Should Your Asset Allocation Look Like Everyone Else's?
These situations would call for a different asset allocation than might otherwise make sense some for someone with your expected retirement date.
Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared Sept. 3, 2012.
For investors bewildered about how to split their portfolios among stocks, bonds, and cash, off-the-shelf sources of asset-allocation guidance can be a reasonable starting point. Even if you'd like more control over your holdings than a target-date fund affords, for example, you can still eyeball the asset allocations for target-date funds geared toward your retirement date. ( Morningstar's Target Date Fund Series Reports enable you to see a particular lineup's glide path--the changes in its asset allocation over time--at a glance.) Even among different target-date series, you're likely to glean some useful takeaways. Not only do equity allocations invariably step down as the investor gets closer to the target date, but so do allocations to riskier investment types such as junk bonds and emerging-markets stocks.
Yet no preset allocation or tool can possibly address the many variables that factor into an appropriate asset-allocation framework. A 62-year-old with limited investment assets and poor health who intends to retire next year will, very likely, need to invest differently than a wealthy entrepreneur with the same expected retirement date.
Setting a customized asset allocation is one part of the planning puzzle where an advisor can earn his or her keep many times over. But if you're trying to sort out your asset allocation on your own, here are some of the key situations that would call for a different asset allocation than might otherwise make sense some for someone with your expected retirement date.
Research from asset-allocation specialist Ibbotson Associates, a Morningstar company, emphasizes the importance of human capital--your own earnings power--in asset-allocation decision-making. As you grow older and get closer to retirement, you need to lay the groundwork for the time when you'll no longer earn a salary. Your portfolio's cash and bond stakes will need to increase so that you'll have money at the ready to supplant what you're no longer getting from your paycheck.
This concept holds true from the standpoint of job stability, as well. If your position is uber-secure--Ibbotson researchers often cite a tenured college professor as an example--you can afford to have a more aggressive asset-allocation mix than someone in a profession with a more volatile income stream. For example, commission-based salespeople and those starting businesses might find their incomes are unpredictable from month to month. The volatility of their income streams argues for having a larger emergency fund than the typical prescription of three to six months' worth of living expenses, as well as a more conservative long-term asset allocation in case those emergency reserves are depleted. The same goes for people who work in rapidly consolidating industries where the number of available jobs is shrinking.
In a related vein, the ultimate use of your portfolio should also shape your asset allocation. Do you consider your retirement nest egg sacrosanct, never to be touched until you exit the workforce? (I hope so!) If that's the case, an off-the-shelf source of asset-allocation guidance is more likely to suit your needs. On the other hand, if there's the possibility you could raid your retirement portfolio to fund other goals while you're still working--for example, you plan to tap your Roth IRA to pay for college--that component of the portfolio should have a more conservative asset allocation.
Risk Level From Security Selection
Another scenario when your personal allocation might deviate notably from the norms for your age band would be if your individual investments are more risky than is typical for that asset class--for example, if a big share of your portfolio's equity allocation consists of company stock. That's not ideal, of course, but tax and other considerations might prevent you from correcting the imbalance. Such a situation argues for a lower overall equity allocation than would otherwise be the case for someone in your age band because the existing equity holdings can be expected to be exceptionally volatile.
Other Sources of In-Retirement Income
Off-the-shelf asset-allocation guidance couldn't possibly take into account the presence of other income-producing assets in a person's retirement program, such as a pension or an income annuity. But those sources can nonetheless have a significant effect on a retiree's optimal allocation. Generally speaking, the greater the share of a retiree's income these nonportfolio sources account for, the higher the equity allocation can be because the investment portfolio will be consumed at a more gradual rate. By contrast, the fewer nonportfolio income sources a retiree has, the more his or her portfolio will be tapped steadily throughout retirement. Not only will it need to be larger on an absolute basis, but it will also need to have a greater share of liquid reserves and intermediate-term assets.
Expected Length of Retirement
In a related vein, the anticipated length of your retirement should also play a role in customizing your asset allocation, particularly if you expect your in-retirement years to be especially long or short. A 60-year-old retiree with an average life expectancy will obviously be placing much greater demands on her portfolio than the 80-year-old new retiree with an average life expectancy. That argues for the former having not only a much larger investment kitty, but also a much more aggressive asset allocation than the 80-year-old because retirement could easily stretch for 25 years or more for the 60-year-old.
Desire to Leave a Legacy
Would you like to leave money to your children, grandchildren, or other loved ones, or are you in the "last breath, last dollar" camp? If the former, that argues for a larger equity stake than would otherwise be the case. With extra mouths to feed, your portfolio needs the extra growth potential that comes with stocks. Moreover, the "legacy" component of your portfolio will automatically have the longest time horizon.