What About Investing For Retirementincome
Index fund allocations provide a good means of investing. This is especiallytrue before you retire, and your main concern is building up your nest egg.
Once you start to transition into retirement index fund allocations are still good, but you do need to think specifically about how your retirement withdrawal strategy affects your investment strategy.
The risks you face before retirement are not the same as the risks you face in retirement. Before retirement you are contributing to a portfolio. During retirement, you take withdrawals from the portfolio. Even this simple reversal changes your risk.
Depending on your withdrawal strategy you may need to adjust your portfolio. For example, if you use an income floor strategy.
However, index fund allocations can still provide the basis of yourportfolio.
The Proper Asset Allocation Of Stocks And Bonds Analyzed
I ran my current 401K through Personal Capital to see what they thought about what my proper asset allocation is. You should do the same thing since its free. To no surprise, the below chart is what they came back with.
I essentially have too much concentration risk in stocks and am underinvested in bonds based on the conventional asset allocation model for someone my age. To run the same analysis on Personal Capital, simply click the Investment Checkup link under the Investing tab.
I am going to provide you with five recommended asset allocation models to fit everyones investment risk profile: Conventional, New Life, Survival, Nothing To Lose, and Financial Samurai.
We will talk through each model to see whether it fits your present financial situation. The proper asset allocation will switch over time of course.
Before we look into each asset allocation model, we must first look at the historical returns for stocks and bonds. The goal of the charts is to give you basis for how to think about returns from both asset classes.
Stocks have outperformed bonds in the long run as you will see. However, stocks are also much more volatile. Armed with historical knowledge, we can then make logical assumptions about the future.
Sequence Of Return Risk
A nest egg is most vulnerable to sequence of return risk five years before and 10 years after retirement. SORR describes the long-term detrimental effects initial negative market returns have on portfolio during de-accumulation. When withdrawing from retirement accounts, selling low locks in the losses.
Figure 1 Source:
The above graph demonstrates the explanatory power of each years return before and after retirement.
Prior to retirement , SORR increases steadily.Upon retirement, SORR peaks dramatically,then evaporates over the next 10-15 years.
Since SORR rapidly wanes after retirement, rising equity glidepaths or bond tents might provide additional market returns.These programmatic increases in stock allocations over time have a positive effect on rising tail sequences and may deliver larger portfolios.
That is, after SORR passes, more stocks means you leave more money when you die.
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Recommended Allocation Of Stocks And Bonds By Age
Given what we know about the stock and bond market, we should conclude the following:
1) If we want to beat inflation, its wise to invest in both the stock and bond market. Cash loses its purchasing power over time given money market returns are minuscule. But cash is also a fantastic temporary store of value during times of uncertainty.
2) Time in the market is better than timing the market. The longer we can invest, the higher the probability we will make money. Employ a disciplined dollar cost average strategy.
3) Market cycles force us to diversify between stocks and bonds. We never know for sure when we will retire, when we will need our funds, and what our future cash flow will look like.
How Much Do I Need For Retirement
There are a variety of models for calculating how much you need for retirement, but the exact amount depends on many factors, including your health, your age when you retire, and your lifestyle expectations. It also depends on how you allocate the assets in your portfolio, as well as market conditions during your retirement. Discuss your situation with your financial advisor, and revisit your plans regularly so you won’t get caught with any surprises.
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When Should I Review And Rebalance My Portfolio
Its a good idea to meet with your financial professional to revisit your asset allocation at least once a year to make sure it hasnt drifted too far. For example, if stocks do well for a sustained period, you might discover your original portfolio with 50% stocks and 50% bonds is now at 60% stocks and 40% bonds.With your financial professionals help, your portfolio can be adjusted appropriately. A common guideline is to consider rebalancing your holdings if any asset class has veered five percentage points or more off its original allocation.2 By rebalancing, you sell securities that went up in value and put the proceeds into those that fell or stayed flat to return to your desired allocation.But rebalancing during a volatile market that swings widely over a few days can be a challenge. For instance, during a single week in March 2020, the S& P 500® Index3 went down 7.6% one day and up 9.3% another day, before falling 12% a few days later.4 Instead of trying to keep up with rebalancing on a daily basis, choose one day each year perhaps early in the new year or your birthday to review your asset allocation and rebalance your portfolio if needed.
