A common piece of retirement planning advice that I’ve come across recently is that a person should adjust their asset allocation out of equities and into fixed-income as they get older. One rule of them is that one should set their stock allocation percentage to 100 minus their age, but I’ve never seen a justification for that. I understand that when one is approaching retirement, they need to get out of stocks and into low-risk fixed income investments to protect their portfolio from the huge swings that the stock market sees. So I can see that if somebody is maybe 5-10 years from retirement, they’ll need to start adjusting their portfolio at a time when the stock market is high. But why should I, for instance, be moving away from stocks when I’m in my 30s? At that time I’ll be 20-30 years away from retirement, so what good does it do me to get away from the much higher return offered by stocks when any temporary downturn will long since been made up for by the time I need the money?
First, rules of thumb are, as a rule of thumb, pretty useless. Still, there is solid justification for never having all of your money in stocks. If you have an efficiently diversified portfolio then you get a significant risk reduction for a relatively insignificant reduction in long term returns by adding bonds. So an investor who is 100% stocks could move to 80% stocks and suffer a significant cut in risk without losing much long term return.
The other reason starts to apply as you get a bit older. Most of us are not concerned solely with the highest balance we can acquire at the year of our retirement. That is obviously unknowable in any case.
The way I think about it is by imagining a range of possible outcomes from what I might have in the worst 10% of market return scenarios to what I expect in average market scenarios.
So take a 45 year old who wants to retire at 65. He could be 100% in stocks. Imagine he needs about $1 million to retire. At 65 the range of balance he might expect might be $575,000 in the worst 10% of outcomes, $1.4 million on average. A rational investor might prefer an asset allocation that gives him $750,000 in the worst 10% of outcomes and a lower average of $1.1 million.
In other words it can make sense to trade away expected return for a narrower range of expectations that would let you plan more effectively. I am sure I am not explaining this as well as I could, but this is an issue many investors struggle with. I don’t think there is a ‘right’ answer, but for most investors having 100% in stocks is not attractive from a risk/return standpoint.
Stock markets can crash and especially a particular stock can crash. Enron.
When you start investing towards retirement, a crash can be made up by simply going back in with a slightly higher % put in.
If the crash occurs near the end, you’re fucked.
More or less, you should put your retirement assets into high risk to start- fading towards a mix, with much in the more stable mutual funds (and your companies stock) in the middle of retirement- then almost all bonds at the end.
Now, one thing that you can do is have your main retirement funded like that, then another much small “mad money” fund, with contrarian investments.
Sure, I get this. My question is, supposing that 80-20 was the right allocation for me at age 30, why wouldn’t it be the right allocation for me at age 35? There’s lots of advice out there that says I should be changing it as I get older. What’s the rationale for doing this in my 30s and 40s?
This, I understand. I spoke to this in my OP. But why would I care about a crash at age 35? At age 45? When I’m years and years away from retirement, a stock market crash bringing down my retirement account doesn’t mean anything. It will be back by the time I’m ready to retire.
I think part of the idea is to avoid market timing as much as possible. Say you’re 100% in stocks at age 30, and you want to be 90% in bonds by age 60. A simple linear interpolation between the two points keeps you from making emotional decisions that overly increase your risk.
For example, you’re 30, and you figure stocks are pretty safe with a 30 year window, so you stay all in stock. You’re young, you’ve got lots of time. Ten years passes, you’re making a decent return, so you’re still all in the stock. Now the market has hit a rough patch and you don’t want to move a big chunk of your stock into bonds at a loss so you decide to wait it out. All of a sudden, you find yourself say 15 years from retirement and still all in stock. Or ten years. You no longer have the 30 year cushion you need to let the market recover. So now you have to choose the exact right moment to move a huge fraction of your investment out of the stock market – how do you do it?
All that said, though, with the Dow barely above 10,000 I think there would be worse things that to stay stock heavy right now and delay upping your bond allocation for a few years. 
Well, the less time to retirement, the less time to recover. Let us say you are 47yo, 20 years from retirement. You have 10 good years of savings, and maybe another 10 of minimum investments. So, if those are wiped out- you’d have to at least *double your contributions to make up for them. Doable, but a pain. So, at age 47 you could still have all your savings in the market, but diversified- some company stock, some high risk funds, and some solid stable mutual funds. That way, the risk of losing it all is almost nil, and you could bring it back up after a crash by making some small sacrifices.
Note that I am not suggesting any funds in savings bonds in that midterm area, just diversification.
Doing it in stages like this also ensure that you won’t mistime the market. Let us say you agree you need to have the funds in stable investments 3 years away from retirement. So, your plan is to move them all on that day. But the crash occurs 1 month before that. If you move your funds in stages, then the risk is smaller.
- the issue here is also that we expect growth in the retirement fund, and the longer you have, the more growth. Which is why 5% of your salary invested at the start of your career is usually worth more than even 20% at the end.
After all the crashing of the last couple of years, the banks and investment pros were all saying, “Don’t panic! Don’t cash everything out! Leave it alone, and ride things out!” That ignores the reality that if your stocks go down by 80%, you have all that ground to make up again that you wouldn’t have had to make up if you had put your money somewhere safe while everything was up and down like a roller coaster.
