The Three Things That Matter Most in Our Retirement Investment Strategy: Allocation, Allocation, Allocation

How can a retiree choose the right invest­ments for his or her portfolio? There are tens of thousands of individual stocks, individual bonds, exchange-traded funds, open-end mutual funds, closed-end mutual funds, and unit investment trusts. The choices can be daunting, which is why it’s so helpful to have a framework or strategy to guide the process. Asset allocation, defined as choosing a balanced mix of stocks and bonds—and the types and propor­tions of those broad securities within your portfolio—can provide that framework.

An investment strategy based on picking individual stocks that will perform better than the market overall can be risky. Likewise, trying to own stocks only when the market is going up and selling before the market goes down can also be risky. The myth that security selection and market timing are keys to investment success may drive many to make poor investment decisions. Is there an investment strategy that can capture market returns while minimizing risk?

What really drives return?

A 1986 study published in the Financial Analysts Journal claimed that asset allocation is the primary deter­minant of portfolio return.¹ The study concluded that asset allocation was respon­sible for 93.6% of the portfo­lio’s quarterly returns variation. The study was updated in 1991, examining returns for different time periods and found a return variance of 91.5%.² Both studies have been widely quoted since.

Nearly 20 years later, Roger Ibbotson noted that parts of the original study had been poorly under­stood and widely misrep­re­sented.³ The 1986 study focused on the variability of returns, not on the relative perfor­mance of the portfolio. While Ibbotson’s research also found that asset allocation explained 90% of the variability of returns, his bigger finding was that mere exposure to the capital markets was the primary factor in overall returns. Just staying invested accounted for 60% of total return over time.

Don’t put your nest egg all in one basket.

The goal of asset allocation is to minimize risk by dividing assets among the major classes and subclasses of stocks, bonds, and cash. Each asset class has different levels of risk and return and behaves differ­ently over time. While this diver­si­fi­cation may not produce the highest return, it is more likely to protect against signif­icant loss caused by overex­posure to a particular asset class or subclass. Think back to the stock market declines of 1929, 1981, 1987, and 2008. Investors chasing the highest possible return may have invested 100% in stock and experi­enced a long road to recovery.

We believe choosing an asset allocation is one of the most important decisions that retirees make. We carefully consider our clients’ financial goals and then recommend an asset allocation that could produce a return to reach those goals with minimal risk. Choosing the right allocation is important; sticking with that allocation can be critical for success. This is especially true when invest­ments are producing more than 50% of a client’s retirement income. Asset allocation is needed to help ensure income is steady and grows to keep pace with inflation.

A strategy for the long term.

In our opinion asset allocation works because it does not rely on jumping in and out of the market. Our clients’ long-term financial plans determine the allocation strategy needed. The strategy calls for allocating fixed invest­ments, like bonds and CDs, and growth invest­ments (stocks and stock funds). Volatility creates oppor­tu­nities to implement the strategy. A sizable move in the market prompts us to rebalance their portfolio. The portfolios may have too much money in fixed invest­ments when the market goes down. This is the time to buy low, sell fixed invest­ments, and buy stocks to rebalance back to the levels outlined in the strategy. This is asset allocation from a macro view.

Asset allocation from a micro view looks at the different investment categories that make up the alloca­tion’s stock portion. We diversify our client portfolios over nine different asset classes by choosing a fund to represent a specific asset class. The fund we select must be broadly diver­sified within the asset class. We avoid funds that are concen­trated within an industry or an individual company. We also avoid funds that use leverage, which typically increases risk and volatility. We monitor each asset class to capture some of the returns of those classes that are doing well because they have become overweighted in the portfolio (think sell high). 

Our asset allocation strategy may not be as exciting as finding the next hot stock or using intuition to time the market. However, it has shown to be a reliable strategy for more stable investment returns. We specialize in retirement planning, and our clients count on a steady income from their investment portfolios.

Insights:

• A 1986 study found that asset allocation was respon­sible for 93.6% of portfolio return variability.
• Choosing an asset allocation is one of the most critical decisions retirees make.
• Asset allocation works by rebal­ancing the portfolio during the ups and downs of the market.

Origi­nally published June 2016