How to allocate and rebalance your pension portfolio

The most challenging part of retirement investing is planning sufficient contributions. Once you solve this problem, you will face the next challenge - deciding how to invest. Your retirement investment decisions should be based on a target asset allocation that aligns with your time horizon and risk level. After implementing this allocation, you will rely on a portfolio rebalancing strategy to maintain it.

Read on to learn how to allocate your retirement portfolio and perform its subsequent rebalancing

This guide outlines the elements of a balanced portfolio and presents six examples of allocation for different scenarios.

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

More complex pension distributions break down classes into subclasses. For example, a 60/40 portfolio may consist of 45% domestic stocks, 15% international stocks, 30% domestic bonds, and 10% international bonds.

This allocation is important because it is one of the main determinants of portfolio risk. A higher percentage of stocks compared to bonds is riskier than a portfolio with a greater weight in bonds. A tilt towards small-cap stocks or international stocks increases the risk.

Portfolio balancing

Portfolio rebalancing is the process of restoring your target investment allocation. Let's return to our example where the portfolio consists of 60% stocks and 40% bonds. In a rising market, stocks will increase in value while bonds will remain stable.

If nothing is done, the percentage of shares will increase to 65%, 70%, or even more. As the share of stocks grows, so does the risk.

To rebalance, you need to reduce your positions in stocks and increase your bond allocation to restore your target allocation of 60/40. Below, you will learn about specific rebalancing strategies.

Investing in stocks

Investing in stocks is one of the best steps you can take to increase your income and build your financial potential. The Forbes team has uncovered undervalued stocks that are poised for growth in this exclusive report.“7 stocks to buy now.”

Assets such as stocks, bonds, and cash are key components of a balanced portfolio. Stocks provide growth and volatility, while bonds and cash offer stability. You combine them in a targeted allocation to tailor the portfolio's behavior and risk.

Stocks

Stocks are key components of any portfolio designed for capital accumulation over time. Why? Because over the past 50 years, shares of large companies have yielded an average of 10.5% annually, including dividends. After accounting for inflation, this means that investors can earn about 8% per year just by following the market.

This average figure of 8% doesn't manifest every year. In fact, the stock market can rise by 30% in one year and fall by 20% the next. Fortunately, there is a reliable way to achieve an average of 8%: hold your stocks for the long term so that the year-to-year fluctuations smooth out into growth.

When talking about stock fluctuations in the stock market, they are usually caused by economic trends. The reaction of a specific stock to the economy can be subtle or exaggerated, depending on various factors. These include the size of the company, its geographical location, and the industry.

Company size

Categories of stocks by size, from least volatile to most volatile:

• Large capitalizations
• Average capitalizations
• Small capitalizations

Please note that volatility can be both positive and negative. For example, under the right conditions, the stocks of a company that has just gone public can show significantly higher growth rates than already established large companies.

Geographical location

Different countries offer varying levels of business opportunities in terms of size and economic maturity. These levels are often classified as developed, developing, and frontier.

Industry

There are always exceptions, but stocks often mirror the behavior of their industry. For example, consumer goods companies typically have low volatility because they profit from selling essential items that people can't live without, such as toilet paper or soap.

Here are 11 sectors classified by low, medium, and high volatility:

• Bonds are debt instruments. As a bondholder, you receive periodic interest payments and then get your investment back at the end of the bond's term.
• Most retirement savers invest in fixed-income funds rather than directly in bonds. The value of these funds fluctuates based on investor demand and interest rates. Typically, demand for bonds decreases when the stock market is strong, and vice versa.

Interest rates

Bonds also have an inverse relationship with interest rates, so their prices fall when interest rates rise. This happens because you wouldn't pay as much for a bond when its interest rate is lower than the market rate. Additionally, you would pay more for a bond when its interest rate is higher than the market rate.

Creditworthiness

The creditworthiness of the bond issuer also affects the bond's interest rate and its secondary market value. Reliable issuers, such as the U.S. government, can offer lower interest rates because the risk of default is minimal. However, defaulting bonds pay higher rates to compensate investors for the risk of default.

