It Boils Down To Having The Correct Asset Allocation


Michael Batnick had a quick post noting that if half your portfolio is in cash and bonds, the other half needs to do a lot of work (that description came courtesy of the Abnormal Returns blog). I take that sentiment to be about having a suitable asset allocation. If you are behind where you should be for your age and intended retirement date then yes, your equity exposure does need to do a lot of work.

Don't confuse that with having to increase equity exposure. If you are behind where you need to be the something has to change but that doesn't necessarily mean you must buy more stocks. First, even if you do buy more stocks there is no guarantee that returns will be sufficient to make up the gap. A lot of people seem to be predicting relatively low returns for the new decade. If that turns out to be correct then more equities wouldn't help that much, maybe a little, but it could make it worse. Other changes that could be made include saving more, working longer, reducing spending somehow or some combination of the three.

Sleep factor should be considered when building your asset allocation as well as changes to your sleep factor as you get older. By sleep factor I mean having a portfolio mix that doesn't keep you up at night. Lack of worry or piece of mind has value.

There is no single right answer here. The answer that is right for you today may not be the same answer five years from now. People typically review and make changes to financial plans based on life events and that makes sense of course but changes in thinking and attitudes are also important considerations. I've quipped before that finding out you had too much in equity exposure after a large decline is a bad position to be in. If that happens, ok, you know that time will bail you out. Maybe more time than you'd like or maybe not (the current event snapped back so quickly that investors who did not panic were bailed out immediately) but time is your friend.

The one exception that I can think of relates to having the bad luck of retiring six months before a large decline that doesn't snap back in two weeks. This is called sequence of return risk. Essentially, there comes a point close to your intended retirement date where a large decline greatly increases the risk of disrupting your plans. No single answer here either, though. If you want to retire at 65 then a huge decline at 45 should be no big deal unless you've done something catastrophically stupid. A large decline at 64 probably is a big deal in this context. What about at 60? Depends who you ask. Proper asset allocation includes understanding how you would answer that question and what you would do to mitigate the threat.

Mitigating this risk can be as simple as setting aside a couple of years worth of expected income needs and doing so while the market is still high.

If you're younger and struggle with normal equity market volatility, I think living below your means and saving more is the simplest solution. If you're well into retirement then you have possibly developed a groove for how you manage your cash needs and while I don't think you necessarily need a couple of years worth of cash, it makes sense to be a little ahead of the game, perhaps with a year's worth or so.

I've been transparent about my finances in terms of the optionality that comes with multiple streams of income, putting in the time to be able to monetize a hobby if I ever need that and doing what I can to avoid spending hundreds of thousands of dollars on prescriptions and doctor visits. Retirement will have plenty of surprises and the greater your optionality, your flexibility, your adaptability the easier it will be. The sooner people can come to this, the better off they will be.