To determine if your equity allocation is in the right ballpark, Jack Bogle has shared the quick tip of subtracting your age from 100. Age--or rather time horizon--is also used as a key determinant of the allocations in target-date funds: The young investor with an anticipated retirement date of 2055, not surprisingly, gets a much larger dose of stocks than one retiring in 2015.
Data bear out that time horizon should play a key role in determining how much risk to take in your portfolio. In more than 90% of rolling 10-year periods, stocks have ended in the black, giving the investor with at least a 10-year time horizon a good shot at making money over that holding period. But with shorter time frames, stocks aren't such a safe bet, losing money in roughly a fourth of rolling 12-month periods. ("Rolling" means that we don't just stick with calendar-year periods but also look at 12-month returns from Feb. 1 through Jan. 31, March 1 through Feb. 28, and so on. This method provides more observable time periods.) Those data suggest that people closing in on retirement should hold a buffer of cash and bonds to draw upon, in addition to holding stocks.
But time horizon shouldn't be the only determinant of investors' asset allocations. And in any case, focusing on the investment portfolio without considering other important financial assets could leave an individual open to unwanted--and avoidable--risks. A recent research paper by Morningstar's David Blanchett and Philip Straehl asserts that the most successfully allocated portfolios consider investors' total wealth--human capital, pension assets (including Social Security), and real estate holdings, not just investment assets--when determining portfolio allocations. In essence, Blanchett and Straehl's research suggests that you think of your investment portfolio as your "completer portfolio," aiming to offset risks that accompany your other financial assets.
As you think through your portfolio's allocations, asking yourself the following questions can help you fine-tune your allocations.
1. What Industry Do You Work In?
Ask individuals about their net worth and they're likely to account for the investment assets, bank accounts, and perhaps their real estate equity. They're not likely to roll their human capital into the total, even though by some estimates it's worth up to four times all of their other financial assets combined. Human capital, put simply, is an individual's earnings power over his or her remaining lifetime.
Because human capital can be such a large asset, Morningstar Ibbotson was among the pioneers of the idea that human capital should help shape the asset allocation of the investment portfolio. The ability to earn a living through work is bond-like in nature; that argues for a high allocation to non-bond assets early on, but increasing allocations to bonds as retirement approaches and the bond-like human capital ebbs away.
But Blanchett and Straehl's study takes human-capital considerations a step further, arguing that successful asset allocation should also take into account the industry in which a person works, in addition to time horizon. It stands to reason that those who work in career paths where the earnings are lumpy--someone who works in commission-based sales, for example--should maintain a more conservative investment portfolio than someone who works in a career with very stable earnings power, such as a tenured college professor.
But Blanchett and Straehl demonstrate that a portfolio's sub-allocations should also be influenced by the industry in which an investor works. For example, finance professionals should de-emphasize large-value stocks, which have historically had a high correlation to earnings within the finance sector. Meanwhile, a person employed in the metals and mining industry can reduce portfolio risk by maintaining a lower allocation to commodities investments than would be recommended for individuals who work in other industries. Ditto for the person who works in the real estate or lodging sectors; fewer REITs would be appropriate in the portfolio than would be the case for someone outside of the real estate or lodging industries.
Blanchett and Straehl conclude that these industry-specific considerations are the most important for individuals with large amounts of human capital--that is, younger workers--because their human capital takes up a larger percentage of their total wealth.
2. Do You Have a Pension or Social Security?
Whether an individual has a pension and/or Social Security should also affect the nature of that person's investment portfolio, Blanchett and Straehl argue. Because Social Security and pension income are inherently bondlike, the more of one's total household wealth that those certain sources of income account for, the more risk the individual can reasonably take in the investment portfolio.
As David Blanchett notes, investors with Social Security and pension assets can reasonably think of that portion of their portfolios as a government bond, and de-emphasize government bonds accordingly in their investment portfolios. The research also indicates that as the individual approaches retirement, the value of pension and Social Security assets--as a percentage of the individual's total wealth--grows, too, because the realization of those benefits draws closer.
3. Do You Own Real Estate?
Real estate holdings are yet another factor affecting an individual's total wealth allocation.
Not surprisingly, Blanchett thinks that individuals with substantial real estate assets should downplay real estate investments in their portfolios. Blanchett and Straehl's research also demonstrates that as an individual gets closer to retirement, the value of real estate holdings is apt to grow as a percentage of the household's total wealth allocation and may, in fact, become the dominant asset, for better or for worse. That's because human capital has declined, and the individual's investment assets are also apt to decline as he or she draws upon the portfolio. Meanwhile, the home may even be appreciating in value during this time. Given this finding, it's probably not surprising that retirement researchers have begun looking more closely at the idea of reverse mortgages in retirement. Reverse mortgages aren't for everyone, but for individuals with significant home equity and declining investment capital, they can provide liquidity while also helping diversify the individual's total financial allocation.