How Retirees Should Invest (Probably Not 60/40)

Now that you’re nearing retirement, or maybe already retired, you may be wondering if the way that you invest your money should change.

The answer is 100% yes, but maybe not in the way that a lot of the financial advice community suggests it should.

When I think about how retirees should invest, I really think of it as a two-piece puzzle.

The first piece is the investments themselves. What do you actually own? And I think this part should be pretty simple. Low-cost, broadly diversified, mostly index-tracking ETFs can do most of the heavy lifting. There’s usually no reason to overcomplicate it.

The second piece is your allocation. How much should you have in stocks, and how much should you have in fixed income?

And this is the part that should not be simple.

If you’ve had much exposure to the big-box investment companies, you know they love the 60/40 portfolio. Sixty percent stocks, forty percent bonds. And while that might be perfectly appropriate for some people, there’s nothing about being retired that automatically makes 60/40 the right allocation for you.

In fact, I think the industry sometimes gets these two pieces backwards. We overcomplicate the investments and oversimplify the allocation.

The investments can be simple. But the allocation should be based on two things: how much risk your retirement plan can actually afford to take, and how much risk you can personally handle without making a bad decision when the market gets ugly.

So let’s look at both pieces, because if you get them right, you’ll have an investment strategy that actually fits your retirement instead of somebody else’s.

The Investments Themselves

For most retirees, I don’t think you need a complicated collection of investments. You don’t need to constantly be trying to figure out which fund manager is going to outperform next year, which sector is about to take off, or which investment strategy is going to give you some kind of edge over everyone else.

There’s an old saying: you can tie a knot, or you can tie a lot. And I think investing can work the same way. You can build something that’s clean, simple, and does exactly what it’s supposed to do, or you can pile on so many funds, strategies, and moving parts that complexity starts to look like sophistication.

But complexity by itself doesn’t make a portfolio better.

There’s been decades of research comparing active management with simple index-based investing, and the results are pretty hard to ignore. Over long periods of time, most active managers fail to outperform their benchmarks, especially after fees.

That doesn’t mean no active manager ever outperforms. Of course they do. The problem is figuring out ahead of time which one is going to do it, and whether they can continue doing it in the future.

So for most retirees, I think the default can be pretty boring: low-cost, broadly diversified, mostly index-tracking ETFs, and very little tinkering.

Boring is okay. The job of your investments is not to entertain you. It’s to give you broad exposure to the markets, and serve as fuel for your retirement plan.

Your Asset Allocation Should Be More Personal

This is where simple investing advice can get retirees into trouble.

Just because the investments themselves can be simple does not mean your asset allocation should be. So how much should you actually have in stocks, and how much should you have in fixed income?

A 60/40 portfolio is probably the best-known example. Sixty percent stocks, forty percent bonds. And again, there’s nothing inherently wrong with 60/40. For some retirees, that may be exactly the right allocation.

But why 60/40?

Why not 70/30? Why not 50/50? Why not 80/20? Why not 90/10?

The answer should not simply be, “well, because you’re retired.”

That is vastly oversimplifying one of the most important decisions in your retirement plan. Your asset allocation should be built around your retirement plan, and there are two things that should drive that decision.

1. Risk Capacity

The first is your risk capacity.

Risk capacity is simply how much investment risk your retirement plan can afford to take. This is not about how you feel about the stock market. This is math.

Imagine two retirees who both have a $2 million portfolio.

The first retiree needs $100,000 a year from that portfolio to support their lifestyle. The second retiree has Social Security, a pension, and maybe some other income sources, and only needs $25,000 a year from the portfolio.

Those two people may have the exact same amount of money invested, but they do not have the same risk capacity.

The first person is much more dependent on the portfolio. If the market falls sharply, they still have to keep taking money out. That creates a much greater risk of being forced to sell investments while they’re down.

The second person has a lot more flexibility because most of their lifestyle is already being supported by income that doesn’t depend on the stock market.

This is why I don’t like starting with an allocation and then trying to make the retirement plan fit around it. I think you should do the opposite.

Start with the retirement plan and let that tell you how much of the portfolio needs to be protected from short-term market volatility.

One of the ways we think about this is by looking at several years of planned portfolio withdrawals and setting aside enough in lower-volatility investments to cover those needs.

For example, let’s say you need $10,000 a month to live on, but Social Security and a pension provide $6,000 a month. That means your portfolio only needs to provide the remaining $4,000 a month, or $48,000 a year.

If you wanted five years of those planned withdrawals protected from stock-market volatility, you’d be looking at roughly $240,000 in that more stable portion of the portfolio.

Now compare that with someone else who also needs $10,000 a month to live on, but only has $2,000 a month coming in from Social Security. Their portfolio has to provide $8,000 a month, or $96,000 a year.

