Summary/TL;DR
Your asset allocation in retirement should be a function of two things: your income need and your time horizon. Specifically, any funds needed within five years should be in less volatile assets, while funds needed beyond five years should be invested in stocks. Pursuing a “bucket strategy” in which parts of your portfolio are imagined as different “buckets”, each of which have a different purpose and are therefore invested differently, can be very simple and highly effective.
Introduction
Getting your asset allocation “right” in retirement is a huge deal, as being both “too aggressive” or “too conservative” can carry huge risk to the long-term sustainability of your retirement plan.
At the end of the day, your portfolio should be optimized for achieving your long-term goal of providing a reliable source of income while minimizing risk. While common knowledge would have you believe that a “balanced” portfolio consisting of almost equal amounts of stocks and bonds is appropriate for retirees, this will actually result in most people taking on far more risk than is necessary.
Today’s post will explore the ins-and-outs of asset allocation and portfolio management in retirement. The best place to start, is a brief discussion of what truly entails “risk”.
Defining Risk
We often mistake “risk” for taboo or uncommon behavior such as quitting one’s job to start a business or owning a high-stock portfolio in retirement. Risk is much better defined as anything that increases the probability of an undesirable outcome. Just about nothing is inherently risky. Risk is always dependent on a broader context of facts that determine how likely a certain action is to throw things off-course.
Consider the example of quitting one’s job to start a business. If you are a single income household with children and a mortgage, then this would appropriately be considered “risky”. However, if you had $10,000,000 in the bank when you decided to do this, a lot of the risk from quitting your job becomes moot.
The same is true of asset allocation and portfolio management. Owning a high stock portfolio in retirement is no more inherently risky than quitting one’s job and starting a business. What determines the risk of the action, in both circumstances, is a broader context of facts. To determine the true risk of your portfolio, therefore, some additional context should be provided. Most importantly, how large is your portfolio, how much will you need to withdraw from it every year, and how long do you need it to last?
Stocks vs Bonds – What’s The Risk?
It’s common knowledge that stocks, while quite volatile in the short-term, will earn more than bonds over the long-term. Generally speaking, stocks have been found to be more likely to produce higher returns than bonds over time periods between 5-10 years. In other words, if your time horizon is at least 5-10 years (or longer), then it is riskier to invest in bonds than in stocks. The only utility that bonds have in a portfolio, therefore, is to provide relative nominal stability over short time periods.
This brings us to the first, and most important, variable to be clarified when determining your portfolio’s asset allocation – your time horizon. For most of your life, your time horizon will be far beyond 5-10 years, meaning that, at essentially all times, the majority of your portfolio should be invested in stocks.
Investing too heavily in stocks, while not nearly as risky as not investing enough in stocks, is still a risk, however. This is where the second variable for determining your asset allocation comes in – your annual income need from your portfolio. If you think of your portfolio as being split into dozens of “chunks”, each representing one year’s worth of distributions to you in retirement, then mitigating the risk of investing “too much” into stocks becomes relatively straightforward. The “chunks” that are 5 years or less away from being distributed to you are safer in bonds, while the remaining “chunks”, having a longer period of time before they’re needed, are safer in stocks.
Your asset allocation should therefore be a function of two things: your income need and your time horizon. Specifically, any funds needed within five years should be in less volatile assets, while funds needed beyond five years should be invested in stocks.
The Perfect Retirement Portfolio
Using the principles discussed above, I’ve developed a clear set of rules for investing one’s portfolio throughout retirement and managing it over time. It employs what’s commonly called “bucket strategy” where the portfolio is segregated into different “buckets” that each contain their own distinct purpose. Here’s what it looks like:
Bucket 1 - 1 years’ worth of distributions is invested in the money market (this is where monthly distributions are taken from).
Bucket 2 - 4 years’ worth of distributions are invested in a mix of short-term bonds.
Bucket 3 - The rest of the portfolio is invested in a diversified mix of stock index funds and Bitcoin.
Managing the Portfolio
If Bucket 3 has risen by the time Bucket 1 is depleted, then Bucket 3 is used to refill Bucket 1. The entire portfolio is also rebalanced as needed.
If Bucket 3 has fallen by the time Bucket 1 is depleted, then bonds from Bucket 2 are sold to refill Bucket 1. No further rebalancing takes place.
Consider the following example of a recently retired couple with a $1,000,000 portfolio. After social security and all other income sources, they decide they need $50,000 (before taxes) to live comfortably. This would mean their portfolio would be invested along these lines:
What if they retired with $2,500,000, however? This would lead to a 90% stock portfolio, which is considerably more “aggressive” than most retirees think they should be.
Although their portfolio would be surprisingly higher in stock, consider the fact that they are actually reducing their risk! Sure, the short-term volatility of their portfolio might be higher, but less of their portfolio is needed in the short-term. In other words, more of their portfolio has a long-term time horizon.
At this point, we have used generalized terms for what to invest one’s portfolio in, such as “stocks”. Not all stocks are created equal, however, and capturing their average long-term rate of return is highly dependent on being invested in the right stocks. This is fairly easy to do through the purchase of index funds. For a variety of reasons, these funds are consistent, safe, and will reliably capture the long-term performance of the stocks that they track.
Finally, I’ve discussed the merits of real estate and Bitcoin as long-term investments here and here. Whether or not these are the right fit for you and a part of your portfolio is best discussed between you and your financial advisor. If you aren’t sure or don’t care to seek professional help, then stocks are the most appropriate things to invest in for Bucket 3.
