As I get older, I start thinking about my own mortality. I start considering my retirement. As I have mentioned on this blog before, I plan on retiring early. However, EVERYONE needs to plan for retirement, regardless of when they plan to hang em up.
There is common thinking about how to adjust your asset allocation as you get closer to retirement: slowly move from equities (stocks, index funds, etc) to something a little less volatile (bonds or cash).
In fact, there’s a common “trick” that you can use to figure out your ideal asset allocation: 100 – Your Age = % of stocks to have.
Some financial experts will give this advice with the caveat that it is only a rule of thumb.
This strategy makes no sense to me.
Even as just a rule of thumb, why are you slowly changing your asset allocation over the years? If you plan to retire at 65, and you are 35, why on earth would you start pulling out of the stock market every year until 40 when you still have 25 more YEARS to reap the rewards of the higher yield stock market?
The risk of being in the stock market too late is that you will retire during a downturn. If you are 25 years away from retirement, that should NOT be a concern.
Additionally, at the moment you retire, you don’t suddenly need ALL your savings. You shouldn’t be 100% in bonds and cash on the day you retire. You still may have 30 years+ left to live!
Here’s what my strategy for asset allocation will be:
Step 1: Pick a Year Range
If the stock market tanked on the day you retired, how many years of funds would you feel comfortable having on hand to see you through the downturn. For me, I would want enough money to get me through 5 years. You may want more or less.
Step 2: Start the Asset Allocation Switch
When you are (in my case) 5 years away from your projected retirement, start putting switching your 5 years worth of buffer to bonds or cash, whatever you feel comfortable with. If the market is down, then wait until the market rebounds. So you may start looking at your allocation 5 years out, but not actually making any changes until 2 years out.
Step 3: Use Your Money In Retirement
In good years, pull money from your equities. In bad years, pull from your bonds/cash. That way, you are still maximizing the growth of your money in the stock market, but mitigating your risk.
I think it is MUCH more useful to think of your asset allocation in terms of years as opposed to a percentage.
Note: I realize that I did not get into what constitutes a good year vs a bad year. How do you know when to start pulling from equities vs. bonds/cash? That is a discussion for a different day and something you will have to figure out regardless of how you structure your allocation. You will always have to make a decision on which of your buckets to pull funds from. For me, I plan on pulling from my equities unless the stock market is in a recession-like state. Again, this strategy may vary.
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