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When calculating my asset allocation for applying allocation guidelines, should I include my retirement funding or not?

You see, my investments have an asset allocation. But then, so do my retirement savings (defined-contribution pension fund and a retirement annuity). Combining investments and retirement funding gives an overall net-worth asset allocation.

If I were to follow an asset allocation (such as 60% equity, 25% bonds, 15% cash) is that supposed to be allocation for just my investments, or the sum of my investments and retirement funds?

I ask because investments+pension would show a much greater allocation to equities than if I only look at investments.

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Personally, I do asset allocation separately for personal investing and for retirement investing, as I the two have vastly different purposes and I have vastly different goals for each.

YMMV depending on how you view your non-retirement investments, and how close you are to retirement.

  • My non-retirement investments would go towards a house, but that would be 2-10 years away, depending on when I reckon I'll stay in one place for 7+ years. So I guess I've been treating them much the same as retirement assets: all on long-term equities. – Graham Jan 3 '12 at 8:31
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You probably want to think about pools of money separately if they have separate time horizons or are otherwise not interchangeable.

A classic example is your emergency fund (which has a potentially-immediate time horizon) vs. your retirement savings. The emergency fund would be all in cash or very short-term bonds, and would not count in your retirement asset allocation. Since the emergency fund usually has a capped value (a certain amount of money you want to have for emergencies) rather than a percentage of net worth value, this especially makes sense; you have to treat the emergency fund separately or you'd have to keep changing your asset allocation percentages as your net worth rises (hopefully) with respect to the capped emergency amount.

Similarly, say you are saving for a car in 3 years; you'd probably invest that money very conservatively. Also, it could not go in tax-deferred retirement accounts, and when you buy the car the account will go to zero. So probably worth treating this separately.

On the other hand, say you have some savings in tax-deferred retirement accounts and some in taxable accounts, but in both cases you're expecting to use the money for retirement. In that case, you have the same time horizon and goals, and it can pay to think about the taxable and nontaxable accounts as a whole. In particular you can use "asset location" (put less-tax-efficient assets in tax-deferred accounts). In this case maybe you would end up with mostly bonds in the tax-deferred accounts and mostly equities in the taxable accounts, for tax reasons; the asset allocation would only make sense considering all the accounts, since the taxable account would be too equity-heavy and the tax-deferred one too bond-heavy.

There can be practical reasons to treat each account separately, too, though. For example if your broker has a convenient automatic rebalancing tool on their website, it probably only works within an account. Treating each account by itself would let you use the automatic rebalancing feature on the website, while a more complicated asset location strategy where you rebalance across multiple accounts might be too hard and in practice you wouldn't get around to it. Getting around to rebalancing could be more important than tax-motivated asset location.

You could also take a keep-it-simple attitude: as long as your asset allocation is pretty balanced (say 40% bonds) and includes a cash allocation that would cover emergencies, you could just put all your money in one big portfolio, and think of it as a whole. If you have an emergency, withdraw from the cash allocation and then rebuild it over time; if you have a major purchase, you could redeem some bonds and then rebuild the bond portion over time. (When I say "over time" I'm thinking you might start putting new contributions into the now-underallocated assets, or you might dollar-cost-average back into them by selling bits of the now-overallocated assets.)

Anyway there's no absolute rule, it depends on what's simple enough to be manageable for you in practice, and what separate shorter-horizon investing goals you have in addition to retirement.

You can always make things complex but remember that a simple plan that happens in real life is better than a complex plan you don't keep up with in practice (or a complex plan that takes away from activities you'd enjoy more).

  • I like the idea of using the tax-deferred retirement annuity for the bond allocation to obtain lower taxation. To get the money "out" later I could switch part of the RA to equities to free up equivalent non-retirement equities for sale. – Graham Jan 3 '12 at 8:48
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I'd imagine that it's a small portion of the population that can have much of both. If one is saving a decent amount for retirement, say 10-15%, they aren't likely to have much else, aside from the house if included. For example, when I look at my 'pie chart' I get Retirement 72%, House 22%, everything else 6%.

Specific to your question, emergency funds should be just that, accessible for urgent matters, other short term needs, such as car fund, big TV fund, vacation, etc, also in non-risky cash (i.e. money funds CDs, etc) and the rest invested long term. The short need money isn't part of the long term asset allocation, to be specific.

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I separate them out, simply because they're for different purposes, with different goals and time-frames, and combining them may mask hidden problems in either the retirement account or the regular account.

Consider an example:

A young investor has been working on their retirement planning for a few years now, and has a modest amount of retirement savings (say $15,000) allocated carefully according to one of the usually recommended schemes. A majority exposure to large cap U.S. stocks, with smaller exposures to small cap, international and bond markets.

Years before however, they mad an essentially emotional investment in a struggling manufacturer of niche personal computers, which then enjoyed something of a renaissance and a staggering growth in shareholder value. Lets say their current holdings in this company now represent $50,000.

Combining them, their portfolio is dominated by large cap U.S. equities to such an extent that the only way to rebalance their portfolio is to pour money into bonds and the international market for years on end. This utterly changes the risk profile of their retirement account.

At the same time, if we switch the account balances, the investor might be reassured that their asset allocation is fine and diversified, even though the assets they have access to before retirement are entirely in a single risky stock.

In neither case is the investor well served by combining their funds when figuring out their allocation - especially as the "goal" allocations may very well be different.

  • 1
    Hmm, not sure I get it. If he has $15k retirement savings and a $50k successful investment, surely he could rebalance by moving some of the $50k into bonds and cash while leaving the retirement account alone? Don't get the "switch account balances bit" - aren't all his pre-retirement assets in a single stock either way? – Graham Jan 3 '12 at 8:25

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