Retire with the Right Asset Allocation

Physician's Money DigestJune30 2003
Volume 10
Issue 12

If anything good came out of the past fewyears' market disaster, it's that it madeeveryone aware of the importance of assetallocation. In determining your portfolio'sappropriate asset allocation, keep in mind you'llneed to adjust it as your circumstances change,especially as you approach and reachretirement. Proper asset allocation iscrucial to successful retirement.

The first step in any asset allocationprocess is to decide what assets youshould consider. Even the simplest portfolioneeds to include at least 3 assetclasses: stocks, bonds, and money marketfunds. Most investors would thenwant to break down stocks and bondsinto subclasses (eg, small and large capstocks, etc) and perhaps add some otherasset classes (eg, real estate and preciousmetals).To keep things simple, let's consider2 approaches to allocating assetsamong the 3 major asset classes.


The traditional approach is to recognizethat as you get older, you can affordto take less and less risk and therefore shouldreduce the proportion of stocks in your portfolio.A rule of thumb is to subtract your age from anumber between 100 and 120—pick a lower numberto be more conservative—to find what percentageof your portfolio should be in stocks. Forexample, if you pick 110, at age 60, you shouldhave 50% of your portfolio in stocks, reducing itby 1 percentage point every year. A portion of therest of the money, probably enough to cover 6months to 1 year of expenses, should go intomoney market funds. The rest should be distributedamong different types of bonds (eg, shortterm to long term, low quality to high quality, etc).

The downside:

The good thing about this approachis that it's simple and mechanical, and ifyou follow it conscientiously, you'llavoid making emotional decisionsabout getting into and out of the stockmarket at the wrong times. It's a 1-size-fits-all solution thatleaves you vulnerable to a major retirementplanning problem that mostinvestors and even most financial plannersare not well aware of.


In traditional retirement planning,investors assume that stocks will earn agiven annual return steadily, and they'llbe able to sell a part of that investmentin stocks every year, to cover expenses,at a price that will earn that steadyreturn. In reality, the stock market goesthrough periods of depressed prices, with muchlower returns than the long-term average, andagain through bull market periods with exuberantprices and higher-than-average returns.

So if you're unlucky and run into a bear marketduring the early years of your retirement,under traditional methods you'll be forced to sell alot more stocks (because of the lower price) thanyour plan had anticipated. Even if the stock marketrecovers in the later years and provides muchhigher returns, you may never be able to fullyrecover from the earlier damage because you willthen have much less money invested in stocks toearn those higher returns.

Depending on how severe and long the earlybear market is, selling some stock every year canreduce the actual return on your stock investmentsby half of what you assumed for planning. This canwreak havoc on your retirement plan, and you mayhave to drastically reduce your expenses or face theprospect of running out of money.

An unconventional, better alternative involvesinvesting enough money in safe assets, such asshort-term bonds and CDs, to cover 15 years orso of your retirement needs, and investing therest of your retirement money in stocks. You needto start moving toward this target about 10 yearsbefore you plan on retiring.

When the market hits lull years during yourretirement, cover your expenses exclusively usingmoney from the safe investments and don't sellany stocks. On the other hand, in years the marketis normal or exuberant, you should cover allyour expenses by selling stocks, and, if necessary,selling additional stocks to replenish the safelyinvested funds to the target level of 15 years orso. I call this "opportunistic selling."

Under this strategy, you avoid selling stocks indepressed markets. Thus, over the years, you'remore likely to earn the long-term average return onstocks you assumed in your retirement plan and,therefore, are less likely to outlive your savings.

Chandan Sengupta,

author of The Only

Proven Road to Investment

Success (John

Wiley; 2001), currently

teaches finance at the

Fordham University

Graduate School of

Business and consults

with individuals on

financial planning and

investment management.

He welcomes

questions or comments


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