How To Allocate And Rebalance A Retirement Portfolio

The hardest part of investing for retirement is budgeting ample contributions. Solve that issue and you jump into the next hardest part: Deciding how to invest.

Your retirement investment decisions should flow from a target asset allocation that aligns with your time horizon and risk tolerance. Once you implement that allocation, you’ll lean on a rebalancing strategy to keep it.

Read on to learn how to allocate a retirement portfolio and rebalance it later. This guide details the elements of a balanced portfolio and provides six sample allocations for different scenarios.

What Is Portfolio Allocation?

Portfolio allocation is the composition of your investment assets in terms of asset class and type. A simple portfolio allocation example is 60% stocks and 40% bonds.

More complex retirement allocations will break the classes into subsets. So, the 60/40 portfolio might consist of 45% domestic stocks, 15% international stocks, 30% domestic bonds and 10% international bonds.

This composition is important because it’s a major determinant of portfolio risk. A higher percentage of stocks vs. bonds is riskier than a bond-heavy portfolio. Emphasis on small-cap or international stocks over, say, S&P 500 stocks also increases risk.

What Is Portfolio Rebalancing?

Portfolio rebalancing is the process of resetting your investments to your target allocation. Going back to our example from above, a portfolio of 60% stocks and 40% bonds won’t stay that way indefinitely. In a rising market, the stocks will increase in value while the bonds hold steady.

Left unchecked, the stock percentage will rise to 65%, 70% or more. As the relative stock exposure rises, so does the risk.

To rebalance, you’d reduce the stock positions and increase bonds exposure to restore your 60/40 allocation. You’ll learn about specific rebalancing strategies below.

Key Points

The core elements of a balanced portfolio are stocks, bonds and cash.

Bonds and cash provide stability in a retirement portfolio, while stocks add growth opportunity.
The relative exposures of the asset classes are the levers you pull to optimize your portfolio risk.
If you have a short investment horizon, a more conservative approach is warranted. This protects you from getting impacted by a market downturn just as you start taking retirement withdrawals.

Investing in stocks is one of the best moves you can make to grow your wealth and build your nest egg. The Forbes investment team has identified undervalued stocks poised to surge in this exclusive report, 7 Stocks To Buy Now.

Key Parts Of A Balanced Portfolio

Asset classes—as in stocks, bonds and cash—are the basic elements of a balanced portfolio. Stocks alone provide growth and volatility, while bonds and cash offer stability. You combine them in a targeted allocation to tailor the portfolio’s overall behavior and risk.

Below is a closer look at stocks, bonds and cash as well as alternative assets.

1. Equities (Stocks)

Stocks are core holdings in any portfolio that’s geared for capital appreciation over time. Why? Because over the last 50 years, large-cap stocks have returned an average 10.5% annually including dividends. After inflation, that leaves investors with the opportunity to earn about 8% per year—simply by riding with the market.

The 8%, as an average, doesn’t show itself every year. In reality, the stock market might rise 30% one year and fall 20% the next. Fortunately, there is a reliable way to realize the 8% average: Hold your stocks for long periods of time so the year-to-year fluctuations level out to growth.

Speaking of stock market ups and downs, they’re usually prompted by economic trends. A specific stock’s reactions to the economy can be subtle or exaggerated, depending on various factors. Those factors include the company’s size, geographic location and economic sector.

Company Size

Size-based categories of stocks from least to most volatile are:

Large-caps
Mid-caps
Small-caps
IPOs (initial public offerings)
Penny stocks

Note that volatility can be positive or negative. For example, in the right conditions, an IPO stock can show far higher growth rates than an established large-cap.

Geographic Location

Different countries provide different levels of business opportunity in terms of size and economic maturity. These levels are often categorized as developed, emerging and frontier.

Developed markets are the largest, most liquid and most advanced economies. The U.S., Canada, U.K., France, Japan and Australia are in this group. Companies in developed markets tend to be less volatile than companies based in less mature markets.
Emerging markets are in transition. They may have some characteristics of developed markets, but still lack maturity. Emerging market stocks can grow quickly in the right conditions. Brazil, Greece and China are emerging markets.
Frontier markets are less developed than emerging markets. Stocks in these countries are high risk and high reward. Investment researcher MSCI categorizes Estonia, Latvia and Vietnam as frontier markets.

