What are the optimal investments for your retirement portfolio?
But investment selection need not be terrifying. A significant part of the problem is resolved by reframing the question as follows: Are my retirement investments well-diversified? That's because diversification—being sure to have an appropriate mix of different categories of investments—is perhaps the single most important principle of investment selection.
And the key to achieving diversification is asset allocation, the topic of today's column. Before you decide on that allocation, you should first reflect upon your capacity and tolerance of risk. Then heed the following practical guidelines:
Consider your assets holistically. To avoid working at cross purposes, calculate your asset allocation on a household basis; include all of your own accounts as well as everything held by your spouse or partner. Include all retirement accounts: 403(b) accounts (such as TIAA-CREF accounts arranged through your university); 401(k) accounts, which you or your spouse may have if you have worked for private employers; traditional IRA's; and Roth IRA's.
It can be daunting to mount a total analysis of multiple accounts. One tool that may help is the Portfolio Manager at Morningstar. Enter in all of the holdings from your various accounts, and the tool will give you an instant analysis of your asset allocation, free of charge (unless you want the data saved for the next time you return to the site, which requires a paid membership). Or use a personal-finance program for your own computer, like Quicken. It may take some time to set up but it gets easier afterward.
Know the basic asset classes. Stocks (or equities) are shares in a company; they entitle you to profits paid out in the form of dividends. Bonds (sometimes called "fixed income") are IOU statements; to own them is to have extended a loan to the issuing entity, with interest payable to you until the principal is returned at a specified time. Cash comes in greenbacks (savings accounts, certificates of deposit) and a variety of cash equivalents (money-market funds).
Those three basic asset classes reflect different risk-reward weightings. Stocks tend to be higher risk but offer the prospect of high rates of return. Cash assets are a very low risk but offer a likelihood of low returns. Bonds typically fall somewhere in between. Diversification puts the whole of this risk-reward spectrum to work for you, making for smoother overall returns.
Consider additional options. A basic stock-bond mix (with cash optional) is fine for most ordinary investors, but as you become more knowledgeable you may wish to consider a deeper range of diversification options. Within the three basic asset classes are many different subcategories, starting with domestic (meaning United States) and international.
International funds can comprise equities or bonds, and be broken down into emerging markets and developed markets (the former being faster growing and higher risk), regions (Asia, Europe), or even particular countries (say, China).
Stocks may be divided further, including subcategories of market capitalization (small-cap and mid-cap being riskier than large-cap, but often with higher bounce potential) or sector (tech, energy, health, and the like).
Among bonds, there are many options: corporate bonds; Treasuries, issued by the federal government; municipal bonds from state and local governments building schools, libraries, roads, and the like; high-yield (issued by hard-pressed companies); and inflation-protected.
There are also more exotic asset classes, from real estate to precious metals to commodities, such as oil or gold. Pennywise intends to examine those in greater detail in a future column.
Arrive at an asset allocation. This diversity of options may suggest why people are filled with terror at the prospect of making choices. But it need not be so. The elementary premise of asset allocation is simply to pick investments sufficiently representative of a wide variety of asset classes. The ideal is to have several that function differently even to the point of having a negative correlation, in the jargon of statistics, meaning they go in different directions, one rising when the other is falling.
A very simple asset allocation would be 60 percent stocks, 30 percent bonds, and 10 percent cash. More risk-averse investors, of course, could scale back the proportion of stocks to 50 percent or less, while bolder ones could drop the cash proportion and increase the stock proportion. Another simple asset allocation, recommended by experts whom Pennywise respects, would be 33.33 percent U.S. stocks, 33.33 percent international stocks, and 33.33 percent inflation-protected bonds.
Figuring out your precise optimal asset allocation depends on a variety of factors. At the very least bear in mind time horizon (the farther away one is from retirement, the more risk one can assume) and personal comfort zone (the sweet state of sanity that allows you to sleep at night).
Consider another option, which Pennywise himself practices: Start with your age—or, if you're part of a couple, the youngest partner's age. Subtract that number from 110. Use the resulting sum every year as your baseline stock proportion of your asset allocation. For a 38-year-old, then, a 72 percent equity allocation would be advised, shifting to 71 percent when that person turns 39. The remaining balance would be for bonds and cash; Pennywise splits it as 10 percent cash, 90 percent bonds.
The advantage of a graduated asset allocation of that kind? You will gradually shift from equities toward bonds as you leave behind the accumulation phase of life and approach retirement.
But don't fret too much over the exact proportions of your asset allocation. Just make a plan and stick to it. Many studies have shown that simply having an allocation plan, not so much the precise ratios, is the key.
Rebalance. This is very important. An asset-allocation plan is all but worthless unless you rebalance. That means periodically restoring your portfolio to the desired mix of your asset allocation.
Investing is like sailing a boat. It is important to chart a course (asset allocation), but if you do nothing after leaving the marina, the ocean winds (market fluctuations) will blow you off course. Once in a while it's imperative to trim the sails, adjust the rudder, and reset direction (rebalance).
Let's assume that you have a simple asset allocation of 50 percent equities, 50 percent bonds. Equities tend over time to outperform bonds. If you don't rebalance, you'll soon find yourself at 55 percent equities, 45 percent bonds. In a major financial crisis like that of 2008, the reverse may occur; you'll have, say, only 40 percent equities and 60 percent bonds.
Rebalancing at those points would not only restore the portfolio to the asset allocation you have set for yourself, it would also compel you to sell high and buy low. When equities are getting bubbliciously inflated, you'll be selling them (smart) and buying bonds at a low price (also smart).
When to rebalance?
- Whenever making new contributions to your retirement accounts, use your target asset allocation as a guide.
- Check your asset allocation on an an easily remembered annual date, say, on your birthday.
- Rebalance whenever your asset allocation drifts off course by at least 5 percent.
Pennywise uses all three of those methods.
Simplify. If setting your own asset allocation and rebalancing sounds like too much of a hassle, consider buying balanced funds or target-date funds, if offered by a credible company. Such funds include a mix of stocks and bonds (you can select an allocation approach with which you are comfortable) and rebalance automatically, without you lifting a finger. Pennywise uses such funds in his children's college savings accounts.
Asset allocation and rebalancing need not be intimidating or time-consuming, but attentiveness to them will help you reach your desired port of destination.