Hopefully, you’ve had a chance to complete Step 1: Determine the amount you need to retire. If not, click here to get started: Investing Basics, Step By Step: Determining your investment/savings goal.
Have you figured out what buying hamburger in a grocery store and the asset allocation of your investment portfolio have in common? Well, look no further.
The July 4th weekend is upon us. I suspect you will be heading to the grocery store and grilling some burgers.
When you shop for hamburger, what do you look for?
For most, it’s the percentage of lean beef to fat. For example, a very lean ground hamburger is 90% lean, 10% fat. Conversely, the ones that make the juiciest burgers on the grill are typically 70% lean and 30% fat. The key here is what you plan to use the meat for, your specific health and dietary restrictions, and sometimes even your pocketbook.
Asset allocation is much like the ratio of lean to fat in your ground beef. The asset allocation of your portfolio is simply the ratio of equity investments (like stocks, stock mutual funds, and stock exchange traded funds (ETFs)) to fixed income investments (typically government, corporate and municipal bonds, but can also include money markets, certificates of deposit (CDs)1, etc.). The asset allocation that works best for you at any given point in your life will depend largely on your goals, your time horizon, and your ability to tolerate risk.
Risk vs. Reward
The goal of an investor is to achieve the highest possible expected return while carrying an acceptable level of risk.
Equities and fixed income investments have different levels of risk and return, so each will behave differently over time. Historically, equities have been the only investment vehicle that has outpaced inflation. It is critical to outpace inflation over the long haul (think retirement) because inflation causes each dollar to have less buying power. This means you will need more money to pay for the same things you buy today. Outpacing inflation is why it is not advisable to have a retirement portfolio that has a large majority in fixed income investments - even though there is less risk, your portfolio will likely not have the same buying power in 30 years that it has today. But the “cost” of that potential for return comes in the form of more volatility and higher risk.
Conversely, fixed income investments typically offer a more steady, though not as high return. By having both equities and fixed income investments, an investor is “hedging their bets” to ensure that the portfolio can sustain market and interest rate fluctuations for the best possible long-term return. As the market “swings both ways,” your portfolio can adequately take advantage of the returns that each scenario might offer.
If your investment horizon is shorter, for example, you want to buy a house in five years, your portfolio will likely include much less risk (a higher percentage of cash equivalents, CDs and bonds) to ensure that volatility does not limit your ability to make the purchase within the timeline you desire.
Determining your basic asset allocation for retirement
How do you know what percentage of your portfolio to invest in equities, and what percentage to invest in fixed income when you are planning for retirement?
Start with a few simple formulas:
Exercise: Take 120 and subtract your current age.
For example, if you are 45 years old: 120 minus 45 = 75
Exercise: Take 110 and subtract your current age.
For example, if you are 45 years old: 110 minus 45 = 65
What this tells you is that generally speaking, the equity portion of your retirement portfolio might work well if it is between 65% and 75% of your total overall portfolio (with the remaining 25% to 35% invested in fixed income vehicles).
Keep in mind: This percentage is based almost exclusively on assumptions about your time horizon and the historical market performance of each category of investment, which may not be everything you need to consider.
Time horizon
The formulas above assume retirement around age 65. For our 45 year old here, that would be a 20 year horizon before any of the money is needed.
What if you want to work until you are 75? As you can imagine, by extending your investing horizon an extra 10 years, you can probably afford to be more “aggressive” in your asset allocation and invest up to 75% (or more) of your portfolio in equities. Time is definitely on your side the longer your time horizon is, and because that horizon is longer, you can afford to take more risks.
Risk tolerance
But if you recall from above, your risk tolerance also plays a major role. But what does that really mean?
Risk tolerance is simply the amount of market volatility and loss you're willing to accept as an investor.
For example, in a bear market (which is when equities are down in value), investors typically see a 20% drop in value. So as you consider your own risk tolerance, consider how you would feel if your portfolio balance dropped by 20%?
Let’s put some real numbers to it:
Person A and Person B are both 45 year old investors who have done the calculations above. They each have $500,000 invested in their 401ks, but a bear market has hit and their portfolio value has dropped by 20% - from $500,000 to $400,000. However, their risk tolerance is very different, and that may impact their asset allocation decisions.
Person A might react by losing sleep over this number, even if it’s temporary. They might start checking their balance all the time and may have a desire to “sell” because they view the market loss with a sense of doom and finality.
Person A has a lower risk tolerance. As such, this individual might want to shift the total percentage of equities to the lower end of your range (as determined by the formulas above), here 65%. Or they may want to take a more conservative approach by reducing the percentage of their investment portfolio in equities to 60%.
Person B might view this drop as simply a feature of the market (which it is). They may understand that all gains and losses are relative unless they “sell” the investment and “realize” the gain or loss. They may understand that the market has historically fluctuated over the years, and that this is a temporary setback.
Person B has a much higher risk tolerance, and as such, would probably do well with a portfolio that is invested 75% in equities.
Which one are you? This matters as you establish your asset allocation.
More ways to determine your asset allocation
Want some other ways to think about asset allocation?
BankRate has a great calculator here that addresses your situation and outlook on a very individualized basis and factors in not only your time horizon and risk tolerance, but also your tax bracket and your economic outlook.
Click here for the calculator: https://www.bankrate.com/investing/asset-allocation-calculator/
Also, as a preview to next week’s content, Forbes has some great sample asset allocations here (scroll to Three Asset Allocation Scenarios). Keep in mind, these also start to introduce the additional asset allocation to consider INSIDE your equity percentage: https://www.forbes.com/advisor/investing/what-is-asset-allocation/
And as we prepare to celebrate America’s independence, consider this: 2 out of 3 Americans would not pass the citizenship test and most people think July 4th is celebrating the ratification of the Constitution (which actually happened in June of 1788).
Would you pass?
Check out the USCIS study guide here, and test (aka torment) your friends as they enjoy the fruits of your grilling labors.
Happy 4th! If you are indoors due to rainy weather or the Canadian fires, check out:
What to do if you are 70 and have no retirement savings
Powerful questions to ask a potential financial advisor
VIDEO: Financial questions couples should ask before getting married
And, when you are sick of thinking about money….watch The Bear which is the closest thing to owning/running a restaurant I’ve seen.
I’m sure you thought I forgot our inspiration for this investing series, Step by Step. Here it is again, LIVE:
In times of low interest rates, CDs and other “guaranteed” vehicles are considered “cash and cash equivalents.” However, in today’s high rate climate, I will include CDs as part of the fixed income category for simplicity.