Is Your Asset Allocation Too Aggressive?

Key Takeaways

• The key factors that should affect how much someone holds in stocks are risk capacity and risk tolerance.
• For those saving for retirement, because they have many years until they get to that point, they should be holding as much in stocks as they can stand.
• For goals with shorter time horizons, you probably would want to have a bigger allocation to safe investments and relatively less in stocks.
• For those people who are getting closer to retirement, it’s important to take a look at nonportfolio income sources, look at how much of your cash flow needs they’ll provide, and use that to inform how much equity risk to take.
• Once someone actually enters retirement and begins to draw upon their portfolio, their asset allocations should become more conservative, especially when taking higher withdrawals.
• You’d want to use your anticipated sequence of withdrawals to inform how each portfolio or how each bucket of your portfolio is positioned.

Margaret Giles: Hi, I’m Margaret Giles for Morningstar. If you’re like many investors, the up-and-down market of the past few months may have prompted you to question your portfolio’s asset allocation. Joining me to discuss how to assess whether you have enough, but not too much, in stocks is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning, and host of The Long View podcast. Christine, thanks for being here.

Christine Benz: Margaret, it’s great to see you.

How Your Risk Capacity and Risk Tolerance Informs Your Asset-Allocation Strategy

Giles: So, what are the key factors that should affect how much someone holds in stocks?

Benz: Really two key factors. So the first one would be what we call risk capacity, which is basically the amount of volatility that you can shoulder without having to change up your plans. So, to use a simple example, if I’m planning to buy a home within the next five years, I probably can’t shoulder a lot of volatility with that portion of my portfolio. I’d want to have it in fairly low-risk assets, and I generally think that if people have spending goals within the next five to 10 years, they should stick with low-risk assets like cash and bonds for those spending needs.

And then the other concept that you want to keep in mind, but I would put it in the back seat, is risk tolerance, so how do you feel about those days when the market is just all red, and that is a factor that you should use to influence your portfolio’s positioning, but risk capacity is really the main driver of how aggressive your asset allocation should be.

Why You Should Hold More Stocks With Long Time Horizon Goals

Giles: So, for those saving for retirement, does that suggest if they have many years until they get to that point that they should be holding as much in stocks as they can stand?

Benz: It does, really. For people who are, say, in their 20s, 30s, even 40s, they have that long time horizon, very likely, until they’ll need their retirement assets. They should be prepared to withstand volatility. They should be comfortable withstanding volatility, so they should ideally just keep investing and pay as little attention to the equity market volatility as possible.

But I would also say at all of our life stages, we inevitably have some shorter-term goals in addition to retirement, so maybe a home down payment, or paying for a wedding, or going back to school, or whatever the case might be, for those assets, you’d want to keep your shorter time horizon in mind, and you probably would want to have a bigger allocation to safe investments and relatively less in stocks.

How to Find the Right Equity Allocation When Approaching Retirement

Giles: OK, so for those people who are getting closer to retirement, how can they figure out the right equity allocation?

Benz: Here is where it’s really important to start thinking about, in addition to my portfolio, what other income sources do I have coming to me? Most of us will have Social Security. Some workers will have pensions available. And you want to take a look at those nonportfolio income sources, look at how much of your cash flow needs they’ll provide, and use that to inform how much equity risk to take.

So to use a simple example, if I’m a tenured college professor who’s going to be able to retire with a full pension, and that’s a very high-class situation to be in, but if I’m in that situation, my portfolio is really just kind of gravy because that pension is going to supply a lot of my living expenses. I probably want to have it fairly aggressively invested. I’d also want to be thinking about, well, what am I using that portfolio for, but that calls for a fairly heavy equity allocation in such a situation.

On the other hand, if someone has a more sort of normal spending pattern that they’re expecting from their portfolio, where they’re taking maybe 4% a year, well, that would call for relatively more in cash and relatively more in bonds. So in my standard Bucket portfolios, I typically call for, like, eight to 10 years’ worth of portfolio expenditures in cash and bonds. That typically equates to, like, a 40% cash and bond allocation, and the remainder in equities.

Why Retirees Should Have a More Conservative Portfolio When Taking Higher Withdrawals

Benz: So, once someone actually enters retirement and begins to draw upon their portfolio, should their asset allocations become even more conservative?

Giles: Probably so, and I would say that cash is an asset that you definitely want to bring into the picture at that life stage when you begin drawing from the portfolio. 2022 was a really great example of why you’d want to do that, when stocks and bonds were down at the same time. If you had cash to pull from, that puts you in a good position.

And then another key dimension here is that many older adults do plan to delay Social Security filing, so they’re not getting that benefit in the early years of their retirements, and so that necessitates higher withdrawals earlier on. Those higher withdrawals should translate to a more conservatively positioned portfolio. So think about your anticipated spending from that portfolio and use that to influence how equity-heavy it is.

Should Retirees’ Asset Allocation Change As They Age?

Giles: OK, so continuing this retirement streak here, how should retirees’ asset allocations change as they age, or should they?

Benz: It’s an important question, Margaret, and one that I think probably hasn’t gotten enough attention. So we want to think about the shape of our glide path throughout retirement, and the way we shape that glide path really depends on our anticipated use of our money during retirement. So if someone is expecting to spend most of that portfolio during their retirement, they should in fact be derisking it throughout retirement. So if you come into your 80s, for example, the majority of that portfolio, if I’m anticipating I will exhaust it during my life span, should be in cash and bonds.

On the other hand, for retirees who think that they will have leftovers or who have a strong priority to have some funds leftover for their loved ones or charity, they probably want to have a more equity-heavy glide path that they’re taking through retirement because they want to have that money continue to grow after they’re gone.

Should Retirees Maintain Different Allocations in Different Accounts?

Giles: So to wrap up here, would there be any reason for retirees to maintain different asset allocations in different account types?

Benz: Yes, probably. So this is a tentacle of retirement planning that we talk about as sort of “sequence of withdrawals”—which asset types I’m tapping first and last in retirement. The general framework is that if you have taxable, sort of non-tax-sheltered assets, you’d want to exhaust them first, and if you have Roth assets, you generally want to save them for later because the tax benefits are the greatest, and then tax-deferred accounts are kind of in a gray area. But you’d want to use that anticipated sequence of withdrawals to inform how each portfolio or how each bucket of your portfolio is positioned, so that taxable portfolio would generally be the lowest-risk piece because you’d be spending from it first. The Roth portfolio would generally be the highest risk, or most equity-heavy.

Giles: All right, Christine, thanks for helping us think about our equity allocations.

Benz: Thanks for taking the time. Thanks so much, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch How Much Guaranteed Income Do You Need in Retirement? for more from Christine Benz.