You know your birthdate right? Now, do you know your future death date? Nobody does. Not to get overly morbid, but it’s the not knowing when you’ll draw your last breath that causes a major dilemma in retirement investing. If you could know the exact date of your pending death you could spend your money down until it’s zero on your death day – oh pray tell, no such luck, it’s a lottery.
The dilemma is, with a long life and over spending, you could potentially outlive your money and be destitute in old age, or, worse, a burden to your children.
Have too much money remaining in your retirement account when you die it’s all left on the table when you visit St. Peter. Oh well, at least your heirs will enjoy the French Riviera.
“It’s a Question of Balance”
So, how can you manage your retirement money with this big unknown? As the Moody Blues said, “it’s a question of balance”.
If you’re like most people you’ll have no pension coming in, so, it’s all on you to build and preserve your IRA. You’re probably already receiving a lot of calls from “financial advisors” or “wealth managers” in your area that are very willing to manage your money for you. Be advised that today’s financial advisors are yesterday’s stock brokers that are merely retooled.
Unless they are bona fide fiduciaries, they are a for-profit business. That financial advisor makes a hefty commission and guess where it comes from? It comes out of your portfolio and into his or her pocket. And although they have very arcane formulas to mitigate risks, they cannot guaranty portfolio growth but they will take their fees, most likely between 1% to 2% annually.
To minimize these fees, should you go it alone and manage your own IRA? If you decide to self-manage, you’ll need to adhere to one critical principle, that of proper “asset allocation” in a balanced portfolio. Even if you give all your money to a financial advisor, it will behoove you to know the basics of sound asset allocation.
Asset Allocation: The Basics
There are two basic buckets you can place your retirement money: growth or safety. Growth generally means investing in in more speculative asset classes such as common stocks or stock mutual funds. These are risky in that, over time, they can grow, but they occasionally tank for a substantial period.
Safety generally means investment in more stable assets that are less volatile like bonds, treasuries, or money markets. In the case of U.S. Treasuries, your money is 100% safe (but could be susceptible to inflation devaluation).
Living a long life is a good thing. To finance it you will want to grow your IRA continuously. This becomes even more important after you retire, when you’re no longer earning a salary and depositing to your IRA – the growth now has to come 100% organically from the investments.
Unless you just fell off the cabbage truck, you realize there are inherent risks to the stock market. You probably witnessed the drop in value of your IRA in 2008 caused by the great recession. That nasty bubble pop took 6 years to get back to its original valuation.
So, why not put it all in safety and avoid another 2008. Well, this particular year, 2017, safe investment in treasuries and CDs are yielding only 2.5%, in contrast to the S&P 500 index fund which is running at 16%. That means on each $100,000 investment, The S&P 500 index fund earned $13,500 more a year – difficult to ignore.
The answer is you need a portion of your portfolio to be in growth and another portion to be in safety. If the stock market tanks again, you’ll have a substantial portion of your portfolio protected. Conversely if the market continues to grow, that part of your portfolio will also grow.
The Proper Allocation
How much to allocate to the safety bucket vs the growth bucket is determined by two factors: (1) your age and (2) your risk tolerance.
Why your age? Take two extremes, the fifty-year-old and the eighty-year-old. The fifty-year-old has a good 15 years or more of earnings before retirement. He or she can sustain another stock market calamity. Conversely, the eighty-year-old may not live the six years for the market to come back.
Risk tolerance varies from person to person. Some are queasy and anxious when the market dips, they get beside themselves. Others want to bet big for a bigger return, albeit also willing to take a bigger loss.
A Simple Formula
For those of you with low tolerance for risk, use 100 less your age to determine the portion of your portfolio to allocate to growth (and therefore more risky).
For those of you with high tolerance for risk, use 120 less your age to determine the portion of your portfolio to allocate to growth.
So, the example of a sixty-year-old would be:
Low risk = 100 -60 = 40% allocated to growth (therefore 60% would be safe)
High risk: 120 – 60 = 60% allocated to growth (therefore 40% would be safe)
Another example of a seventy-five-year-old would be:
Low risk = 100 -75 = 25% allocated to growth (therefore 60% would be safe)
High risk: 120 – 75= 45% allocated to growth (therefore 40% would be safe)
O.K., so you set up your IRA with the proper asset allocation for your age and risk tolerance, do you now just ignore it? No, the magic lies in the rebalancing after the situation changes.
Let’s take the year 2016 as a low risk tolerant fifty-year-old, if you had a total of $200,000 in your portfolio, you would place $100,000 (50%) in stock funds, and $100,000 (the other 50%) in something safe like treasuries or bonds. That’s what it looks like on January 1, but one year later, the picture has changed, that stock fund went up 18%.
So, now the picture looks like this:
Growth: $118,000 — now 54% of the portfolio
Safety: $102,500 — now 46% of the portfolio
If you do nothing, you’re over exposed in stocks (54% when it should be 50%) and now need to take some chips off the table and place into safety.
So, to properly rebalance, you would sell off $7,750 of your growth bucket and place into it into the safety bucket to make them again 50% / 50%.
“Buy Low, Sell High”
Here’s the magic: buy low, sell high.
Stocks don’t go up forever, eventually they top off and decline, but even the most prescient soothsayer cannot predict the exact top, so what you’re doing is moving money away from high risk to protection. You’re selling high!
If the reverse occurred, and stocks declined by 18%, you would actually sell the roughly $7,750 in bonds and buy more stocks. You’re buying low!
The world is fraught with risk, think Donald Trump and Kim Jong-Un, a lot of things are out of your control, so you need an investment strategy that meets your risk tolerance and takes into account how many years you’ll have on this planet. Allocate properly and rebalance once per year and you won’t go too far wrong. In a future post we’ll address a formula for withdrawals so you can enjoy your retirement and not run out of money.