Key takeaways:

• Your retirement asset allocation should balance risk and return by aligning with your need, willingness, and ability to take risk, with risk capacity ultimately setting the limit.
• Stocks offer higher long-term growth but with more volatility, while bonds provide stability, making diversification and a mix tailored to your tolerance essential to avoid selling at the wrong time.
• Asset allocation is not just about stocks vs. bonds—it must also account for broader retirement risks such as sequence-of-returns, spending, inflation, and longevity to protect your plan.

When planning for retirement, your asset allocation decision, or the percentage mix of stocks and bonds in your portfolio, is one of the most important decisions you will make.  Because your chances of being able to hit or miss your financial goals are so closely tied to it, your asset allocation decision should not be made lightly.   

As retirement planning specialists, we’ve helped hundreds of clients ensure their asset allocation helps them achieve their retirement goals while still  sleeping at night. Today, we share a simple framework that can help you think through this decision to ensure that you are able to meet the funding of your retirement goals.    

Your Asset Allocation Decision is Closely Tied to Your Investment Risk Tolerance

Investment risk tolerance is a critical input when determining your asset allocation between stocks and bonds. Investment risk is the risk that actual returns will differ from the expected return outcomes at any point in time. Investment risk is only one of the big five retirement risks a retiree faces (see our Insight entitled "Evaluating the Big Five Retirement Risks Every Retiree Faces" for more).  

No one knows with certainty what the future holds, so we look to the past to make observations about how certain asset classes performed. We take specific note of each asset's average return and the variability of return experienced around that average return, known as standard deviation. We can typically make a reasonable long-term forecast of future expected returns from these observations for planning.    

When selecting your retirement investment strategy, it’s important to know that stocks have higher potential for return but also higher variability in the path of return. In contrast, bonds have lower potential for return but also less variability in the path of return. The greater the allocation to stock in your investment portfolio, the greater the expected return and the higher the investment risk you are taking. 

Why Everyone Has a Unique Risk Tolerance

Some individuals can tolerate wider swings in their investment portfolios' performance in the search for higher returns, while others cannot comfortably stomach such swings.  Investment risk gives rise to the concept of risk versus return and the need to select an asset allocation of stocks and bonds in an investment portfolio such that the performance variability does not exceed that which is palatable for you. 

The risk of not having your retirement portfolio aligned with your personal risk tolerance is that in times of high volatility, you may be tempted to make impulsive or irrational decisions that could derail your financial goals. And without a financial advisor or retirement planning specialist to help keep you accountable, you may not be able to get your financial plan back on track if you, for example, sell at the bottom of the market.

The key when it comes to determining the right asset allocation for retirement lies in finding that sweet spot where your portfolio can generate the returns you need without exposing you to more risk than you can handle—both emotionally and financially. 

Following is a framework that can help you find that sweet spot.

Three Dimensions to Evaluate When Choosing Your Asset Allocation for Retirement

The three dimensions that should be evaluated and then compared to determine an appropriate retirement asset allocation decision between stocks and bonds are:

1. Need to take risk
2. Willingness to take risk
3. Ability to take risk

Let’s take a closer look at each:

1) How much risk do you need to take to meet your goals?

Evaluation starts with understanding the amount of risk, or stock exposure, that may be necessary to take to be able to earn the return needed to achieve your goals.  The rule of thumb is to take no more risk than is needed to meet your return goals, though obviously, there is much more to consider. This is where financial planning software is helpful to help you model the probability of being able to achieve your goals given a certain amount of risk. If you have a financial advisor or a retirement planning specialist, let them run the numbers to help you make a strategic decision.  

2) How willing are you to take on risk to meet your goals?

Your willingness to take risk is known as your risk tolerance and is measured by determining how much volatility you can "stomach," often measured through the use of a risk profile questionnaire. This is directly related to our conversation of investment risk above, in terms of being able to stick to your investment allocation even when there is volatility in the markets.   

3) How much capacity do you have to be able to take on risk?