Why Are Stocks And Bonds Both Near Record Highs
The S& P 500 is at or close to a record high because of high earnings rebound expectations.
The historical mean and median S& P 500 P/E multiple is around 15X. Therefore, at 33X, stocks are very expensive, but not yet as outrageously expensive as they were in 2001 and 2009.
The bond interest rates are still very low because of the Fed and the amount of liquidity in the system. The belief is that the inflation spike were seeing post pandemic is temporary.
When inflation is low, investors buy bonds to gain yield. But as investors bid up bond prices, the yields come down e.g. $10 dividend payment on a $100 bond = 10% dividend yield, but if the bond gets bid up to $200, the dividend yield is only 5%. Remember we are looking at snapshots in time. The markets are fluid.
Notice how the 10-year bond yield has been coming down since it reached 15.8% back in 1980. Were at only ~1/.2% for the 10-year bond yield, which is absolutely absurd! This is one of the reasons why paying a higher mortgage rate for a 30-year fixed is a suboptimal choice. Why pay more when you can pay less with an ARM?
Unless you think coordination among global central banks will become weaker, technology will become slower, and there will be no more global upheavals like Brexit, its unlikely that inflation in the US will spike higher. Think about how much technology is displacing jobs. Think about how globalization is creating cheaper labor and goods.
Low inflation and low interest rates are here to stay.
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Manage Your Money In One Place
Sign up for Personal Capital, the webs #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool. You will see exactly how much youre paying in fees.I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible. Definitely run your numbers to see how youre doing.
Ive been using Personal Capital since 2012. As a result, I have seen my net worth skyrocket during this time thanks to better money management.
Asset Allocation By Age Calculation
There are several quick, oft-cited model calculations used for dynamic asset allocation of a portfolio of stocks and bonds by age, moving more into bonds as time passes because theyre safer. For the sake of clarity and consistency of discussion, were going to assume a retirement age of 60.
Generally speaking, it could be said that these 3 formulas coincide with low, moderate, and high risk tolerances, respectively.
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Why Asset Allocation Matters
Asset allocation is important because it is the bread-and-butter of risk management. Its the way in which we approach diversificationthe age-old wisdom of dont put all your eggs in one basket applied to investing.
If you were to invest all your money into a single business, youd obviously do terribly if it were to fail. The same logic applies on a wider scaleif all your money is tied up in stocks, and the stock market has a couple of bad years, youre in for a rough time.
To avoid this, you dont invest all your money into a single asset class. In fact, some asset classes mirror each others performancewhen one goes down, the other goes up. This is called correlation, and stock correlations in the post-COVID market are as unpredictable as everall the more reason to look at the wisdom of Modern Portfolio Theory.
Now, MPT got its author a Nobel prizeand although that is high praise, that doesnt mean that MPT is without its flaws. However, the basics in how it approaches diversification still applyto achieve a good result, you need a mix of high-risk, high-reward assets, and lower-risk assets to act as a counterbalance. On the whole, this both reduces risk and increases returns.
Tip : Consider All Your Income Sources
As you put together your retirement portfolio, you also need to think about the role your savings will play in your overall income plan. For example, how much income do you expect from guaranteed sources like annuities, pensions, and Social Security?
If these guaranteed income streams will generate enough income to cover the majority of your expenses, you might be able to maintain a more aggressive stance with your portfolio well into retirement, Rob says. Conversely, if youll rely on your portfolio for the majority of your income, youll need to take a more balanced approach with your investments.
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Types Of Rising Equity Glidepaths
For this model, I am using two different types of glidepaths Glide10 and Glide20. Glide10 increases to its highest allocation through 10 years, and Glide20 through 20 years after retirement. Some authors suggest that a glidepath over 30 years of a 30 year retirement is too slow, and looking at bar graph in figure 1 we see why.
In addition, previous models have looked at allocations increasing from 30% stocks up to 70% stocks. Further mathematical modeling shows that this allocation is underweight in equities.
In themodel demonstrated here, asset allocation is brought to 60/40 five years before retirement. It is held there until retirement and then increases incrementally to 90/10 over either 10 or 20 years after retirement.
A quick note about future expected returns: I demonstrate two different returns. In this scenario, using harsh 2000-2010 returns to model SORR, I wanted to have both low expected returns as well as higher expected returns . Expected returns may likely be higher following a significant period of low returns, but take your pick.