Economic Sector

There are always exceptions, but stocks often follow the behavior of their sector. As an example, consumer staples companies normally have low volatility because they profit from sales of goods people can’t live without—like toilet paper or soap.

Here are the 11 economic sectors categorized by low, medium and high volatility:

Low volatility sectors: consumer staples, utilities, healthcare and financials
Medium volatility sectors: communication services, consumer discretionary and real estate
Higher volatility sectors: industrials, materials, technology and energy

2. Fixed Income (Bonds)

Fixed income securities, or bonds, are debt shares. As a bondholder, you earn periodic interest payments and then receive your investment back when the bond matures.

Most retirement savers invest in fixed income funds, rather than directly in bonds. Funds fluctuate in value based on investor demand and interest rates. Typically, demand for bonds drops when the stock market is strong and vice versa.

Interest Rates

Bonds also have an inverse relationship to interest rates, such that their prices fall when interest rates rise. This is because you’d wouldn’t pay as much for a bond when its interest rate is lower relative to the market. As well, you’d pay more for a bond when its rate is higher than the market average.

Creditworthiness

The creditworthiness of the bond issuer also affects the bond’s interest rate and secondary market value. Strong issuers, like the U.S. government, can pay lower interest rates because the risk of default is minimal. But junk bonds pay higher rates to compensate investors for higher default risk.

Popular bond types, ordered from least volatile to most, are:

U.S. Treasurys
Investment-grade corporate bonds
Municipal bonds
Junk bonds
Emerging markets bonds

You can build a bond portfolio out of any of these, though most retirement savers prefer U.S. Treasurys and investment-grade corporate debt. For more information, see best retirement income strategies.

3. Cash And Equivalents

Cash and equivalents are highly liquid assets that act as cash or can be quickly converted into cash without risk of value loss. Examples include:

Savings deposits
Money market funds
Short-term Treasury bills
Certificates of Deposit (CDs)

Cash and equivalents provide stability and liquidity in your portfolio.

Stability

Cash and equivalents don’t rise and fall in value the way stocks do. So, your $500 checking account balance remains $500, regardless of what’s happening with the economy.

Unfortunately, the $500 does lose purchasing power over time due to inflation. Even if the money is in an interest-bearing account, the rate will be lower than the current inflation rate. This is why people invest in the stock market, to realize higher growth rates after inflation.

Liquidity

Liquidity is an insurance policy to protect against market downturns. Market crashes and corrections are most damaging financially if you must sell when stock prices are down. Having cash on hand allows you to avoid that scenario. You’d use the cash to cover emergencies rather than selling stock.

4. Alternative Investments

Alternative investments are nontraditional assets that don’t move in lockstep with the stock market. Exposure to alternative investments adds diversity to a portfolio, which can help level out the peaks and valleys of your equity assets.

Alternative investments can range in risk and complexity. Here are some examples, roughly ordered from least to most complicated:

Real estate Investment trusts (REITs)
Commodities ETFs
Cryptocurrencies
Collectibles such as artwork or classic cars
Farmland
Timberland
Options and derivatives

Retirement Portfolio Examples

Two factors that should influence your retirement portfolio allocation are time horizon and risk tolerance. Time horizon is how long you plan to invest before withdrawing any funds. If you’re 25 and plan to retire at 65, your time horizon is 40 years.

Risk tolerance is your general willingness to accept risk. If you can accept high volatility in exchange for growth potential, you can invest aggressively. A moderate approach would be more suitable if you don’t mind some volatility. But you’d invest conservatively if you’d rather limit your exposure to capital losses.

Your time horizon can also affect your risk tolerance. Generally, a longer timeline allows for more aggressive investing, while a shorter one does not.

Think of it this way: If retirement is 40 years away, a market downturn today will be long over by the time you leave the workforce. But if you’re retiring in five years, a more conservative strategy can minimize losses in portfolio value just as you’re about to start retirement withdrawals.

Time Horizon Examples

The four simple portfolio allocations below demonstrate how you might invest aggressively early in your career and then shift to a more conservative approach later. You’ll see the 30-year allocation has the most exposure to stocks and the five-year allocation has the least.

