Asset allocation in investment planning goes beyond simple diversification or “spreading risk.” Determining an amount to invest in both stocks and bonds can form the foundation of any investment portfolio because they are “uncorrelated.” Simply put, the up or down direction of one does not determine the up or down direction of the other. This is especially important for retirees taking income from their investment portfolio.

The allocation of stocks and bonds can help reduce risk to an appropriate target.* Stocks represent ownership of a company and like a business owner, a stockholder takes on the higher risk and potentially higher reward. Bondholders, however, are lending money to the bond issuing entity (government or corporation), and therefore are due an interest payment plus a known payback amount at maturity. Lenders (bondholders) are due to be paid back before the business owners (stockholders) if things go downhill for the company. Due to this increased risk, stockholders are generally rewarded greater growth than bondholders. Bonds provide stability while stocks provide growth opportunity. It’s common to develop an investment plan based on a percentage allocation of stocks vs. bonds as this can target a preferred degree of risk. A retiree, for instance, may commonly be comfortable with a 60% stock, 40% bond allocation.

Here’s why retirees or pre-retirees may consider going beyond the percentages and evaluating the dollar amount in each of these asset classes, particularly in bonds:

Let’s say Joe is retired with $1,000,000 in investments with the aforementioned 60/40 allocation, from which he will take $40,000 each year in income. In a year that stocks are appreciating or at least neutral, Joe can easily take his income from both stocks and bonds and keep his investment plan closely aligned with his preferred 60/40 allocation. If stocks are appreciating more than bonds in that given year, which is the objective, he would actually be drawing more from stocks to keep the portfolio in balance. In that scenario, all is well. But another scenario can play out. What happens if (when) stocks decline significantly? The last thing Joe wants to do is sell stocks that are significantly depressed in value and lock in those losses. Rather, if he understands that fluctuations in stocks are merely the birth pangs of a long-term higher reward, he wants to wait out the decline and allow values to recover.

But, Joe’s immediate need is income even if he believes stocks will recover at some point. He cannot afford to take a pay decrease because stocks are down 20 to 50%. This is why the dollar amount he has in bonds is important. How many years can he sustain his income from bonds to allow stocks to recover?

Does viewing the bond allocation in dollar terms all come back to a set percentage? Yes. But, an investor, particularly a retiree, is less concerned with a risk target (i.e. 60% stock market risk) than how it affects his or her income — now and in the future.

Considering how bonds translate to income helps the investor to remember that …

Stocks are for growth

Stocks are to help outpace inflation long term

Stocks are to create long-term income sustainability

This long-term journey will indeed be filled with ups and downs for which the investor is prepared to withstand because income has been addressed.

This line of thinking creates a more informed investor. We have a portfolio that gives us choices from where to take income, and we are prepared for market downturns knowing they will happen. We’ve assigned purpose to the stocks and bonds and the critical role each play. Like any investment plan, the actual implementation (i.e. discipline) is more difficult in reality, but preparation provides a better opportunity to succeed.

*Diversification does not eliminate risk. Bonds can decrease in value.


Anthony Saffer

Principled Prosperity is focused on equipping those who choose to ignore the noise. The world of finances can be complex, but basic truths have persevered over time, across cultures, and in spite of changing circumstances. Anthony Saffer writes on his experiences in personally working with families to coordinate principled financial and investment solutions.

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