I say, take all your stocks out of US American companies, and park them somewhere as close to bullet-proof as you can get, because the second wave of subprime mortgages is going to come due in a year or two. Canadian money market funds are nice this time of year.
The more direct answer to the OP involves two phrases: capital growth and capital preservation.
During your thirties, you need growth, and have the time to allow for fluctuations. For someone in their early thirties, they started investing when the marked peaked, and have seen a lot of that deteriorate. But as they continue to invest while the market is tanking they’ll eventually see some really great long term growth. The key here is that you don’t need the money, so you are never forced to sell at a loss.
Once you approach retirement, you no longer have the benefit of time to recover from a loss. You need the money, but you also need it to beat inflation. This is the term capital preservation. You want a nice steady 3-5% and have zero risk, since you’ll be withdrawing from it at fix intervals.
The rationale is that if you start at 30 and are 100% in stocks, by the time you are 35 you’ll have been making significant contributions. By switching to 80-20 (or what ever) you are essentially keeping the first chunk of your savings 100% in stock, and now devoting a small portion of it to preservation. And again, when you are 40, you have made significant contributions to the portion that is 100% in stock, so you break it up again and go 70-30. Remember that the 70% of your portfolio is quite big at this point (we hope) and should be larger than the 100% that you had at age 33.
In terms of gambling, say you start with $100. You may lose it all and that’s okay, but you are adding $100 every month. So it goes up, it goes down, and eventually you win some. You could then gamble with the $150, or you could set the $50 aside (where there is zero risk) and continue to gamble the $100. Again, it will go up and it will go down, when you win a bit you can add that to your $50 pile.
You started gambling 100% of your assets. After some time it grew, so you put 33% into preservation, and continued gambling with 66%. After some more time it grew, and now you have a 50/50 ratio. Eventually you’ll want to leave and no longer risk any of your money.
Did that make sense to anyone here?
You mean those ones earning 1.5%?
Caterpillar pays a 2.5% dividend and is up over 100% in a year.
Actually I agree with the OP in that regard, and so do most professionals.
Take a look at the Vanguard Target Retirement funds. These are meant to provide the right asset allocation based on when you plan to retire. If you take a closer look at the funds you see something interesting.
Target Retirement 2050 = 89.48% Stocks
Target Retirement 2045 = 89.79% Stocks
Target Retirement 2040 = 89.61% Stocks
Target Retirement 2035 = 89.49% Stocks
Target Retirement 2030 = 81.96% Stocks
Target Retirement 2025 = 74.57% Stocks
Target Retirement 2020 = 67.05% Stocks
Target Retirement 2015 = 59.51% Stocks
Target Retirement 2010 = 49.28% Stocks
Target Retirement Income = 30.14% Stocks
So notice that whether you are retiring in 2030 or 2050 you don’t really have a different asset allocation except for rounding errors. It is only when you are much closer to retirement that your allocation drops significantly. I would also argue that most investors in these pre-packaged portfolios have no idea they are so heavily exposed to stocks at the cusp of retirement. I don’t necessarily think it is a bad thing to have a healthy stock exposure, but I think most people who are five years from retirement would guess that their target portfolio has 35-40% stocks.
You’re absolutely right.
One of the comments made at a recent seminar I was at was about how people are living so long through retirement, that there actually needs to be still a significant amount of “growth.” Capital preservation is important when you need the money in 5-10 years. So a person retiring at 65 needs to get things more stable as they pass 55. But they also need to consider that they may live past 80. So all that money saved needs to continue to work for 15 years!
I would also like to argue that being <90% isn’t recommended either. Even early on it’s fine to keep things mixed up and diversified. A portfolio in 1997 that was 20% bonds is a lot better off today than one that was 5% in bonds.
What you do is buy an annuity, and also get a reverse mortgage. Income for life.
Yup, assuming they have the equity in their house and can afford the taxes/insurance.
One more thing I haven’t seen mentioned. Asset allocation doesn’t mean you buy to that ratio and then hold forever. Every so often you need to rebalance. Having some money in bonds means you have resources to buy stock low with bond earnings in order to rebalance, which is a kind of dollar cost averaging. If it was all stocks, you’d be limited to new investments.
I originally liked the notion of target retirement funds, but Thaler and Sunstein point out in Nudge that they make no sense unless they are the only thing you buy, or if the rest of your allocation matches them. My advisor says they are relatively fee heavy also. I realize they were brought up to examine how they allocate the portfolio, but I got out of mine.
Better than -25%. 
ETA: I should clarify a bit - I parked my RRSPs in Canadian money markets before the last crash - I lost zero ground through all of that crap (and made a little bit). I considerer making a little bit while other people were losing their shirts fine by me. I’m not going to stay in money markets indefinitely, but I’m not coming out of them just yet.
This is a very good point. It’s also why it’s always a good idea to have some money in “cash.” Then it’s just a matter of what you consider cash, I include money market accounts.
Although at this point we’re talking about normal people being much more involved with the markets and their retirement portfolio.