I've got about 80% of my retirement savings in stocks and 20% in bonds and cash. Over the past five years this asset mix has served me well, but given how much stocks have risen, I'm considering re-allocating to a more moderate portfolio. What do you consider an appropriate stocks-bonds mix for today's market? --Joseph L., South Carolina
I understand why you're feeling jittery about having a relatively high percentage of your savings in stocks. Since the market bottom in March 2009, stock prices have tripled, making many people wonder whether we're due for a setback.
But I think you're coming at this the wrong way. The rationale behind asset allocation is that it's impossible to predict the market's ups and downs. So you set a mix of stocks and bonds that allows you to participate when stock prices are climbing and gives you some protection when they dive. Then, aside from occasional rebalancing, you stick to that mix regardless of what the market is doing -- or what your gut tells you it might do.
But you now want to change your asset mix because you're worried that stocks are vulnerable. Which means you really want to mix the discipline of asset allocation with the speculative behavior of market timing. That's a bad combination. If you start changing your asset mix every time you think stock prices are ready to rise or fall, you've abandoned the concept of asset allocation and turned investing into a guessing game.
Related: The safest way to make your retirement savings last
My guess is that a high-octane blend of 80% stocks-20% bonds is actually too racy for you. You had no trouble holding it while the market was soaring. After all, what's not to like about blockbuster gains? But you seem to have doubts about whether you can handle the downside to such an aggressive stocks-bonds mix.
What you really need to do is figure out the right asset allocation for you -- that is, a mix of stocks and bonds that you won't be tempted to overhaul every time there's some commotion in the market.
Here are three steps that can help you do that:
Step 1. Assess your risk tolerance. Getting a handle on your true appetite for risk is crucial to creating the right asset mix. Take on less risk than you're actually capable of handling, and your nest egg won't grow as much as it otherwise could, perhaps leaving you short in retirement. Overshoot the level of risk you can bear, and you may end up selling stocks in a panic during a setback, turning temporary losses into real ones.
The best way to evaluate how much risk you can take on is to complete a risk tolerance questionnaire. Vanguard has a free one that asks 11 questions. Based on your answers, you'll get a recommended blend of stocks and bonds. Australian firm FinaMetrica offers a more comprehensive 25-question risk profile questionnaire that's used by many financial planners and costs $45. It grades you on a scale of 0 to 100 and comes with a detailed report that you can then translate into an asset allocation.
Step 2. Do a crash test. When the market is doing well, many people tend to project recent gains into the future and forget about past downturns, leading them to underestimate the real risk in stocks. As a result, some investors may be tempted to load up on equities even if their risk tolerance test suggests a more conservative mix.
To guard against that possibility, it's a good idea to check how the recommended stocks-bonds mix you get in Step 1 has performed in times of extreme stress. From the market's high in 2007 to its trough in 2009, stocks lost about 54.7%, while bonds gained roughly 7.6%. So a mix of 80% stocks and 20% bonds would have lost just over 42% over that period (assuming no rebalancing). If that size setback would have had you fleeing stocks and hunkering down in bonds and cash, then you may want to consider a more conservative portfolio, say, a 60-40 stocks-bonds blend that would have lost roughly 30%, a 50-50 mix that would have declined a bit less than 24% or even a 40-60 mix that would have lost about 17%.
Related: Should I bet it all on Buffett?
Remember, though, if you opt for too much short-term security, you may not get the returns you need to reach your financial goals. If you're still saving for retirement, tilting too far away from stocks could mean you'll need to save a lot more to build a suitable nest egg. Dialing back on stocks is less of an issue if you're getting ready to draw income from your retirement savings or already doing so, as preserving capital is typically a bigger priority when you're older. Even then, however, you want your portfolio to have some growth potential, so you still want to keep a portion in stocks, say, 30% to 60%, depending on your risk tolerance.
You can get a sense of how different stocks-bonds mixes might perform long term by going to a retirement calculator that uses Monte Carlo analysis to estimate the probability that you'll generate the retirement income you'll need.
Step 3. Get to your target mix quickly. You'll often hear pundits and advisers recommending that you move gradually or dollar-cost average if you're re-jiggering your portfolio or investing a large sum. But that advice is misguided, and only leaves you invested in the wrong asset mix longer than you should be. So whatever mix you arrive at by going through the steps above, don't dawdle getting to it.
One exception: If selling assets in taxable accounts would trigger a big tax bill, you may want to move at a more measured pace. But even then, you may be able to avoid burdensome taxes by offsetting gains against losses in other investments, homing in on assets with the smallest unrealized gains or, if you also have savings in tax-advantaged accounts, doing as much of your re-allocating there as possible. But the idea is to get to your target allocation sooner rather than later.
Of course, by following the steps above you may very well end up switching to a more conservative allocation, which is what you were thinking of doing in the first place. But if that's the case -- and I suspect it will be -- you'll be doing so to set an asset mix that you can live with for the long-term, not in an attempt to outguess the market.
More from RealDealRetirement.com
The Retirement Income Mistake Most Americans Are Making
