, well in advance of retirement, to see "well, how am I looking, in terms of my income needs during retirement."

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So, if you've crunched the numbers and it looks like you may come up short that would argue for holding a higher equity allocation. But you don't really want to completely shift to, say, 100% equities or even 75% equities leading up to retirement--just because the volatility of that portfolio would be so much higher.

So, these would be kind of incremental moves, but assuming it looks like you will come up short, you'd want to hold relatively more on equities.

If fit it looks like you'll have well more than you could possibly need in retirement, kudos to you, and you could afford to keep more in bonds, because there is really no need to risk that money coming into the home stretch.

Stipp: You mentioned to me earlier, though, those people who have quite a lot for retirement, and they are in good shape, they could also maybe section off part of that and potentially they could go ahead and be more aggressive then, too.

Benz: Well, that's the thing. So this is kind of a philosophical question--but absolutely. So, if you are coming into the home stretch getting ready to retire, it looks like you'll have more than enough, why not just sort of put that in very safe investments, but take any overage and invest that in stocks. That's money that perhaps you could grow on behalf of your heirs or maybe to even live a more lavish lifestyle than you had planned.

Stipp: So, let's move into retirement now and as you are assessing, where your income is going to come from in retirement, how does that affect how much you might want to have in equities and how much you would have in fixed income?

Benz: Certainly people who are looking to certain sources of income beyond their portfolio, those are people who could afford to have relatively more in equity. So, if you've got a pension and it's a very stable pension, that's a person who could have more in equities.

If you are going to continue working, at least part time, also that would argue for holding more in equities because you've got more income coming in, in the form of your paycheck.

Also if you are able to draw on an annuity, you've already bought an annuity, and you know it will deliver x% of your income in retirement, that would argue for holding relatively more in equities.

Stipp: Certainly, Social Security factors into that as well, and what percentage of Social Security for your living needs, how much it takes up there.

What about for folks who are worried about their pensions? They are getting a pension, but it looks like it could be shaky in the future?

Benz: I think it's really important to do your research on what the situation is with your pension. Make sure that you have read up on the current documents, the current viability of your pension. If you are one of those people who is looking at a pension and worried about a shortfall, that would argue for having relatively more in safe sources of income, because there might be a concern about really meeting your income needs with your pension plus Social Security.

Stipp: You mentioned longevity before in answering another question.

How should I think about longevity and the idea that retirement could be a 30-plus-year prospect for some people? How should that play into my consideration for asset allocation?

Benz: Longevity is such a happy thing in so many ways, but it really does test the longevity of our portfolios. So, if you are someone with a lot of 90-year-olds, 95-year-olds walking around in your family, you want to think hard about longevity and the need for your portfolio to last many years. You would arguably want to tip into equities than a person who doesn't have nice long-lived relatives in their gene pool.

Stipp: We think about our portfolios even going longer potentially than we are privileged to be on this earth.

How should you think about legacy planning, then, and the fact that you might want to have that extend even to a longer time horizon for your heirs, for example?

Benz: So that's certainly an important consideration for so many people. That would argue for holding more in equities than someone who is not concerned about leaving a legacy, either because they do not have heirs or they simply don't want to have any money left over.

So it's a personal decision, but definitely the person for whom legacy leaving is a big consideration, they'd want to have more in equities.

Stipp: So, Christine, let's set life stage aside a little bit here and talk about some of the other factors that might influence whether you ratchet up equities. One of them being current economic environment--so I know there are a lot of concerns out there on the economic front. How might that influence your asset allocation decision-making?

Benz: Well, certainly inflation--this isn't really even a controversial one. We know over long periods of time, inflation is a force to be reckoned with. So, if you are looking at maybe the 3% standard inflation rate, and you have a lot of your portfolio in very safe assets, look at that equation and say, "well, gosh, am I likely to out-earn the inflation rate with this portfolio that I have?"

For most people, that argues for holding at least a component of their portfolios in stocks, even if they are well on track to meet their income needs in retirement. So, inflation is a consideration.

Certainly the current interest rate environment and what we might expect from bonds, I think, has to be in the mix. So, we enjoyed a couple of decades' worth of declining interest rates, which provided a very strong tailwind for bonds. Is that likely to be the case over the next couple of decades?

So, to me, that also argues for having at least a portion of a pre-retirement and retirement portfolio in equities, simply because the absolute rate of return on such a portfolio is bound to be better than one that does not include equities.

Stipp: Lastly, we know that the economic environment can have a potential impact on the performance of your portfolio. That obviously leads to questions of your risk tolerance. So, if I'm especially risk tolerant, or I just can't handle risk at all, how should I adjust my portfolio and that stock-bond mix due to those considerations?

Benz: It's a good question, and I'm glad we're putting it last.

A lot of people put risk tolerance right up top when they're talking about asset allocation. I think it's of secondary importance to some of these other factors, but it's certainly something you should think about, and try to anchor it in the numbers if you possibly can or in past history.

So, think about your own behavior during market inflection points such as the recent bear market. If you were someone who found yourself with too much equity and you panicked at what turned out to be a completely inopportune time, think about that when creating your asset allocation mix.

So, maybe you've run the numbers and such-and-such calculator is saying, well, you should have about 70% equity, 30% bonds. If you know your own behavior hasn't been great, and you're not confident in your ability to check yourself during those market inflection points, that argues for having a slightly more conservative mix than would otherwise be argued.

Also, for folks who are retired, they want to think about their equity position and if they were to lose a large share of their portfolio, of their equity portfolio, would that result in a meaningful income disruption during retirement? That to me should put a check on how much such a person should hold in equities as well.

Stipp: All right, Christine. Asset allocation, one of the, if not the, most important decisions that you make about your portfolio. Some great tips for fine tuning that. Thanks for being here today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.