Note: This article is part of Morningstar's January 2016 5-Step Retirement-Portfolio Assessment Week special report. This article originally appeared Jan. 21, 2016.
The size of your retirement nest egg and the pace at which you plan to spend it--your withdrawal rate--are the key determinants of the viability of your financial plan for retirement.
But when it comes to your actual investment portfolio, no other factor will have a bigger impact on your portfolio's success or failure than your asset-allocation plan--your mix of stocks, bonds, and cash. Be too meek and you heighten the risk of a shortfall; maintain a too aggressive portfolio and you run the risk of incurring a bigger loss than you could reasonably recoup over your in-retirement time horizon.
Although it's hard to go terribly wrong with a simple 50% stock/50% bond mix, there aren't any one-size-fits-all asset-allocation frameworks for retirement portfolios. An individual's age, other income-producing retirement assets (like pensions or Social Security), and spending rate, among other factors, can all dictate higher or lower equity or bond weightings.
As you evaluate your retirement portfolio, making sure you're sidestepping the following asset-allocation pitfalls is a good way to steer your portfolio in the right direction.
1) Being Too Conservative
Survey market experts' outlooks for the stock and bond markets, and you'll notice that true equity bulls are in short supply. Even more scant are experts who are expecting very strong returns from the bond market; most agree that owners of high-quality bonds will be lucky to earn a positive return once inflation is factored about it. Cash looks like an even worse bet from the standpoint of preserving purchasing power. That means that on a long-term real basis, seemingly safe securities aren't all that safe.
The fact that most retirees need to hold a significant position in stocks is not a terribly comforting message in a period in which equity-market volatility is spiking. But stocks give retired investors a fighting chance at outgunning inflation, something cash and high-quality bonds will be hard-pressed to do. That explains why most all-in-one investments geared toward retirees maintain healthy allocations to stocks, as do my model in-retirement bucket portfolios.
2) Confusing Risk Tolerance With Risk Capacity
Many retirees and pre-retirees are way out on the other extreme: They're equity true believers, and don't see much of a role for anything BUT stocks in their portfolios. This describes many baby boomer investors I run in to. They've had a good experience with stocks over their investing careers, whereas bonds' prospects seem downright questionable given the headwinds of higher interest rates.
But it's important to make sure you're not confusing your ability to tolerate risk--in this case, not getting too bugged about equity losses--with risk capacity, a much more important consideration. Risk capacity refers to what sorts of losses you can handle without having to meaningfully alter your plans. For retirees who encounter big losses in equity portfolios that they're actively spending from, the net effect is that less of their portfolios are in place to recover when stocks eventually do. This can be a big problem for a portfolio's longevity, especially if those losses occur early in the retiree's time horizon.
That's the reason that most in-retirement asset-allocation frameworks call for holding significant shares of the portfolio in cash and bonds to meet in-retirement living expenses in years when stock returns are poor. They also call for reducing equities in a retirement portfolio over time to reflect the fact that risk capacity shrinks with an individual's time horizon.
3) Ignoring Your Behavioral Track Record
Yet, even as risk capacity should supersede considerations about your comfort level with risk, it's important to take your past investing behavior into account when determining your portfolio's asset allocation. Do you have a track record of running for the exits when the going gets rough for your stock portfolio? If so, consider nudging your equity allocation down a bit and your cash and bond cushion up relative to recommended allocations for investors at your same life stage to improve the odds that you'll stick with the program in periods of volatility. Just remember that a more-conservative portfolio may necessitate changes elsewhere in your plan--for example, the lower your equity weighting, the lower your withdrawal rate should generally be.
4) Not Factoring in Nonportfolio Income Sources
The reason that making one-size-fits-all asset-allocation recommendations is so difficult is that no one but you knows all of the pieces of your financial life. (This is why a financial advisor can be so valuable, in that he or she can make recommendations based on your own variables.) One of the biggest factors that can affect an individual's asset allocation, both leading up to and during retirement, is the presence of other in-retirement income sources, above and beyond what the portfolio will supply. Here, I'm talking about Social Security or pensions, mainly, but fixed annuities as well.
If those stable income sources will supply most or all of your needed income in retirement, your risk capacity (see above) is high and you should be able to withstand a higher equity weighting, at least in theory. Retirees with limited stable income sources, by contrast, will need to batten down the hatches with the parts of their portfolios they'll spend within the next several years. They'll need higher weightings in cash and bonds.
Let's say, for example, that a retiree anticipates she needs $60,000 annually in retirement, $38,000 of which is coming from Social Security and her small pension. The remaining $22,000 per annum is coming from her portfolio. Thus, under my bucket approach, she's steering roughly $44,000 to cash (two years' worth of living expenses that aren't supplied by her pension and Social Security), another $100,000 or more to bonds, and the remainder in stocks. The lucky retiree whose income needs are entirely supplied by a pension or Social Security could do without such a big buffer of cash and bonds.
5) Not Factoring in Nonretirement Goals
In a related vein, successful asset-allocation plans should take into account other goals--in addition to providing cash flows during retirement--that you have for your portfolio later in life.
A common example of such a goal would be to leave assets behind for children, grandchildren, or charity; individuals for whom this is a priority will generally want to maintain a more equity-heavy posture in their long-term portfolios than individuals who aren't aiming to make bequests. Not only do they have a greater incentive to make their portfolios grow, but they also have a longer time horizon for their assets than investors who are using the "last breath, last dollar" approach to portfolio management. (Of course, some retirees view their homes as the chief asset that would eventually be sold to benefit their heirs; a desire to make that type of bequest wouldn't have an impact on the positioning of the investment portfolios.)
6) Having a Fuzzy View of Your Asset Allocation
If you hold individual stocks and individual bonds, or your portfolio consists entirely of index funds, it's easy to keep tight rein on your portfolio's asset allocation. But maintaining oversight and control over your portfolio's asset allocation can be trickier if you hold actively managed funds. That's because what you see isn't always what you get. Domestic-equity funds may hold foreign stocks, bond funds may be hoarding cash, and allocation funds may shift their stock/bond weightings around. Your portfolio's asset allocation may not be what you thought it was.
Morningstar's X-Ray function can help solve this issue by letting you view your portfolio's actual allocations, based on the composition of your holdings. For investors who own actively managed funds, they're often surprised by their large cash weightings in the X-Ray view. That cash is apt to give the portfolio better downside performance than if it were fully invested, but it isn't available to serve as spending money or your emergency cushion. For that reason, it makes sense to consider your cash needs for near-term expenses--bucket one in my bucket framework--apart from what you see in X-Ray.