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Investing Specialists

Are You an Asset-Allocation Outlier?

From pensions to small-business ownership, how to know if your mix of stocks, bonds, and cash should not look like the others'.

Note: This article is part of Morningstar's January 2016 5-Point Retirement-Portfolio Assessment Week special report.

Professional asset-allocation guidance has never been easier or cheaper to obtain. Target-date funds, with stock/bond mixes informed by professional asset allocators, have emerged as the default investment choice for most defined-benefit plans. Target-date fund asset growth has slowed in recent years, but the funds held more than $700 billion in assets at the end of 2014, according to Morningstar research

Target-date funds haven't just been a win for firms that offer them: Investors appear to have benefited, too. Likely owing to a confluence of factors, including the fact that most target-date investors are buying in through a company retirement plan that facilitates dollar-cost averaging, target-date fund investors have been able to earn a big share of their funds' returns. That may not sound like that big a deal, but it stands in contrast to a broad swath of categories where, owing to poor timing decisions, investors have badly detracted from their take-home returns

Yet, as encouraging as the early results are for target-date investors, these funds are blunt instruments. They use a single factor--the investor's anticipated retirement date--to arrive at the portfolio's mix of stocks and bonds, as well as its suballocations. 

For many people, their anticipated retirement dates provide enough information to back them into a sensible asset allocation. But other individuals have financial dealings that make them asset-allocation outliers--their situations are unique, and off-the-shelf asset-allocation guidance might not address their needs and risks. A more customized stock/bond mix, whether supplied via a financial advisor or some type of managed-account service that takes into account the presence of more factors than just retirement date, will be appropriate. 

As you review the viability of your retirement portfolio, here are some key factors that would contribute to being an asset-allocation outlier. (The research paper "No Portfolio Is an Island," by Morningstar Investment Management's David Blanchett and Philip Straehl, does a deeper dive into this topic.) 

1) Your business ownership makes up a big share of your net worth. 
This is a common issue for entrepreneurs: The money they have tied up in their businesses is far greater than their investment assets. While individuals who own stock in their employers can and should consider diversifying away that risk as soon as possible, as discussed in this video, small-business owners can't readily divest their ownership stakes.

That makes it crucial that, first, small-business owners prioritize investing in their investment portfolios as well as their businesses. (Many small-business owners don't, as discussed in this research.)

Moreover, because their small businesses are an illiquid asset, their investment portfolios should prioritize liquidity and safety more than would be the case for other individuals with the same anticipated retirement date. Their investment portfolios should also be positioned to reduce the idiosyncratic risk of their businesses. Not only should the portfolio downplay the industry in which the small business operates, but it should avoid big sector-specific and stock-specific risks in general. 

2) A pension and/or Social Security will supply most of your in-retirement income needs.
With the ebbing away of pensions, it's a shrinking share of the population that isn't leaning heavily on their portfolios to fund in-retirement expenses. But some readers say that, either due to lush pensions, modest spending, or some of both, they're practically sipping from their investment portfolios during retirement. For such investors, holding a more equity-heavy portfolio than the conventional in-retirement portfolio will generally be warranted. After all, such retirees don't have the same liquidity needs that other retired investors do, so they'll need to earmark less of their portfolios for cash and bonds. And if their time horizons for their portfolios are longer because they expect to leave that money to their kids, grandkids, or children, that portion of the portfolio should be positioned for growth and hold a heavier equity weighting. 

The bucket system that I've been writing about can help investors determine how much to stake in liquid assets. As discussed here, start by tallying up your expected in-retirement income needs, then subtract income provided by safe sources of income like Social Security, pensions, and fixed annuities. The amount that's left over is the amount you'll need your portfolio to supply annually. For example, an individual with $80,000 in income needs--$60,000 of which is being supplied by Social Security and a pension--would hold anywhere from $20,000 to $40,000 (one to two years' worth of portfolio withdrawals) in cash, and another $100,000 to $160,000 in bonds (five to eight years' worth of living expenses). The remainder of her portfolio could go into stocks. Of course, retirees will also want to hold an emergency fund in cash, too, to help avoid digging into the long-term portfolio to cover unexpected outlays for car or home repairs. 

3) You have substantial real estate ownership interests.
Individuals with substantial real estate ownership interests should also consider the impact of those assets on their portfolios' positioning. Those who rely on rent-producing properties to supply a portion of their in-retirement income streams, for example, could arguably ratchet down their holdings in cash and bonds. (See above.) But because their rental income could be prone to periodic disruptions, even short-term ones, rental-property owners will want to build in a larger cash/bond cushion than the individual who's getting most of his income from a pension, Social Security, or a fixed annuity. Rental-property owners should also consider downplaying publicly traded real estate investments like REITs in their investment portfolios, because the rental properties and REITs could be buffeted around by some of the same forces. 

The calculus is different for investors whose homes represent a large share of their net worths. Unless they plan to draw upon their homes for living expenses via a reverse mortgage, homeownership shouldn't have a big impact on how they position their portfolios. But individuals who do plan to use a reverse mortgage to fund in-retirement living expenses could arguably run with a somewhat lighter allocation to cash and bonds.

4) You're juggling goals other than just retirement income.
Many retirees are not just relying on their portfolios to supply their living expenses; they also want or need their investment assets to fund additional goals during their lifetimes or after they're gone.

For example, many retirees would like to splurge on a special family trip or party to commemorate a big life event like an anniversary; the presence of such goals would obviously necessitate holding a larger share of the portfolio in short- and/or intermediate-term assets. (Just be sure to quadruple-check that your portfolio--sans the splurge assets--has a high probability of lasting throughout your retirement years.)

On the flip side, as discussed earlier, retirees who hope to leave assets behind for children, grandchildren, or charity, should generally maintain heavier equity weightings than retirees using the "last breath, last dollar" approach to retirement-portfolio planning.

5) You have a younger spouse.
Many married couples are planning for two time horizons--those of an older retiree as well as a younger spouse. In that instance, it's only sensible to look beyond asset-allocation recommendations for the older partner and focus on planning for the longer time horizon instead. This article discusses the topic in greater detail.