People conflate “risk” with “volatility” – the amount a financial asset might rise or fall in value in one day.

We define risk as “the chance money won’t be there when needed.” If a client must pay taxes or close on a house in three months, we must secure those funds in a no-risk, no-return money market account.

For long-dated financial needs, such as retirement that is more than five years away, volatility risk is irrelevant. The risk we must address is “longevity risk” – the chance that a family outlives their retirement assets.

Investors often make the mistake of holding all their financial assets in a single account, and then don’t invest that account properly taking multiple needs into consideration.

Purpose-Based Asset Allocation

“Purpose-based asset allocation” is the process of dividing our clients’ money into as many buckets as necessary to give peace of mind about the future. A “bucket” refers to a specific financial objective.

During client discovery conversations, we ask open-ended questions to enumerate and elucidate all the concerns that a family might have. The list of a 40-ish married couple with children could include:

  • Buying a home
  • Saving for retirement
  • Building tuition funds
  • Budgeting for taxes
  • Creating a safety net

We create as many investment accounts as necessary to satisfy each need.

Thereafter, we assign a different asset allocation to each bucket. The upcoming tax payment will remain in a bank checking account earning no return, but good to go.

We invest family retirement accounts 100% in equities. Those funds need to grow as large as possible over the next 20 to 30 years.

We include bonds – 20% to 30% of the investment allocation – in the 529 plan of a child going to college next year. Bonds earn 3% per year or less these days, but we want to be sure that we can pay tuition on time.

Investing retirement money aggressively may sound counterintuitive. Why take chances with a nest egg? Commonly we see clients’ retirement accounts overweighted in bonds or worse, invested in guaranteed interest funds yielding less than 2%.

We calculate that a 401(k) earning 2% per year will double in value after 35 years, while an equity-invested 401(k) earning 7% per year will double every 10 years and grow 10x larger after 35 years compared to the “conservative” portfolio.

As our clients get closer to retirement, we adjust asset allocations to emphasize reliability over maximum growth, increasing bond allocations to between 20% and 30%, and, in retirement, 30% to 40%.

The expected return might drop to 6% per year, but we can reasonably distribute an annual draw to the client family of 4% to 5% per year and never run out of money. In nearly three decades of working with retired clients, never once have we reduced a client’s monthly retirement draw because of stock market volatility.

Invest With Purpose

Whether a family works with a financial planner or wealth advisor or manages their investments directly, everyone can benefit from purpose-based asset allocation. Make a list of financial needs and goals for the next five years. Then target specific portfolios to satisfy each of those needs.

Allocate assets according to time periods. For needs of one year or less, keep the cash in bank checking or money market accounts. Funds needed in the next one to five years should be invested in bonds. For goals more than five years out, we recommend equities (both U.S. and international markets) for maximum growth.

Look at the overall asset allocation across the entire household. Younger investors with a steady income and no dependents should allocate heavily to equities.

Middle-aged families might have an overall asset allocation of 80% stocks and 20% bonds, while families approaching retirement might allocate at 75/25 or 70/30.

Families in retirement require stability of income over asset growth and would invest at 65/35 or 60/40.

Determine purpose and time period. Then choose the asset allocation that will achieve the desired outcome.

David Edwards is president and wealth advisor with Heron Wealth, a $500 million registered investment advisor based in New York City working with 225 client families across the U.S. and around the world. Dustin Lowman contributed additional research for this column.

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