If you're approaching or in retirement, it's a good bet that you've heard about the importance of reducing risk in your portfolio. What retirement researchers call sequence risk--encountering a bear market early on in retirement--can lead retirees to prematurely deplete their assets, especially if the retiree overspends during the market shock.
What gets less play, however, is that de-risking is even more urgent if you’re saving for nonretirement goals, especially if your spending date is close at hand. That’s because the vast majority of financial goals besides retirement are either one and done (for example, making a down payment on a home) or paid for over a limited time horizon, such as college. For shorter-term goals, the downside of being too aggressive at the wrong time is even greater than would be the case for a too-aggressive retirement portfolio.
This issue could be an underappreciated risk for many investors right now. For one thing, the market has been strong for a long period of time and extended downdrafts have been exceedingly rare. Although stocks crashed in the first quarter of 2020, they've since regained ground and then some. That could impart a false sense of security especially among younger investors who didn’t experience 2000-02 or 2007-09. Meanwhile, U.S. equity valuations are on the steep side, exacerbating the risks for investors who hold stock-heavy portfolios for goals that are close at hand. Investors are betting that stocks will continue to deliver, but high valuations leave less room for error.
Different Spending Horizons, Different Glide Paths To help illustrate the importance of approaching asset allocation differently for shorter-term goals, let's contrast a retirement portfolio with one geared toward another major goal for many families: college savings.
One of the key differences right out of the box is duration--of both the savings period and the spend-down. You might save for retirement for 40 years or more and be retired for another 25 or 30 years or even longer. But you have less than half that amount of time to amass the funds needed for college, and if all goes well, you'll spend down those assets quickly--in four years or so, or perhaps a few more if the student is on the “five-year plan” or you're also footing the bill for graduate school.
The duration of each spending period, especially, should influence each portfolio's asset allocation. With an anticipated 25- to 30-year time horizon for spending, it's only sensible that a retirement portfolio includes a healthy dose of stocks as retirement approaches. For one thing, all but the wealthiest retirees need their portfolios to grow a bit in retirement, to outpace inflation at a minimum and ideally to do even better than that. Moreover, that's a sufficiently long holding period for stocks, which land in positive territory in rolling 10-year periods more than 90% of the time. If the portfolio is properly allocated, it would include safer assets that the retiree could spend through without having to touch stocks. The typical target-date fund geared toward someone retiring in 2025 includes nearly 50% of its assets in equities, and target-date funds geared toward people who are already retired have an average of nearly 40% in stocks. Similarly, my Model Bucket Portfolios include 40% equity exposure at the low end (for the Conservative portfolios) and nearly 60% at the high end, for the Aggressive versions.
By contrast, college funding has a much shorter duration of just four or five years or so. That means that the risk/reward profile of holding on to a very equity-heavy portfolio as college approaches is less attractive. If you get lucky, your stock-heavy college portfolio will sail through and grow during the college years. But if you guess wrong and stocks get clocked early on in your child’s college career, you’ll have fewer levers. In a worst-case scenario in which your child entered college with an all-equity portfolio in the fall of 2007, for example, her portfolio would have still been down by 50% at the end of her sophomore year. That could force some tough choices.
That poor risk/reward trade-off during a truncated time horizon helps explain why the typical age-based 529 plan includes less than 20% in equities for students who are 17 or 18 years old. The typical equity allocation for age-based 529 plans for students who are already in college is even lower--less than 10% for moderate age-based 529 plans.
What About Other Goals? What about people who are saving for other goals such as home down payments, weddings, remodeling, or special family trips? In that case, the closer the goal date is, and the firmer that date and required amount, the greater the urgency around de-risking--locking down what you've managed to accumulate. Here the saying, "if you've won the game, quit playing" applies perfectly. If you've been holding equities for short-term goals, congratulate yourself on your good timing and then get the heck out of, or at least dramatically curtail your exposure to, stocks.
Age-based 529 plans and target-date funds geared toward retirement nicely handle de-risking for their shareholders, which is one reason they can be such reliable solutions for hands-off investors. (Some age-based 529 options got caught leaning too aggressively during the 2007-09 financial crisis, but most have since corrected that issue.) But if you’re saving for other goals, there’s no similarly hands-off solution; you’ll have to asset-allocate and de-risk on your own.
For very short-term goals--those that you hope to fund within two years--my bias would be to avoid risk altogether and simply stick with the highest-yielding cash account you can find. The risk/reward trade-off of venturing into a higher-yielding bond vehicle, let alone stocks, simply isn’t there.
If you have a slightly longer time horizon until your goal date, taking a little bit more risk in an effort to pick up a bit more return makes sense. If your time horizon to spending is between two and five years, holding equities still isn’t a good idea--stocks have been too unreliable over such a short time period, and their troughs have been too deep. But it is reasonable to complement cash with holdings in high-quality short- or even intermediate-term bond funds. My model portfolios for short-term goals feature the following asset allocation:
20%-40% cash 40%-60% high-quality short-term bond fund 0%-20% high-quality intermediate-term bond fund
More-conservative investors would want to err on the side of holding more cash and short-term bonds. If you’re holding this portfolio in a non-tax-sheltered account--usually the best receptacle for nonretirement goals--munis may make sense if you’re in a high tax bracket.
If your time horizon is a bit longer--say, five to 10 years from now--a bit of equity risk can come into play, boosting the portfolio’s return potential without subjecting it to undue risk. In my model portfolios for intermediate-term horizons, I’ve employed the following asset allocation:
20% cash 20% high-quality short-term bond fund 40% high-quality intermediate-term bond fund 20% large-cap equity fund
As with the short-term portfolio, investors in higher tax brackets who are saving in a taxable account may want to favor municipal-bond funds rather than taxable-bond funds. For the equity exposure, it makes sense to reduce idiosyncratic risk by favoring a broadly diversified fund. A total U.S. market fund or a conservative-leaning index option like Vanguard Dividend Appreciation VDADX would be decent choices in this slot.