Tuesday, 29 January 2019

Retirement Allocation Explained

Often financial "experts" make asset allocation for retirement planning difficult to understand. This article covers what asset allocation is and why it is important the main asset categories and your ideal asset mix.

Asset Allocation 

Asset allocation simply means how your investment portfolio is divided across different asset classes or investment types. This is often confused with diversification. Diversification refers to buying a number of investments within an asset category to reduce investment risk. Asset allocation theory states that by dividing your portfolio into different types of investments, you can reduce the volatility of your portfolio. Some financial experts claim this is more important than the individual stocks you choose. I believe that both proper allocation of your portfolio and the careful selection of investments within each asset category is the key to long-term investment success. The asset allocation of yesteryear used to be simple. The formula was to subtract your age from 100. This resulted in the percentage of your portfolio you should have invested in stocks. For example, a 65-year-old would have 35% in stocks and 65% in bonds and cash. But, due to longer life expectancies, people run the risk that their investments will not grow fast enough to last their lifetime when following this formula. Reading this article and using the retirement calculator can help prevent this from happening to you.

Asset Categories 

There are three main asset categories;

  • Cash and cash equivalents, 
  • Bonds (income investments) and 
  • Stocks (equity investments). 

Each of these categories has risks associated with it. Generally, the more risk you assume, the higher the return. Once you have your ideal mix identified, you can plug these percentages into the retirement calculator. This will help to identify if there is any shortfall with your current plan. If there is a shortfall, you can plan to work longer, take a smaller annual withdrawal amount and/or increase your savings rate. Again, you can plug these "what if" scenarios into the retirement calculator until you no longer have an investment shortfall. Your asset allocation plan is done, for now. 

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