New Life Asset Allocation Model For Stocks And Bonds
The New Life asset allocation recommendation is to subtract your age by 120 to figure out how much of your portfolio should be allocated towards stocks. Studies show we are living longer due to advancements in science and better awareness about how we should eat.
Given stocks have shown to outperform bonds over the long run, we need a greater allocation towards stocks to take care of our longer lives. Our risk tolerance still decreases as we get older, just at a later stage.
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What Is Proper Asset Allocation
Proper asset allocation is a dynamic process and not just the end result of the mixture of stocks, bonds, and cash. Asset allocation should be guided by the investors objectives and constraints, not headlines or top mutual fund lists. Asset allocation aligns the risk tolerance of the investor with the risk of their portfolio.
So What Is Asset Allocation
Think of asset allocation as your mix of these ingredients. It uses the benefit of diversificationthats the idea that asset classes dont move in sync, so one or more may grow while others decline. Winston adds, The end goal is to have longer, more consistent growth by investing within and across a variety of asset classes.
So, how to determine what investments are best for you? Its typically based on how much time you have until you need to dip into these investments and your comfort with risk.
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The Right Asset Allocation Depends On Your Risk
Ideally, your asset allocation should let you sleep well at night and wake up every morning with vigor. When it comes to investing, you need to calculate your existing investment exposure and invest accordingly.
I encourage everyone to take a proactive approach to their retirement portfolios. Ask yourself the following questions to determine which asset allocation model is right for you:
- What is my risk tolerance on a scale of 0-10?
- If my portfolio dropped 50% in one year, will I be financially OK?
- How stable is my primary income source?
- How many income streams do I have?
- Do I have an X Factor ?
- What is my Money Strength?
- What is my knowledge about stocks and bonds?
- How long is my investment horizon?
- Where do I get my investment advice and what is the quality of such advice?
Once youve answered these questions, sit down with a loved one to discuss whether there is congruency with your answers and how you are currently investing.
Its important not to overestimate your abilities when it comes to investing. We all lose money eventually, its just a matter of when and how much.
Lets just hope the bull market continues!
What Should My Portfolio Look Like At 55
An asset allocation of 55% stocks, 40% bonds, and 5% alternatives can do the trick for those who are comfortable but still hope to get more out of their portfolios in the years to come. An appropriate stock allocation might be 25% large caps, 20% split between mid-caps and small caps, and 10% international stocks.
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Invest In Real Estate To Build Wealth
In addition to investing in stocks and bonds, Im a big proponent of real estate investing. Real estate is a core asset class that has proven to build long-term wealth for Americans. Real estate is a tangible asset that provides utility and a steady stream of income if you own rental properties.
Given interest rates have come way down, the value of rental income has gone way up. The reason is because it now takes a lot more capital to generate the same amount of risk-adjusted income. Further, in an inflationary environment, rents and property prices tend to go up.
You can think about real estate as a bonds plus asset class. Real estate acts very much like bonds with its income generating ability and defensive characteristics. However, real estate can often do much better than bonds in a bull market.
Tactical Asset Allocation Overview
Tactical asset allocation is a more hands-on approach where you adjust your allocations to various asset classes based on where you think good risk/reward ratios exist in the market.
The advantage is that you can substantially reduce your volatility and mildly increase your returns. However, its more prone to human error, and if done poorly will reduce your returns.
As an example, some investors actively reduced their exposure to U.S. stocks during the height of the Dotcom Bubble because they saw how dramatically overvalued U.S. stocks were at that time compared to bonds.
This chart of the cyclically-adjusted price-to-earnings ratio of the S& P 500 showed how dramatically overvalued U.S. stocks were:
As a result, they minimized their exposure to the massive bear market in stocks that happened for years afterward.
Tactical Asset Allocation Based on Valuation
Personally, I use a tactical asset allocation approach based on valuation.
In other words, I compare the stock valuations of different regions of the world, and gradually increase my allocations towards undervalued regions and reduce my exposure to overvalued regions. My turnover is pretty low I dont make changes frequently, but I adjust periodically based on where opportunity exists.
The same is true for bonds, REITs, business sectors, or commodities I increase my exposure to things that are unusually cheap, and minimize my exposure to things that are unusually expensive.
Tactical Asset Allocation Based on Momentum