A Simple Rule for Retirement Diversification

At its core, retirement planning focuses on asset mix and where each dollar of your savings is invested for the best combination of risk to reward. However, it is about time the world takes a different view of what risk really means!

High risks mean high rewards, and low risks mean low rewards, right? When it comes to retirement planning, this question isn't as simple as it seems. Low risk investments are those that offer very little volatility, and they generally bring very low percentage returns. High risk investments usually offer greater volatility and bring higher returns. However, low risk funds can easily become high risk, and high risk funds can become low risk.

A young person planning for retirement, for example, may get caught up in the idea of accepting a very low risk profile, even if it means low returns. While the chance is very low this saver will ever see a drop in their account balance below their total cash investment, there is a very high chance they won't ever see a financed retirement. Too low returns for too long are just as risky as a 100% aggressive portfolio.

Likewise, higher risk investments aren't always as risky as they seem. For instance, equities are considered to be higher risk retirement products, but there is a big difference between a blue chip dividend stock and a small cap in emerging markets.

Supposed safe havens, such as bonds and fixed income instruments, which provide plenty of default diversification, can plunge in value as interest rates rise. If an investor were to purchase long dated bonds for short term asset protection, a small rise in interest rates could bring immediate paper losses. For someone with a long term horizon, this outcome wouldn't be so significant. In the short term, however, it would mean their money they believed was safe wasn't safe at all.

Retirement Diversification

Diversifying with Age

The common rule for diversification is that investors should take 100, and from that number, subtract their age. The remaining number is how much of their portfolio should be invested in equities or other high risk investments. Their age is the amount of cash that should be invested in fixed-income, or lower risk investments.

This simple diversification equation, even as a guide, is far too simple, particularly for people on the fringe age groups. A 25 year old could probably get away with an all equity portfolio, especially if current interest rates do not warrant any fixed-income investments. A 60 year old nearing retirement, however, could probably not afford 40% in equities, especially with how volatile the markets have been as of late.

Obviously, the problem is here that people tend to retire at different ages. Therefore, to counteract this variable, the age diversification rule should be substituted for a new equation, one that considers the time to retirement, instead of the saver's age. The goal is that as the retiree reaches retirement age, asset allocation and diversification trend toward safer investments.

Now let's take the same examples. If a 25 year old plans to retire at 75, he or she has a whopping 50 years to accrue savings. At 26, the saver could have 2% in fixed income and 98% in equities. At 36, the saver would have 20% in fixed income and 80% in equities. At 46, the saver would have a 40/60 equity/bond retirement diversification. And at 50, the saver would finally reach an equilibrium, at which point the weight of equities and bonds are at an even 50/50.

This simple equation helps to even out the earnings potential of the saver over time. At 50, the saver can contribute far more to his or her retirement plan than he or she can at 26. Near retirement at 70 years old, it is unlikely he or she can contribute more than was possible at 26.

Under this plan, the retirement plan would likely see a bulk of its contributions at an age range where the future retiree is saving at 40/60-60/40 bonds to equity or at 45-55 years old. The least amount of contributions would be made at the fringes, where the 26 year old is saving in 98% equities and the 70 year old is saving at 90% fixed income.

One Final Twist

There are a few rules to keeping this retirement diversification equation working. First, barring any apocalyptic event, the total asset base of the retirement plan should not be shifted. That is, the contributions to your retirement plan will change the dynamics of your portfolio, but it should be left alone with no asset moves of your own, other than to add funds routinely. This rule is meant to shake out the role of emotions and the “here and now” market news you don't want to affect a long term plan.

Next, equity investments should be well balanced between growth, dividend, and value funds, while fixed income funds should only be purchased in a timeframe that will settle before retirement. For example, buying 30 year bonds at 30 is reasonable, since the 30 year bonds will have reached maturity before retirement. However, buying 30 year bonds before retirement only opens up the possibility that interest rates rise and bond values plummet before you reach retirement.

The beauty of this algorithm, rather than the original retirement diversification age equation, is that it accounts for the length of time before retirement. It allows for flexibility adding or subtracting years until retirement and ensures that the biggest contributions made in the future retiree's forties and fifties are well diversified. Finally, following this guide requires that an investor worry only about adding enough to their retirement savings plan.

Diversification and asset allocation are products of the market, and as stated earlier, is something that shouldn't be a concern. With that in mind, however, it would be perfectly reasonable to go to a nearly 100% fixed-income investment at your planned retirement date, liquidating your equity and bond funds in exchange for income producing assets that will pay for many long years of retirement relaxation.
Tim Ord
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