Popular types of bonds, ordered from least volatile to most volatile:

• You can create a bond portfolio from any of them, although most retirement savers prefer U.S. Treasury bonds and investment-grade corporate bonds. If you need more information, check out the best strategies for generating retirement income.

Cash and cash equivalents

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

• Money in the bank account
• Deposit certificates
• Money market instruments

Cash and cash equivalents provide stability and liquidity in your portfolio.

Stability

Cash and equivalents do not fluctuate in price like stocks. Thus, your balance of $500 in the account remains $500, regardless of what happens with the economy.

Unfortunately, $500 is losing purchasing power due to inflation. Even if the money is in an interest-bearing account, the interest rate will be lower than the current inflation rate. That's why people invest in the stock market to achieve higher growth rates after accounting for inflation.

Liquidity

Liquidity is insurance that helps avoid price drops in the market. Crashes and corrections in the market have the greatest financial impact when you have to sell stocks at a declining price. Cash allows you to avoid this situation. You can use cash to cover emergencies instead of selling stocks.

Alternative investments

Alternative investments are unusual assets that do not move in parallel with the stock market. Investing in alternative assets adds diversity to your portfolio, which can help smooth out the fluctuations of your equity portfolio.

Alternative investments can vary in risk and complexity. Here are a few examples, roughly ordered by their level of complexity:

• Real estate
• Hedge funds
• Private energy assets
• Cryptocurrencies

Two factors that should influence your retirement portfolio allocation are your time horizon and the level of risk you are willing to take. The time horizon is the period during which you plan to invest before withdrawing any funds. If you are 25 and plan to retire at 65, then your time horizon is 40 years.

The level of risk is your overall willingness to take risks. If you can tolerate high volatility in exchange for growth potential, you can invest aggressively.

Your time horizon can also affect your willingness to take risks. In general, a longer time horizon allows for more aggressive investments, while a shorter time horizon does not.

If you plan to retire in 40 years, today's market downturn will be long over by the time you leave the workforce. However, if you retire in five years, a more conservative strategy may help minimize losses in your portfolio's value as you start taking retirement withdrawals.

Investing in stocks

Investing in stocks is one of the best steps you can take to increase your income and build your financial potential. The Forbes team has uncovered undervalued stocks that are poised for growth in this exclusive report.“7 stocks to buy now.”

Here are four simple portfolio allocations that show how you can invest aggressively at the beginning of your career and then shift to a more conservative approach later on. You'll see that the 30-year allocation has the highest percentage of stocks, while the 5-year allocation has the lowest.

These allocations do not include alternative assets. Due to their complexity, there is no universal recommended distribution for retirement savers. Consider your knowledge of assets such as real estate or cryptocurrency, as well as your risk tolerance, to establish an appropriate allocation for alternative assets. As a rule, keep their share below 3% until you are confident in the asset's behavior over time.

30 years until retirement

Focus on growth, a 30-year allocation may include:

• Domestic and international large-cap stocks
• Industry and geographic funds
• Low-cap and low-profit securities

Please note that you can use any brokerage firm of your choice to implement these portfolios. Vanguard is popular, especially because of their low fees, but any low-cost funds will work.

15 years until retirement

As the time until retirement decreases, you should reduce the proportion of stocks. This adds greater stability to the portfolio and lessens the impact of market downturns right before retirement. Here's an example:

• Large-cap internal stocks
• International large-cap stocks
• Investment-grade bonds
• Sector mid-cap funds

5 years until retirement

Five years before retirement is a cautious time. You will soon start receiving pension payments, and you don't want to lose part of your savings. At the same time, you don't want to miss out on growth opportunities. Many investors find balance in a mixed 60/40 portfolio, combining stocks and bonds:

• Large-cap stocks in the USA
• Shares of large-cap companies in the international market
• Medium-term bonds
• Bonds with high reliability and liquidity

During retirement

During retirement, your focus should be on preserving capital. At this point, you want your accumulated wealth to last as long as possible. Your asset allocation in retirement might look something like this:

• High-quality bonds with a short maturity period
• Large-cap stocks

This strategy of implementing various allocations of pension assets based on age may be familiar to you. It is a practice of funds designed for targeted pension accumulation, which are developed to be low-maintenance and comprehensive portfolios for retirement savers.

