Your asset allocation decision, or the percentage mix of stocks and bonds in your portfolio, is one of the most important decisions you will make when retirement planning.   Retirement plan success and failure probability rates are very sensitive to this assumption.  Your asset allocation decision should not be made lightly.   There is a framework that can help you think through this decision to ensure that you are making the decision that will best enable you to meet the funding of your retirement goals.    

Your Asset Allocation Decision is Closely Tied to Your Investment Risk Tolerance

Investment risk tolerance is a critical input when determining your asset allocation between stocks and bonds.   Investment risk is only one of the big five retirement risks a retiree faces (see our Insight entitled "Evaluating the Big Five Retirement Risks Every Retiree Faces" for more).   Investment risk is the risk that actual returns will differ from the expected return outcomes at any point in time. No one knows with certainty what the future holds, so we look to the past to make observations about how certain asset classes performed. We take specific note of each asset's average return and the variability of return experienced around that average return, known as standard deviation. We can typically make a reasonable long-term forecast of future expected returns from these observations for planning.    

Stocks have higher potential for return but also higher variability in the path of return. In contrast, bonds have lower potential for return but also less variability in the path of return. The greater the allocation to stock in the investment portfolio, the greater the expected return and the higher the investment risk you are taking. Some individuals can tolerate wider swings in their investment portfolios' performance in the search for higher returns, while others cannot comfortably stomach such swings.  Investment risk gives rise to the concept of risk versus return and the need to select an asset allocation of stocks and bonds in an investment portfolio such that the performance variability does not exceed that which is palatable. Otherwise, you run the risk of aborting your plan at an unfavorable time (when markets are lowest), causing irreparable harm to your investment portfolio.  

Three Dimensions to Evaluate

The three dimensions that should be evaluated and then compared to determine an appropriate asset allocation decision between stocks and bonds are:

1. Need to take risk
2. Willingness to take risk
3. Ability to take risk

Evaluation starts with understanding the amount of risk, or stock exposure, that may be necessary to take to be able to earn the return needed to achieve your goals.  The rule of thumb is to take no more risk than is needed to meet your return goals, though obviously, there is much more to consider.  Your willingness to take risk is known as your risk tolerance and is measured by determining how much volatility you can "stomach," often measured through the use of a risk profile questionnaire.   Once you understand your need to take risk and your willingness to take risk, you must check against your ability to take risk.  Your ability to take risk is known as your risk capacity and is measured by looking at your personal situation to see if you have the resources and flexibility needed to afford to take the risk without causing undue stress or harm.  Your ability to take risk overrides your need and willingness to take a risk. Even if you are willing to take more risk than you have the capacity for, you will be constrained by your risk capacity. You cannot bet what you cannot afford to lose.

In assessing all three dimensions, the goal is to find a level of stock and bond allocation that allows you to meet your return need without exceeding your willingness and ability to take on the corresponding level of investment risk to earn that return.   

What if Couples Have Different Risk Tolerances? 

Couples will share the same need to take risk and ability to take risk, but it is not uncommon for couples to have a different willingness to take risk (or risk tolerance).  I have found in practice that differences in risk tolerance usually stem from not understanding what investment risk is and differing levels of aversion to loss.  Most people interpret investment risk to mean absolute loss.  In other words, "how much would I be comfortable losing?".   This interpretation could be accurate depending upon the makeup of the investment portfolio.  Suppose the couple held an undiversified portfolio containing just a few individual stocks. In that case, investment risk could very well represent permanent loss because one or more of the companies held could go bankrupt, leaving the couple with an absolute loss.  

Investment risk takes on an entirely different meaning when you have a maximally diversified portfolio.  Suppose you have a portfolio that gives you exposure to over 30,000 different securities across 44 different countries (see our Insight entitled "Building an Investment Portfolio for Retirement" for more). In that case, the impact upon the portfolio if some companies go bankrupt during bad times is immaterial.   It becomes simply a matter of time for the economic cycle to improve, companies to grow again, and for stocks to regain their value and begin growing again.  Investment risk in the context of a maximally diversified portfolio is not an absolute loss but rather the potential for fluctuation in the portfolio's value at any point in time.  The greater the percentage of stock in the asset allocation, the greater the potential fluctuation.  As long as the portfolio's investments are not sold during a period when the market has fluctuated down in value, you will not have locked in an absolute loss.   This is why being honest with yourself about your willingness to take risk is serious and important. Otherwise, fear and anxiety may cause you to sell while markets are down, thereby locking in that loss.  This is also why it is important to have an appropriate level of "reserve" assets outside of your investments to fund retirement expenses during times of unfavorable market fluctuation.     

Additional Complicating Factors

Retirement planning is very complex, and every factor seems to be somehow connected to other factors.  I would be remiss if I did not share two additional factors that should be kept in mind:

1). Stock and Bond Portions of Portfolios Are Not All Constructed the Same

So far, we have only talked about making the asset allocation between the stock and bond portion of the portfolio.  The reality is, how each person or financial advisor constructs the stock and bond portions of their portfolios matters.  The individual stock and bond holdings determine the correlations and expected returns that in turn determine the entire portfolio's expected return and standard deviation (which is the measure of volatility or investment risk).  

2). The Asset Allocation Decision Should Consider Other Risks Also

As mentioned earlier, investment risk is just one of the big five retirement risks retirees face and need to manage.  The other four risks that need to be considered include 1). Sequence-of-returns risk, 2). Spending risk, 3). Purchasing Power risk, and 4). Longevity risk.   Each of these risks are material and pose a potential threat to an individual's retirement plan.  The asset allocation decision is a risk management tool that can help manage these other risks.  At the end of the day, in addition to everything we discussed in this Insight, the asset allocation decision should be made in conjunction with the overall risk assessment and risk management strategy. (see our Insight entitled "Managing the Big Five Retirement Risks Every Retiree Faces" for more).  

If you would like help determining your optimal asset allocation for retirement, we stand by ready to help.  To learn more, you can schedule a date and time that is convenient for you here at this link: https://calendly.com/thriveretire/thriveretire-call or contact us here at any time.

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