These allocations do not include alternative assets. Due to their complexity, there’s no one-size-fits-all alternative asset recommendation for retirement savers. Consider your knowledge of the asset, be it real estate or crypto, and your risk tolerance to set a suitable allocation for alternative assets. As a rule, keep the exposure below 3% until you’re comfortable with the asset’s behavior over time.

30 Years Until Retirement

A growth-focused, 30-year portfolio could include:

55% U.S. Stocks: Vanguard Total Stock Market ETF (VTI
VTI
)

35% international Stocks: Vanguard Total International Stock ETF
VXUS
7% U.S. Bonds: Vanguard Total Bond Market ETF
BND
3% International Bonds: Vanguard Total International Bond ETF
BNDX

Note that you can use any fund family you prefer to implement these portfolios. Vanguard is a popular choice, especially since they have low expense ratios, but any low-fee index funds will work.

15 Years Until Retirement

As your timeline to retirement shortens, you’d reduce your stock exposure. This adds stability so the portfolio is less affected by down markets just before you retire. Here’s an example:

45% U.S. Stocks: Vanguard Total Stock Market ETF (VTI)
25% International Stocks: Vanguard Total International Stock ETF (VXUS)
20% U.S. Bonds: Vanguard Total Bond Market ETF (BND)
10% International Bonds: Vanguard Total International Bond ETF (BNDX)

5 Years Until Retirement

The five years before retirement is a careful time. You’ll be starting retirement withdrawals soon and you don’t want a setback in your savings balance. At the same time, you don’t want to miss out on growth opportunities. Many investors find that balance in a 60/40, stock-to-bond mix such as:

35% U.S. Stocks: Vanguard Total Stock Market ETF (VTI)
25% International Stocks: Vanguard Total International Stock ETF (VXUS)
30% U.S. Bonds: Vanguard Total Bond Market ETF (BND)
10% International Bonds: Vanguard Total International Bond ETF (BNDX)

In Retirement

In retirement, your focus should be capital preservation. At this point, you want the wealth you’ve built to last as long as possible. Your asset allocation in retirement might look like:

40% U.S. Bonds: Vanguard Total Bond Market ETF (BND)
30% U.S. Stocks: Vanguard Total Stock Market ETF (VTI)
20% International Stocks: Vanguard Total International Stock ETF (VXUS)
10% International Bonds: Vanguard Total International Bond ETF (BNDX)

This strategy of implementing different retirement allocations by age may sound familiar. It’s the practice of target-date funds, which are designed to be low-maintenance, all-in-one portfolios for retirement savers.

Risk Tolerance Examples

You can also build your retirement portfolio to match a target risk level. Examples for aggressive, moderate and conservative approaches are shown below.

Aggressive Portfolio Allocation

An aggressive portfolio will have heavy stock exposure including mid-caps, small-caps and emerging markets. You might also dabble in real estate by way of REITs:

40% U.S. Large-Cap Stocks: Vanguard Large-Cap ETF
VV
15% U.S. Bonds: Vanguard Total Bond Market ETF (BND)
10% U.S. Mid-Cap Stocks: Vanguard Mid-Cap ETF
VO
10% International Stocks: Vanguard Total International Stock ETF (VXUS)
5% U.S. Small-Cap Stocks: Vanguard Small Cap ETF
VB
5% U.S. REITs: Vanguard Real Estate ETF
VNQ
5% Emerging Markets Stocks: Vanguard FTSE Emerging Markets ETF
VWO

Moderate Portfolio Allocation

A moderate approach, like the 15-year retirement portfolio, has a more even split between stocks and bonds and slightly less exposure to more volatile stock categories:

40% U.S. Bonds: Vanguard Total Bond Market ETF (BND)

37% U.S. Large-Cap Stocks: Vanguard Large-Cap ETF (VV)
10% International Stocks: Vanguard Total International Stock ETF (VXUS)
4% U.S. Mid-Cap Stocks: Vanguard Mid-Cap ETF (VO)
4% Small-Cap Stocks: Vanguard Small Cap ETF (VB)
3% U.S. REITs: Vanguard Real Estate ETF (VNQ)
2% Cash and Equivalents