Five years of withdrawals would be closer to $480,000.

Same lifestyle. Same basic retirement stage. But a very different amount of the portfolio may need to be protected.

That is risk capacity.

For one retiree, 40% in fixed income may be far more than the plan actually requires. For another retiree, it may not be enough.

The allocation should come from the math of the retirement plan, not from an arbitrary percentage.

2. Risk Tolerance

The math is only half of it. The second part is risk tolerance. And this is not math. This is behavior.

You can have a retirement plan that says you have the capacity to own 70% or 80% in stocks, but that does not mean you should. Because if the market drops and you panic, none of the math matters.

I’ve always called this your freak out number. And the easiest way to figure this out is to stop talking in percentages and start talking in dollars.

Let’s say you have a $2 million portfolio. If the market drops 10%, you’re down $200,000. How does that feel? For a lot of people, that’s uncomfortable, but manageable.

Now let’s say you’re down 20%. That’s $400,000. At that point, a lot of people start paying a lot more attention.

What about 30%? Now you’re down $600,000.

What about 40%? That’s $800,000 gone, at least on paper.

And then ask yourself this: what if your portfolio dropped by $1 million? Half of everything you’ve accumulated.

Would you stay invested? Would you trust the plan? Or would you get to a point where you finally said, “I can’t do this anymore. Get me out.”

That point is your freak out number.

And I think this is one of the most important things to figure out before the next bear market, not during it.

I’ve created a free tool that can help you work through this exercise and figure out your own freak out number. But I think it’s important to use this tool and get this figured out because everybody has a high risk tolerance when the market is going up.

The real test is what you’ll do when your account balance is falling and the financial news is telling you things could get worse.

Two people can have the exact same financial capacity for risk and still need very different allocations. One person may be perfectly comfortable with 70% in stocks. Another person may have the capacity to take that much risk, but knows that if the portfolio falls 30% or 40%, they’re going to want out.

That matters.

Because the best allocation is not the one that gives you the highest expected return on paper. It’s the one that gives your retirement plan enough growth while still allowing you to stay invested when markets get ugly.

Risk Capacity Sets the Floor. Risk Tolerance Sets the Ceiling.

This is where the two pieces come together.

I think of it this way: risk capacity sets the floor, and risk tolerance sets the ceiling.

Your risk capacity tells you the minimum amount of the portfolio that needs to be in more stable investments so the retirement plan can function the way it’s supposed to. Your risk tolerance tells you the maximum amount of stock-market risk you can realistically live with.

Let’s say your retirement plan shows that you only need 20% of your portfolio in fixed income to provide the liquidity you need. Mathematically, that means you could have as much as 80% in stocks.

But then we go through the risk-tolerance conversation and you tell me that if your portfolio ever fell by 30%, there’s a very good chance you’d want to sell.

Now we’ve got another constraint.

Maybe your plan can handle 80% in stocks, but you can’t. So your actual allocation might end up being 60% stocks and 40% fixed income.

And yes, that happens to be a 60/40 portfolio.

But notice how we got there.

We didn’t start with 60/40 because you’re retired. We ended up at 60/40 because your retirement plan and your own behavior both pointed us there.

For somebody else, the answer might be 70/30. For someone else, it might be 40/60. And there are retirees with enough guaranteed income and enough flexibility in their plan that they may be able to take considerably more stock-market risk than people assume is possible for a retiree.

The point is not that 60/40 is wrong. The point is that 60/40 should be the result of the analysis, not the starting point.

That’s the distinction I think matters.

Keep the Investments Simple. Make the Allocation Personal.

So if you step back, the framework is this: keep the investments themselves low cost, broadly diversified, and mostly index based.

Then spend your energy on the part that actually deserves more thought: how much risk you should be taking.

Let the retirement plan tell you how much risk you have the capacity to take. Then be honest about how much volatility you can actually live with.

And build the allocation where those two things meet.

The number itself is not the goal.

The goal is to build an allocation that fits your retirement plan and that you can actually stick with.

Because a portfolio that looks perfect on paper but falls apart the first time the market drops is not a good portfolio.

Find Your Freak Out Number

If you want to figure out your own freak out number, I built a free tool that will walk you through that exercise using your actual portfolio value.

You can look at different market decline levels, see what those losses would mean in actual dollars, and then map that back to an allocation that would have historically stayed either within or above your comfort zone.

That gives you a much better sense of where your own breaking point may be, and whether your current allocation is exposing you to more volatility than you’re actually comfortable with.

This tool lives inside a membership group I’ve been building that isn’t open to the public yet, but it will be soon.

So if you want access to the tool, just tell me where to email it and I’ll send you the link.

And if there’s one thing I want you to remember from this article, it’s this:

Don’t make your investments more complicated than they need to be, and don’t make your asset allocation simpler than it should be.