Note: This video is part of Morningstar's 7 Days to Retirement Readiness week special report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Some retirees swear by a 50% equity/50% bond allocation, while others prefer to invest more in stocks. How can you know the right asset mix for you?
One way I like to approach this question is to use anticipated portfolio withdrawals to guide your allocations. Money that you expect to withdraw within the next year or two can go into cash, where you won't earn much or lose anything either. I like the idea of setting aside two years' worth of portfolio withdrawals in cash. If your withdrawal is $40,000, you'd earmark $80,000 in cash.
There's an opportunity cost to having too much in cash, because you may not earn enough to keep up with inflation. If you have a spending horizon of at least a couple of years but not more than 10, you can afford to take some risk with your money, but you don't want to be in stocks because their return potential is too variable. That's why I like high-quality bonds and bond funds for this part of a portfolio. Over a five- to 10-year time horizon you're likely to earn a higher return than you will with cash, but you won't experience the volatility of stocks. My Bucket portfolios earmark 8 years' worth of portfolio withdrawals for bonds.
For money that you won't spend for another 10 years, it makes sense to invest it in assets with more growth potential. Stocks have been pretty volatile over shorter time horizons, but they've been really reliable over various 10-year periods in market history. That's not to say that you'll always need to wait 10 years in order to withdraw anything from your stock holdings, but holding enough cash and bonds helps reduce the likelihood of needing to withdraw from stocks when they're down.
Thanks for watching. I’m Christine Benz for Morningstar.com.