Once you understand your need to take risk and your willingness to take risk, you must check against your ability to take risk.  Your ability to take risk is known as your risk capacity and is measured by looking at your personal situation to see if you have the resources and flexibility needed to afford to take the risk without causing undue stress or harm.  

It’s important to note that your ability to take risk overrides your need and willingness to take a risk. Even if you are willing to take more risk than you have the capacity for, you will be constrained by your risk capacity. You cannot bet what you cannot afford to lose.

In assessing all three dimensions, the goal is to find a level of stock and bond allocation that allows you to meet your return need without exceeding your willingness and ability to take on the corresponding level of investment risk to earn that return.   

What if Couples Have Different Risk Tolerances? 

When couples have different risk tolerances, it often creates tension in retirement planning. Couples might share the same need to take risk and ability to take risk, but it is not uncommon for couples to have a different willingness to take risk (or risk tolerance).  As retirement planning specialists, we have found that differences in risk tolerance usually stem from not understanding what investment risk is and differing levels of aversion to loss.  

Most people interpret investment risk to mean absolute loss.  In other words, "how much would I be comfortable losing?".   This interpretation could be accurate depending upon the makeup of the investment portfolio.  Suppose the couple held an undiversified portfolio containing just a few individual stocks. In that case, investment risk could very well represent permanent loss because one or more of the companies held could go bankrupt, leaving the couple with an absolute loss.  

Investment risk takes on an entirely different meaning when you have a maximally diversified portfolio.  Suppose you have a portfolio that gives you exposure to over 30,000 different securities across 44 different countries (see our Insight entitled "Building an Investment Portfolio for Retirement" for more). In that case, the impact upon the portfolio if some companies go bankrupt during bad times is immaterial.   It simply becomes a matter of time for the economic cycle to improve, companies to grow again, and for stocks to regain their value and begin growing again.  

Investment risk in the context of a maximally diversified portfolio is not an absolute loss, but rather the potential for fluctuation in the portfolio's value at any point in time.  The greater the percentage of stock in the asset allocation, the greater the potential fluctuation.  As long as the portfolio's investments are not sold during a period when the market has fluctuated down in value, you will not have locked in an absolute loss.   

This reframe often helps the more conservative spouse understand that a diversified portfolio's "risk" is really about timing and patience, not permanent loss. This is also why being honest with yourself about your willingness to take risk is serious and important. Otherwise, fear and anxiety may cause you to sell while markets are down, thereby locking in that loss.  Additionally, this is why it is important to have an appropriate level of "reserve" assets outside of your investments to fund retirement expenses during times of unfavorable market fluctuation.     

Additional Complicating Factors in Determining Your Retirement Asset Allocation

Retirement planning is very complex, and every factor seems to be somehow connected to other factors.  We would be remiss if we did not share two additional factors that should be kept in mind:

1). Stock and Bond Portions of Portfolios Are Not All Constructed the Same

So far, we have only talked about making the asset allocation between the stock and bond portion of the portfolio.  The reality is, how each person or financial advisor constructs the stock and bond portions of their portfolios matters.  The individual stock and bond holdings determine the correlations and expected returns that in turn determine the entire portfolio's expected return and standard deviation (which is the measure of volatility or investment risk).  If each of the stock and bond portions of your portfolio aren’t well diversified, then your stock/bond mix may not be able to make a difference in decreasing your level of overall portfolio risk.

2). The Asset Allocation Decision Should Consider Other Risks Also

As mentioned earlier, investment risk is just one of the big five retirement risks retirees face and need to manage.  The other four risks that need to be considered include 1). Sequence-of-returns risk, 2). Spending risk, 3). Purchasing Power risk, and 4). Longevity risk.   Each of these risks are material and pose a potential threat to an individual's retirement plan.  The asset allocation decision is a risk management tool that can help manage these other risks.  (See our Insight entitled "Managing the Big Five Retirement Risks Every Retiree Faces" for more)

At the end of the day, in addition to everything we discussed in this Insight, the asset allocation decision should be made in conjunction with the overall risk assessment and risk management strategy. .  

If you would like help determining your optimal asset allocation for retirement, you can schedule a complimentary call with one of our retirement planning specialists here.