This post also appears at Forbes.com. Reprinted with permission.
Imagine having to get ready each morning without knowing what you would be doing that day or what the weather would be like. It wouldn’t be pretty.
Now consider the same situation from an investment perspective. You established a logical rationale for your allocation to stocks, bonds, cash and other asset classes. But failing to account for two of the most important variables – future savings and your home – could potentially be disastrous.
The stakes are huge. Being too conservative too long could result in retirement spending being cut in half, or worse. And for those already drawing on portfolios, taking too much risk could result in exhausting retirement funds unnecessarily.
If you’re working and saving for retirement, you’re in what’s known as the accumulation phase. Your main goal should be obtaining enough wealth to retire with the lifestyle you desire. And when you do retire, the goal tends to shift to providing and maintaining a certain level of withdrawal income.
If you are just starting your career, it’s most likely that your future earnings far outweigh your investment portfolio. Let’s say you just graduated college and have no assets or debt. You get a job, and on your first paycheck $200 goes into your 401K. You now have an investment portfolio.
Since you are young and aggressive, you invest 100% in stocks. The next Monday, Apple announces it has been cooking the books, Bank of America declares bankruptcy and Spain withdraws from the Euro and launches a military attack against Germany. The market drops 50%. You lose $100 and are pretty disappointed. But what is the long run impact on your retirement? Not much. In fact, if the market stays depressed for the next several years as you continue to save, this dark day in the market will likely be a financial blessing.
But for a newly retired investor predominately exposed to stocks, this scenario would likely be catastrophic.
If you are working, investments intended for retirement spending should be invested based on the total amount you expect to have when you retire, not how much you have now.
The following table provides a simple example accounting for future earnings. This hypothetical individual maintains a 75% stock and 25% bond allocation their entire working life. To keep it simple, we ignore investment growth.
Even assuming no asset growth, you can see the dramatic increase in stock exposure at retirement. A 10% decline in the portfolio would cost $35,000 at age 45, but $80,000 at age 65. Not only that, the 10% decline at age 45 would allow this individual to invest another $450,000 at lower prices. Without portfolio withdrawals, you still have the power of compounding on your side.
Most people are more aggressive when they are young and more conservative when they are older, but the change in behavior is usually not as dramatic as it should be.
Takeaway: Don’t be too conservative if you’re young. Potential losses are not as meaningful as you think. And if you have not scaled back stock exposure as you approach retirement, take a good long look at the risk and rewards of your asset allocation.
The other major variable consistently overlooked is the value of real estate and mortgage debt. If you buy a home with a mortgage loan, you are increasing your allocation to real estate and decreasing your allocation to bonds because the real effect of your loan is shorting (selling) a bond issued by you.
Let’s build on the same example above, this time adding in the purchase of a $500,000 house at age 35 with a $400,000 mortgage and a $100,000 down payment coming from the investment portfolio.
We ignored the future earnings here. I know I said not to do that, but it helps clarify the point. When the house was purchased, the stock allocation went way down. If we included future earnings, the stock allocation at age 35 would be around 10% – way too low.
The negative debt number is scary for a lot of people, but it shouldn’t be. Leveraging your balance sheet when you are young, especially to buy a home you enjoy, is a very reasonable thing to do. What you want to avoid is a big mortgage at 4% while you sit on cash or bonds yielding 1%.
Takeaway: Look at the whole pie. Even if you own a home, ideally your equity allocation should stay above 35% of your current total net worth until you are within 10 to 15 years of retirement. If a chunk of your net worth is tied up in real estate and you still have significant future earnings, your true equity exposure may be very low, which could be quite costly for your retirement if we experience a multi-year bull market.
Craig Birk, CFP®
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