I recently received a question from someone who was using our risk tolerance profile and asset allocation worksheet and noticed that the worksheet’s guidelines were to have 0% in stocks since his time horizon was less than 5 years away while his target date retirement fund had 40% in stocks. While there are differences between the asset allocations of various models and target date funds, that gap was pretty stark. So who was right?

It turns out that in this case, the problem was that he had assumed his time horizon was less than 5 years because he was retiring within that time period. But I pointed out to him that his time horizon was actually longer than 5 years because his money would continue to be invested throughout his retirement, which could be easily 30 or even 40 years, so the fund’s 40% stock allocation was pretty reasonable. This is a common mistake. We often focus on the number of years until we retire and forget about all the years we may spend in retirement.

However, there are circumstances in which our time horizon really may be that short. For example, any money that you plan to use to purchase an immediate annuity, pay off your mortgage, or buy a home within the next 5 years, has a pretty short time horizon and should be kept out of the stock market. That’s because if the market plunges almost 40% like it did in 2008 or does even worse,  it could take a while for your money to recover. That means having to get a lower paying annuity, pay off only part of your mortgage, purchase a less expensive home, or delay your goal. On the other hand, earning the average 8-10% annualized return is unlikely to make a significant difference to your wealth in such a short period of time.  (But 8-10% does wonders compounded over 30-40 years.)

(Incidentally, this doesn’t necessarily apply to investing for education. Even though your child may be less than 5 years away from going to college, you still might want to have some money in stocks. That’s because if the college fund declines in value just before they go to school, you can always borrow the difference. Because of that “safety net,” it could make sense to take some risk for a potentially higher return. Unfortunately, there’s no financial aid for retirement though.)

So if you are planning to leave your money invested throughout retirement, does that mean you should be aggressive with such a long time horizon? Not necessarily. First, people tend to be more emotionally conservative when they’re close to or in retirement and may be tempted to bail out of stocks the next time they take a hit, turning a paper loss into a real one.

But even if you’re comfortable with an aggressive allocation, there’s  a pretty compelling reason to dial down your stock allocation in your portfolio if you’re taking income from it in retirement. That’s because while volatility works for you when you’re putting money into the stock market (if you periodically invest the same amount, you’ll buy more shares when they’re low priced and less when they’re high priced), it works against you when you’re taking money out (if you periodically withdraw the same amount, you’ll sell more shares when they’re low priced and less when they’re high priced). This is why a safe withdrawal rate in retirement is generally seen as no more than 4% even though the market has averaged much higher returns than that.

As the chart in this blog post demonstrates, if you’re withdrawing 4% a year, a 40% stock allocation will give you the lowest probability of running out of money during your lifetime. If you’re more aggressive, the portfolio will be too volatile. Interestingly enough, you can also be too conservative. A smaller stock allocation actually increases your chances of running out of money because your portfolio doesn’t grow enough to keep pace with inflation.

So what’s the moral of the story here? As usual, it starts with understanding your goals. When do you need the money and how much risk are you comfortable taking?