Definition and Example of a Fair Balance Path
How the Fair Balance Path Works
Types of Fair Balance Paths
Which Balance Path is the Best?
Definition and Example of a Fair Balance Path
The fair balance path describes the changes in the distribution of assets for stock investments as one ages. Individuals can use such a path to build and maintain a retirement portfolio that achieves an optimal balance between risk and reward.
How the Fair Balance Path Works
If you are saving for retirement, it is likely that you will be advised to have a diversified portfolio that includes stocks, bonds, and cash, to avoid giving too much weight to any one asset class. Having diversified assets reduces the risk of losing money in the market.
Not all asset classes carry the same level of risk. Stocks often carry more risk than bonds. Stocks can fluctuate significantly in price, which means you could lose money in the short term. These fluctuations also mean that they achieve greater growth, giving you higher returns in the long term.
Conversely, bonds have lower growth and less volatility. This means they are less risky in the short term but yield lower returns in the long term. Savers should shift their assets over time in a way that balances risk and returns and meets their investment goals. These shifts are known as “fair balance paths.”
Suppose you are 25 years old and want to retire at 65. Since you have 40 years until you retire, your investments can withstand declines and losses in value from a distribution that comes with more risk. By avoiding more risk as you age, you choose an asset allocation that follows a fair balance path.
With this type of fair balance path, the amount of stocks you hold in your account decreases as you age. You can buy individual mutual funds and adjust your allocation over time to reduce your tilt toward stocks in your account. You might also buy a target retirement fund, which is typically named after the calendar year you expect to retire. These funds are usually managed in a way that reduces the level of risk as the target date approaches without requiring you to change things yourself.
A target date fund that is 40 years away from its target date might start with an allocation of 95% stocks. After twenty years, it might decrease to 70% stocks. By the time you reach its target date, the percentage of stocks owned might be 50% or lower. This path is followed by trading stocks for lower-risk investments over time.
Note: When deciding where to place your assets, consider the fair balance path alongside the amount you will need to withdraw at retirement. A higher withdrawal rate may require a higher allocation to stocks over time to achieve the growth you will need.
Types of Fair Balance Paths
There are three main types of fair balance paths:
Downward Fair Retirement Path
A downward fair retirement path is where you gradually reduce your exposure to stocks as you age. If you plot this path on a linear chart, with age on the X-axis and the amount of stocks you own on the Y-axis, the line would have a negative slope. The rule of thumb “100 minus your age” is a way to think about the downward path.
This rule of thumb states that to determine how much you should have in stocks — equities or equity index funds — you should subtract your current age from 100. For example, at age 60, you would have 40% of your money in stocks, with the rest in safer asset classes like bonds. Each year, you would reduce the stock allocation by 1% and increase the bonds by the same percentage.
Path
Fixed Fair Balance Path
The fixed fair balance path is an approach that maintains a predetermined strategic asset allocation, such as 60% in stocks and 40% in bonds. Each year, you will rebalance your portfolio back to the target allocation. If you are withdrawing money from your account – using a systematic withdrawal approach – you will take enough from each asset class so that the distribution remains at 60% stocks and 40% fixed income after the withdrawal.
For example, at the beginning of the year, you have $100,000. You have 60% of this amount, $60,000, in a stock index fund, and 40% in a bond index fund. But by the end of the year, the stock index fund is valued at $65,000, and the bond index fund is valued at $41,000. You also need to withdraw $4,000 from the account.
After you take this amount, you will have a balance of $102,000. To maintain the 60/40 allocation, you would want to have $61,200 in stocks and $40,800 in bonds. You will split the $4,000 between the two asset classes to achieve this, selling $3,800 of your stock index fund and $200 of your bond fund for a total of $4,000.
Upward Fair Balance Path
The upward fair balance path is the opposite of the downward fair balance path. As you age, the percentage of stocks will gradually increase as long as they are yielding a positive return. Such a path would produce a line with a positive slope when plotted on a line chart.
This approach may begin with a larger percentage in lower-risk asset classes such as bonds – perhaps 70% – and 30% in stocks. You might create a bond ladder where bonds mature annually to meet the cash flow you’ll need to withdraw from the account. The percentage of stocks in your account may grow to about 70% over time.
Which Balance Path is Best?
The downward fair balance path, which calls for reducing stock exposure in the portfolio over time, aligns with many people’s decreasing risk tolerance as they age.
However, some experts have praised the fixed fair balance path as the best approach. For instance, financial expert Bill Bengen stated that a fixed stock allocation of 50% to 75% is optimal.
Retirement experts Michael Kitces and Wade Pfau found that the upward fair balance path, such as starting with 30% in stocks and rising to 70% over 30 years, yields better results than a fixed or downward path.
Aside from the research, there is no way to know in advance which type of fair balance path will provide you with the best outcome for the market fluctuations you will face at retirement. Your best option is to assess the time you have until then, your risk tolerance, and your investment goals. Then choose the approach that best fits you and stick to it diligently.
Source: https://www.thebalancemoney.com/what-is-an-equity-glide-path-2388560
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