Probably more than you think.
In the United States, as Defined Contribution plans have grown, individuals have been given responsibility for asset allocation decisions. Individuals are presented with a menu of investment options, and they must choose how much to allocate to stocks vs. bonds. Then, within each asset class, they must choose how much to allocate between different strategies and sub-asset classes. These choices aren’t easy to make for non-investment professionals, such as doctors, school teachers, construction workers, etc.
Recently, I discussed this topic with a financial advisor. He argued that it was unreasonable to ask individuals to solve their life cycle portfolio construction problem on their own. “Most people don’t have the expertise required to make these investment choices. Would your surgeon ask you to perform surgery on yourself?”, he rhetorically asked.
In practice, most individuals simply don’t make a choice. This inertia has given rise to the importance of default options. Following the Pension Protection Act of 2006, the Target Date Fund (TDF) has been the most popular default option. A TDF starts with a high allocation to stocks when you’re early in your career, and gradually shifts from stocks to bonds as you approach retirement (the so-called “glide path”).
Glide paths are designed in a way that considers what individuals are trying to achieve, and how much risk they’re willing to bear in order to get there. It’s the good old return vs. risk portfolio construction process, but across multiple time periods, and with multiple objectives.
In Beyond Diversification I explain how to design glide paths and construct TDFs. I show a popular TDF strategy according to which when an individual is 25 years away from retirement, their allocation to stocks is 90%. Their time horizon is quite long, so their risk tolerance is higher. This allocation then gradually decreases as time passes. Ten years from retirement, the allocation to stocks is about 70%. The at-retirement allocation to stocks is 55%, which may seem high, but again, most individuals are under-funded, and they need their nest egg to keep up with inflation and last for 20+ years in retirement. After retirement, the allocation to stocks continues to decrease at roughly the same pace, all the way to about 25% in stocks.
How much to allocate between stocks vs. bonds is the most important asset allocation decision. And it requires a so-called “multi-period optimization”. You contribute to your retirement savings throughout your life, and you spend over multiple periods in retirement. Your goal is simple: to meet future income needs in retirement, i.e. to replace your salary.
And of course, your level of funding matters. It’s easy to simply recommend a more conservative portfolio comprised of bonds. However, expected returns on bonds aren’t high enough, and most people don’t have enough money set aside, such that they need their portfolio to work harder for them. If you’re far enough from retirement, and your individual circumstances allow, you should consider accepting to bear the cost of higher short-term volatility, because, as Einstein supposedly said, “compounding is one of the most powerful forces in the universe”.