How To Optimize Your Asset Allocation For Retirement

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Includes: BUD, CMP, DUK, EMR, KO, SEP, VIGRX, VISGX, VWESX, VZ
by: Doug Carey

Summary

Asset allocation decisions can have nearly as much effect on the success of a plan as saving money in the first place.

Dividends are great for a lot of reasons, but the stocks that pay them may not provide enough capital appreciation.

Taking on more risk requires some trade-offs, but could be worth it.

Seeking Alpha readers know better than most people what asset allocation is. Simply put, it's where you invest your money.

In my corner of Seeking Alpha, which tends to be dividend- and retirement-oriented, I often talk about ideas for income-generating investments. More often than not, these are household-name, blue-chip stocks that have long histories of paying dividends. My argument tends to be that these stocks are great holdings even over shorter periods: They may bounce around, but the dividend on these (broadly speaking) value stocks will keep coming almost no matter what.

But in the years leading up to retirement, such investments may not get you the capital appreciation you need. You'll probably need to juice up the portfolio a bit with some growth stocks.

Not Taking On Risk Can Be Risky

If you can handle the ups and downs of the stock market without losing sleep or your mind, and you still have enough years until retirement, it's generally best to be as aggressive as you are willing to be with your investments.

A savings account won't earn much, and almost surely won't keep up with inflation. But at least you know it's not going to suddenly drop in value by 5% in a day, and then bob and weave on a daily basis for as long as you have the money.

The stock market, meanwhile, will do just that. But that's OK: Over time, the additional risk normally will lead to additional reward. The key is to get that risk/reward balance right.

Shifting Some Assets Around

Today we'll take a look at a hypothetical couple that is beginning to contemplate retirement. They have mostly done the right things in terms of saving and investing, and want to see if they will be able to retire early, at around age 58. They are 50 years old now, and have about $850,000 in invested assets, and think they'll be spending around $80,000 a year once retired.

In the WealthTrace Retirement Planner (which you can use as well), here's what their portfolio looks like now by asset class:

The issue most people run into when considering retirement is not where to put the money, but rather having enough money to retire in the first place. That is probably not a problem with this couple. When I run their plan through the WealthTrace Monte Carlo simulator, the results aren't quite where we would like to see them, but they're not too bad:

We will need to make a few tweaks to our couple's asset allocation to move that needle a little further into the green. There will be a trade-off to making those tweaks, of course. To get that additional return, the couple will probably have to take on a bit more portfolio risk (as measured by potential volatility). For example, in the pie chart above, cash makes up 11% of their overall assets. We will deploy that money into equities of some sort, and probably will need to reduce the bond portion of the portfolio too.

I ran the couple's portfolio through WealthTrace's Asset Allocation What-If Scenario generator, which allows you to see the effect of potential changes to a portfolio's asset allocation.

Here's how we are starting out...

...and, after some experimentation, we end up here:

We got rid of the medium-term bond holdings and the cash holdings entirely. We bumped up the long-term bond holdings a bit, and dramatically ramped up the growth stock holdings.

After running these changes through WealthTrace, here's how things look:

Our probability of success jumps by nine percentage points, from 80% to 89%. Not only that, our worst quartile and best quartile investment value amounts jump substantially.

What might the portfolio look like? I'm plenty comfortable recommending stocks for the value-oriented portion of the portfolio. For the rest of the portfolio, though, I'll defer to Vanguard, thanks to their low fees. Vanguard Long-Term Investment-Grade (MUTF:VWESX) is a very solid, well-diversified choice with mostly corporate bond holdings. For the growth portion of the portfolio, I might recommend putting half in the Vanguard Growth Index Investor (MUTF:VIGRX), which skews large-cap, and half in Vanguard Small Cap Growth Index Investor (MUTF:VISGX), which obviously skews toward the small-company side.

Here's what our couple's portfolio could look like to get them to that 89% probability of success:

Company

Ticker

% of Portfolio

Anheuser-Busch InBev

(NYSE:BUD)

6%

Coca-Cola

(NYSE:KO)

6%

Compass Minerals

(NYSE:CMP)

6%

Duke Energy

(NYSE:DUK)

6%

Emerson Electric

(NYSE:EMR)

6%

Spectra Energy Partners

(NYSE:SEP)

6%

Verizon

(NYSE:VZ)

4%

Vanguard Long-Term Investment Grade

15%

Vanguard Growth Index Investor

22%

Vanguard Small Cap Growth Investor

23%

Your Allocation Situation Matters

When putting together an actual retirement plan for a couple, there would be plenty of factors to consider before making such a radical change to the asset allocation. Dropping the cash portion to 0% might not sit well with a lot of people, for example. Still, the point remains: Making the right asset allocation choices will have a dramatic effect on your retirement plans.

Disclosure: I am/we are long KO, DUK, SEP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.