You can also build your retirement portfolio to match your target risk level. Below are examples of aggressive, moderate, and conservative approaches:

Aggressive portfolio allocation

An aggressive portfolio will have a significant share of stocks, including mid-cap stocks, small-cap stocks, and stocks from emerging markets.

• Mid-cap stocks
• Small-cap stocks
• Emerging market stocks
• Commercial real estate

Average portfolio allocation

A moderate approach, similar to a portfolio 15 years before retirement, has a more balanced distribution between stocks and bonds, with slightly less exposure to more volatile categories of stocks.

• Large-cap stocks in the USA
• Shares of large-cap companies in the international market
• Bonds with a maturity period from medium to long-term

Conservative portfolio allocation

And finally, the conservative approach holds most of its value in American bonds and large-cap stocks.

• High investment-grade American bonds
• Large-cap stocks in the USA

You might be wondering how to account for high interest rates in your retirement portfolio. Here’s my advice: don’t change your approach because of economic conditions that are temporary.

Although high interest rates may seem eternal, this cycle is just a small peak in a period of over 30 years that you should be investing for retirement. If you constantly change your investment decisions with every shift, you increasingly risk making a poor choice, which usually does more harm than good.

After implementing one of the allocations mentioned above, it's wise to think about how you will maintain your target allocations. This is where rebalancing comes into play.

There are two main methods for balancing a pension portfolio. You can trade for an immediate implementation of the new allocation. Or you can adjust the composition of new investments for a gradual implementation of the new allocation.

Using the first method, you will sell overrepresented assets and use the proceeds to purchase underrepresented assets. This allows you to quickly restore your target allocation. Unfortunately, this comes with the following issues:

• You have to pay trading fees.
• You need to take into account the taxes on profits from the sale of stocks or bonds.
• You need to keep an eye on the market to know when it's time to do some rebalancing.

If you don't want to sell your assets, you can change the way you make new investments. Start buying more undervalued assets and fewer overvalued ones. Your allocation will gradually shift in the right direction over time.

This method avoids the issues of additional trading. However, it does not restore your target allocation immediately. It happens gradually, which may leave you with more risk than you want.

Portfolio rebalancing

You can organize your balancing actions in various ways to meet your tax needs, urgency, and market environment. Below are three strategies to consider.

Rebalancing according to the schedule

You may need to rebalance your retirement portfolio by making strategic trades on a schedule. This method is suitable when your primary goal is to maintain allocation stability.

As for how often to rebalance your portfolio, once or twice a year is sufficient. You may have the option for automatic time-based rebalancing in your individual retirement plan. If your account supports this feature, you can set a schedule and let the rebalancing happen without your involvement.

You can also set thresholds that will prompt you to rebalance. For example, you start with an allocation of 60% stocks and 40% bonds. You can rebalance when the percentage of stocks rises to 70%. At that point, you would sell enough stocks to bring the percentage back down to 60% and use the proceeds to buy bonds.

To rebalance without liquidating assets, change the way you purchase new contributions. If you want to reduce your equity share, temporarily buy large percentage points of bonds with new contributions. Once your portfolio reaches the desired allocation, you can return to purchasing large percentages of stocks.

Tactical rebalancing

Use this method when you have reasons for not wanting to sell assets. It might be the wrong time, or you are investing in a taxable investment account.

Tactical rebalancing gives you more flexibility to navigate economic and financial conditions. If you see a short-term opportunity for aggressive investments in stocks, for example, because prices are low, you can take advantage of it, even if it contradicts your target allocation strategy. You can return to the allocation later when bonds look more attractive.

Careful construction of your retirement active portfolio is the most powerful tool for managing risks. Create an allocation of retirement assets that aligns with your time horizon and risk tolerance. Then, develop a rebalancing strategy to avoid increasing risk over time.

By following these steps, you can be confident in a comfortable retirement as long as you are committed to the plan. Investing in stocks is one of the best steps you can take to boost your financial growth and build your financial nest egg. The Forbes team has identified undervalued stocks that are poised for a rise in this exclusive report.“7 stocks to buy now.”