Control Investment Anxiety with Purpose-Based Asset Allocation
People conflate “risk” with “volatility” – the amount a financial asset might rise or fall in value in one day.
We define risk as “the chance money won’t be there when needed.” If a client must pay taxes or close on a house in three months, we must secure those funds in a no-risk, no-return money market account.
For long-dated financial needs,?such as retirement that is more than five years away, volatility risk is irrelevant. The risk we must address is “longevity risk” – the chance that a family outlives their retirement assets.
Investors often make the mistake of holding all their financial assets in a single account, and then don’t invest that account properly taking multiple needs into consideration.
Purpose-Based Asset Allocation
“Purpose-based asset allocation” is the process of dividing our clients’ money into as many buckets as necessary to give peace of mind about the future. A “bucket” refers to a specific financial objective.
During client discovery conversations, we ask open-ended questions to enumerate and elucidate all the concerns that a family might have. The list of a 40-ish married couple with children could include:
We create as many investment accounts as necessary to satisfy each need.
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Thereafter, we assign a different asset allocation to each bucket. The upcoming tax payment will remain in a bank checking account earning no return, but good to go.
We invest family retirement accounts 100% in equities. Those funds need to grow as large as possible over the next 20 to 30 years.
We include bonds – 20% to 30% of the investment allocation – in the 529 plan of a child going to college next year. Bonds earn 3% per year or less these days, but we want to be sure that we can pay tuition on time.
Investing retirement money aggressively may sound counterintuitive. Why take chances with a nest egg? Commonly we see clients’ retirement accounts over-weighted in bonds or worse, invested in guaranteed interest funds yielding less than 2%.
We calculate that a 401(k) earning 2% per year will double in value after 35 years, while an equity-invested 401(k) earning 7% per year will double every 10 years and grow 10x larger after 35 years compared to the “conservative” portfolio.
As our clients get closer to retirement, we adjust asset allocations to emphasize reliability over maximum growth, increasing bond allocations to between 20% and 30%, and, in retirement, 30% to 40%.
The expected return might drop to 6% per year, but we can reasonably distribute an annual draw to the client family of 4% to 5% per year and never run out of money. In nearly three decades of working with retired clients, never once have we reduced a client’s monthly retirement draw because of stock market volatility.