By Matthew Burnell
A key term often heard in investing is “asset allocation”. In simple terms this refers to the percentage of holdings in an investment portfolio to stocks, bonds, and cash.
Using these broad categories, asset allocation reflects the amount of market risk an investor is comfortable with and is not static over time. Stocks have historically had the greatest risk and highest returns among the three major asset categories.
Bonds are generally less volatile than stocks but typically offer more modest returns. Cash and cash equivalents such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds are the safest investments, but offer the lowest return of the three major asset categories.
A major factor in the market risk one can tolerate is the investors time horizon. If an investor is young and plans to work for many more years, then typically they are willing to take on more market risk in hopes of better returns. In this case, stocks would be a larger percentage of their portfolio.
Alternatively, if an investor is closer to retirement, then typically they will have less tolerance for market risk (i.e. more risk averse) since they will be using their retirement assets to fund living expenses in the near future. The more risk-averse an investor is, the more they will want to be invested in “safer” assets, like high-quality bonds and cash. Recommendations vary, but often it is strategic to have a year or two of expenses in cash to begin retirement.
Tying this to today’s economy, if someone retired at the end of 2021 and needed to take funds from their investment portfolio to live off, they would likely be selling assets at a loss due to the down market. If they had cash to cover this year’s expenses, this would allow them to stay invested in hopes for a market rebound before raising cash from these assets. In this scenario it would not be prudent to be 100 percent in stocks at the end of 2021 if you were planning to retire at years end and use these funds to supplement retirement income.
The downside of course is that nobody ever fully knows exactly where the market will go in the future, so holding bonds and cash in your portfolio may cost upside if the market has great returns for a period, but what if it didn’t like so far in 2022?
Historically the market has always increased from previous levels, but increases are not linear. There are dips along the way, and these dips have always recovered and moved beyond previous highs. The real question is how long do these larger dips (often due to a recession) last? Recessions broadly speaking are defined by a contraction in the economy marked by consecutive quarters of falling real GDP.
Historically the U.S. has a recession approximately every 5.5 years. It seems investors have forgotten this as the U.S. is not far off of its longest run-in history without a recession, or economic expansion which lasted from the end of 2009 until 2020. The 2020 recession was the fastest market recovery in U.S. history. So, the people of the U.S. have gone an unprecedented amount of time without dealing with an economic downturn of any major significance.
During this timeframe of unprecedented growth, many investors have become more brazen or aggressive in their investment strategies and overall asset allocations.
Hindsight is always 20/20 when looking back at returns seeing that an investor would have profited more being 100 percent in the market versus holding a portion of their portfolio in less volatile lower returning assets. That is why time horizon is so important in deciding the correct allocation If the market were to have a pullback does the investor have time to recover before needing to access these funds? If so, remember, these losses are on paper until the assets are sold. If one were invested 100 percent in the in the S&P 500 in 2020 and sold out at the lowest point their portfolio would have been down nearly 34 percent, and many people did just that.
Meanwhile, if they held tight through the end of the year, these same holding would have been up over 18 percent. The same may hold true today. With a down market, if time allows, now may be an opportunity to move further into the market as stocks are “cheaper”. Many investors will keep waiting to invest until the market has fully recovered and buy into the market at a high point.
This is all a general guideline and why it is important to understand yourself or have a financial advisor that understands your specific situation to determine the best way to invest for your own retirement.