Conservative Portfolio Allocation

Finally, a conservative approach puts most of the value in domestic bonds and U.S. large cap stocks:

60% U.S. Bonds: Vanguard Total Bond Market ETF (BND)
20% U.S. Large-Cap Stocks: Vanguard Large-Cap ETF (VV)
5% International Stocks: Vanguard Total International Stock ETF (VXUS)
5% Cash and Equivalents
4% U.S. Mid-Cap Stocks: Vanguard Mid-Cap ETF (VO)
3% U.S. Small-Cap Stocks: Vanguard Small Cap ETF (VB)
3% U.S. REITs

About High Rate Environments

You might be wondering how to account for today’s high interest rates in your retirement portfolio. Here’s my advice: Don’t modify your approach for economic conditions that are ultimately temporary.

While high rates seem like they’ve been around forever, this cycle is a small blip in the 30-plus years you should be investing for retirement. If you’re in the habit of switching up your holdings every time something changes, there’s an ever-increasing chance you’ll mistime those adjustments—which generally does more harm than good.

How Do You Rebalance A Portfolio?

Once you implement one of the above portfolios, it’s smart to think about how you’ll maintain your target allocations. That’s where rebalancing comes in.

There are two basic methods for rebalancing a retirement portfolio. You can trade to implement your new allocation immediately. Or you can change the composition of new investments to implement the new allocation gradually.

Trading To Rebalance

With this method, you will sell overweighted assets and use the proceeds to buy underweighted assets. This is the way to restore your target allocation quickly. Unfortunately, it comes with these downsides:

You may incur trading fees and taxes, depending on how your account is structured.
You may have to liquidate when the market is down. That’s generally not the right time to sell, because you’ll net less cash for your assets.
Unless you’re invested in a simple mutual fund portfolio or index fund portfolio, trading to rebalance can be a complicated math problem.

Changing Composition Of New Investments To Rebalance

If you don’t want to sell assets, you can adjust the way you’re investing new contributions. Start buying more of the underweighted assets and less of the overweighted assets. Your allocation will then shift in the right direction over time.

This method avoids the downsides of extra trading. But it won’t reinstate your target asset allocation immediately. It will happen gradually, which may leave you with more risk than you want.

Portfolio Rebalancing Strategies

You can organize your rebalancing activities in different ways to accommodate your tax needs, your urgency and the market environment. Below are three strategies to consider.

1. Time-Based Rebalancing

You may want to rebalance your retirement portfolio by making strategic trades on a schedule. This method is appropriate when your primary goal is keeping your allocation stable.

As for how often to rebalance the portfolio, once or twice annually should be sufficient. You may be able to implement automatic, time-based rebalancing in your 401(k). If your account supports that feature, you’d set the schedule and let the rebalancing happen without your involvement.

2. Threshold-Based Rebalancing

You could also set thresholds that prompt you to rebalance. Say you start with an allocation of 60% stocks and 40% bonds. You could rebalance when the stock percentage rises to 70%. At that point, you’d liquidate enough stocks to bring the percentage back to 60% and buy bonds with the proceeds.

3. Contribution-Based Rebalancing

To rebalance without liquidating, adjust how you invest your contributions. If you’re trying to reduce stock exposure, buy higher percentages of bonds with your contributions temporarily. Once your portfolio reaches the allocation you want, you can return to buying higher percentages of stocks.

Use this method when you have reasons for not wanting to liquidate assets. Maybe the timing is wrong or you’re investing in a taxable investment account.

4. Tactical Rebalancing

Tactical rebalancing allows you more flexibility to work around economic and financial market conditions. If you see a short-term opportunity to invest heavily in stocks—say, because prices are low—you might take advantage, even if it goes against your target allocation strategy. You can then restore your targeted allocation later when bonds look more attractive.

Bottom Line

Thoughtful composition of your retirement assets is your most powerful tool for managing risk. Design a retirement asset allocation that fits with your timeline and the amount of risk you can handle. Then, implement a rebalancing strategy so you’re not adding risk over time.

Take those steps and a comfortable retirement is as sure as your commitment to the plan.