Although the concept of an ideal retirement portfolio is somewhat relative, many financial planners would define this in terms of what it is able to do. An “ideal” plan in this sense is one that would meet the retiree’s financial needs until death.
But the manner in which the actual funds are allocated in order to accomplish this can vary substantially depending upon a number of factors. Most ideal portfolios are going to have at least some measure of the following characteristics.
Retirement plans are designed to grow over long periods of time, and growth instruments such as stocks and real estate typically form the nucleus of most successful retirement portfolios, at least when they are in the growth phase. It is vitally important to have at least a portion of your retirement savings growing faster than the rate of inflation because this allows you to increase your purchasing power over time.
Data from Ibbotson Associates clearly shows that stocks have posted by far the best returns of any asset class over time. Since 1926, stocks have averaged about 10% growth per year, while bonds have grown at only half that rate and cash has posted about 4% growth per year.
For this reason, even retirement portfolios that are largely geared towards capital preservation and generation of income will often maintain a small percentage of equity holdings in order to provide a hedge against inflation. (For more, see: Introduction to Growth Investing.)
This characteristic will take a somewhat different form over time as the plan owner or participant approaches retirement age.
Those in their 40s and 50s probably need to start moving some of their holdings into more conservative sectors such as corporate bonds, preferred stock offerings and other moderate instruments that can still generate competitive returns with less risk than pure equities.
Alternative investments such as precious metals, derivatives, oil and gas leases and other non-correlative assets can also reduce the overall volatility of a portfolio and help to generate better returns during periods where traditional asset classes may be stagnating.
An ideal retirement portfolio will also not depend too heavily on shares of company stock that are purchased either inside or outside the participant’s 401(k) or other stock purchase plan. A substantial drop in the value of these shares can drastically alter the employee’s retirement plan if they constitute a substantial percentage of the employee’s overall retirement savings. (For more, see: The Importance of Diversification.)
Investors who are at or near retirement age need to focus more on capital preservation and income than growth. This means that instruments such as certificates of deposit (CDs), treasury securities and fixed and indexed annuities may become appropriate for those who need a guarantee of principal or income.
However, most ideal retirement portfolios will not become exclusively invested in guaranteed instruments until the investor has reached their eighties or nineties. An ideal retirement portfolio will take the investor’s drawdown risk into account, which measures how long it will take an investor to recover from a large loss in the portfolio. (For more, see: What Is Your Risk Tolerance?)
Investors today have more choices than ever when it comes to who can manage their money. Many planners exclusively recommend portfolios of index funds that are passively managed, while others offer actively-managed portfolios that may post superior returns than the broader markets with less volatility.
Robo-advisors have also arrived on the scene that can allocate and manage portfolios according to preset algorithms that are triggered by market activity. These automated advisors also typically charge far less than human managers, although their inability to substantially deviate from their programs may be disadvantageous in some cases and the trading patterns that they use are generally less sophisticated than those employed by their human competition. (For more, see: Passive vs. Active Management.)
Conceptually speaking, most people would define an “ideal” retirement portfolio as one that will allow the retiree to live in relative comfort and provide for any expense that arises along the way. Of course, “real” ideal retirement portfolios will always contain the appropriate balance of growth, income and capital preservation.
But the importance of each of these characteristics is always based upon the individual investor and their risk tolerance, investment objectives and time horizon.
In general, most young retirement savers will focus their portfolios either mostly or completely on growth until they reach middle age, at which time their objectives may begin to shift towards income and lower risk. But different investors also have different risk tolerances and those who intend to work until a later age may be willing to take greater risks with their money.
The ideal portfolio for a given investor is therefore always ultimately dependent upon that person and what they are willing to do to reach their goals. (For more, see: Assets for Your Retirement Portfolio.)