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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 2021 Portfolio Tuneup 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. As of year-end 2020, target-date fund assets stood at $1.6 trillion. 

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, investors in multiasset vehicles like target-date funds have been able to earn a big share of their funds' 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 for their retirement assets; if they can obtain "advice" from a low-cost target-date fund, all the better. 

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.

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, 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, according to research from the Small Business Association.)

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. You know that 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 doesn't expect to lean heavily on their portfolios to supply expenses once they retire. But some accumulators know that they'll be able to retire with solid pensions that will supply most of their in-retirement spending needs. Other accumulators may not have pensions but have nonetheless managed to live so frugally and/or save so much that they'll be just sipping from their portfolios during retirement. For such investors, holding a more equity-heavy portfolio, both in the years leading up to retirement and during it, will generally make more sense than following standard asset-allocation guidance. After all, such investors don't have the same liquidity needs that other 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 some or most of their retirement assets to their kids, grandkids, or charity, that portion of the portfolio should be positioned for growth and hold a heavier equity weighting. Of course, behavioral factors are in the mix, too. If an investor has limited spending needs from his or her portfolio but an equity-heavy portfolio mix causes sleepless nights, it's sensible to embrace a more conservative asset allocation. 

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 hold rent-producing properties that they'll lean on 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 as the rental properties. 

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, home ownership 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 not just saving for your retirement.
Many people are not just accumulating assets in their retirement kitties to supply their living expenses after they quit working; they also want or need their investment assets to fund additional goals during their lifetimes or after they're gone.

As discussed earlier, investors 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. Meanwhile, investors who have short- and intermediate-term financial goals (within the next 10 years) should bear in mind that an all- or mainly stock portfolio will be too volatile to fund those goals; they'll need to hold more bonds and cash.   

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 younger spouse's longer time horizon instead.