For those of you who are entering the retirement phase of your lives, my preferred strategy is to use a process sometimes referred to as “asset dedication” to fund your retirement plan and create the overall asset allocation. This process fits in well with my preference for income-producing assets such as high-quality dividend paying stocks. It’s really quite simple, but is also highly customized for each client. It involves the following steps:
1. Analyze the current budget and income requirements.
2. Compare the current budget to the projected retirement cash flow need.
3. Factor in extraordinary expenses such as projected automobile replacement and one-time expenditures, such as an exotic vacation, new home, education costs, etc.
4. Project the future sources of income – Social Security, Pensions, etc.
5. To the degree that investment assets will be used to fund future cash needs, dedicate 7-10 years of cash flow requirements to reliable sources of income, such as Treasury bonds, high quality corporate bonds, municipal bonds, CD’s and cash. This serves as a buffer period where we don’t want to be concerned about volatility. We want reliability and safety for this period of time.
6. The remaining assets are dedicated to growth assets, with a preference for income (i.e. dividend-paying stocks). Additionally, we may enhance this income with a covered call writing strategy as well (a topic for another article). The net effect of this planning process is to “back in” to an overall asset allocation that is tailored to your needs, not one generated randomly by a risk-tolerance profiling tool.
We believe that this process takes into account your ‘real life’ situation, and can be adjusted as necessary on an annual or more frequent basis if necessary.
Much has been said about asset allocation over the last several decades. Usually, this is in the context that Modern Portfolio Theory and the “efficient frontier” of optimum portfolios is an inviolable rule for all investors.
My advice to you is BEWARE OF ABSOLUTES! I contend that Modern Portfolio Theory has been corrupted by large investment firms and uneducated salespeople to the point that it has become a dangerous fantasy. I have no issue with PROPER diversification, however, when we become deluded that everything will be ok if we just combine enough assets of supposedly different characteristics, and that our returns will become predictable, and that volatility will be acceptable, we are setting ourselves up for disappointment, or worse.
One last bit of advice – don’t forget that committing money to a portfolio is an investing decision, not strictly an asset class decision. Treat it with the diligence and thoroughness of an INVESTOR (think Warren Buffett, Marty Whitman, John Osterweis, and Bruce Berkowitz, to name a few.