It is easy to get excited about the path to early retirement, but sometimes when people get caught up in the excitement, they forget some basic investing principles. Misunderstandings of risk and timelines run rampant throughout the internet. Comments like, “I’m young and going to retire early so I am going to invest 100 percent in stocks so I can get to retirement faster,” contradict themselves.
A 100 percent equity allocation can work, but under certain circumstances where the ability and tolerance to take risk are high or the retiree can modify their retirement goals.
Risk Tolerance: What’s Your Timeline?
Before picking an asset allocation, you need to determine your risk tolerance, capital needs and return expectations. If you are planning to retire early, your distance from needing to withdraw your nest egg is naturally closer than for someone facing a traditional retirement. Because of this, the risk of your portfolio needs to reflect an initial withdrawal in the somewhat near future – maybe 10 to 15 years. In standard retirement terms, this would be equivalent to a 50-year old’s retirement portfolio.
This fact doesn’t sit well with younger investors seeking early retirement because this portfolio would be relatively safe with at least 30 percent in bonds. This means that they are potentially giving up on those sweet stock returns. To counter this feeling of missing out, young early retirement adventurers push for 100 percent stock portfolios.
Unfortunately, an all-equity portfolio has more risk than what experts would recommend for a short timeline. In normal retirement circumstances, a young investor would have no issue putting 100 percent of their assets in equities because there is enough time before retirement to weather any significant market downturns. However, with a shorter timeline, having 100 percent stock exposure puts early retirement dreams at risk.
Goals: What Does Early Retirement Look Like For You?
The fundamental issue with an early retiree’s asset allocations is how strict early retirement plans are. If you plan to work a side hustle or drop to part-time upon “early retirement,” then the 100 percent stock allocation makes sense. The allocation makes sense because, at retirement, there are other income sources to smooth any effects of a potential market downturn. However, this situation isn’t a strict early retirement, but instead, extreme financial independence.
If you are aiming for early retirement and don’t want to or can’t worry about decreasing expenses or working after the big day, you should treat your portfolio like you are approaching traditional retirement. The risk of that portfolio should decrease as the retirement date approaches. If, however, you are seeking a flexible early retirement and have no problem adjusting your plans given a major market pullback, then ramp up the risk.
Adjustments to your lifestyle could include picking up a side job after you retire, delaying retirement or decreasing your post-retirement expenses to make it through a potential downturn from such a high stock allocation. If any of these options are not doable, then protect yourself by focusing on a lower risk investment allocation.
There are many retirement strategies available to you based on your preferences and risk tolerances after day one of retirement arrives. Regardless of the asset allocation you choose, as an early retiree you need to keep in mind that while their retirement timeline is different than most of the world, Mr. Market still moves the same for everyone. He doesn’t care whether you retire in 40 years or four days. Any day can finish with a massive loss of your portfolio value. All that matters are if you and the portfolio were prepared for it.
Ability to Take Risk: Account Balance Matters
I’ve read articles and blog posts touting 100 percent equity allocations and how this is a great path to be on, but two considerations stick out in almost all these cases. The first is that the investor is willing to cut back on expenses or has other sources of income to patch the portfolio drop. This plan is fine, and I discussed this above, but then the 100% equity allocation is misleading because the portfolio was affected and the retiree had to change their retirement plans.
The second factor is the account balance. If the retirement account balance is large enough not to require a four percent withdrawal, then the portfolio has major risk protection built in. There is money to lose without affecting the retirement. On the other hand, if someone has enough in their account to handle a four percent withdrawal and they need to live on four percent, then a market pullback for a 100 percent equity portfolio will have a substantial affect on retirement plans at least in the near future.
Just like all investment options, asset allocation is based on a variety of factors. Be careful of investment advice that is “for everyone.” Without considering your risk tolerance, ability to take risk, and goals no one will have the correct answer to what percent of your portfolio should be in equities.