Why Your Portfolio Needs Stocks, Whatever Your Age

By Jeffrey P. Deiss, CFP ®, AEP ®

One rule of thumb suggested to me when I started my career was that your equity exposure should equal 100 percent minus your age: 70 percent for a 30-year-old, for example, but just 35 percent for someone who is 65.

Typical recommendations nowadays propose greater equity exposure than they did 30 years ago, but it is still the overwhelming view among investment counselors that people should reduce their holdings of common stock and beef up their ownership of bonds as they grow older.

Problem is, it wasn’t very good advice back then, and it’s still poor advice today.
This opinion perhaps puts me in the minority when compared to mainstream advice today, but if you are a retiree or nearing retirement, you should hear me out.

Let’s begin with the standard view today.

An easy example of the standard view is a “target-date-fund”, which changes the allocation over time as you approach a target retirement date. Target-date-funds are the default investment choice for many 401(k) plans and 401(k) plans are the primary vehicle for retirement saving today. The target-date-funds of major fund sponsors like Vanguard, Fidelity, and BlackRock all allocate 84 to 97 percent stocks for people who plan to retire in 2045 versus 52 to 61 percent for those planning to retire in 2020.

The rationale behind these allocations is that they will mitigate the short-term volatility of your portfolio that derives mainly from the equity component as your “investment time horizon” shortens. The flaw in this thought process is that, although your earned income may stop when you retire, your investment time horizon has not actually ended or even shortened. More likely, you’ll live another 20 or 30 or even 40 years from when you retire and so you still do have a long term investment horizon.

Contrast a target-date-fund to a “529 plan”, which is a common vehicle used to save for college expenses. Most 529 plans offer a similar variation of a target-date-fund, which has a higher equity allocation when the beneficiaries are younger to allow for growth and which is reduced in favor of bonds or cash by the time the child turns 18. This pattern makes sense for the purpose of a 529 plan where the objective is to spend all of the 529 plan funds in a short few years and where you understandably can’t afford any stock market volatility when the tuition bill is due.

Unlike parents who plan on draining the 529 proceeds in a short period of time, however, retirees typically liquidate only a small portion of their assets every year (typically 3% – 5% is considered prudent). Accordingly, “retiring” should not necessarily prompt any change in your exposure to the financial asset – common stock - that will produce the highest returns over the long run and allow you to withdraw 3 – 5% over an extended period.

The belief that as people grow older, the investment horizon shortens and, therefore, their ability to withstand volatility diminishes considerably, is a fallacy. While our 99 year old retiree may be fast approaching her personal horizon, her assets have not reached their horizon. In my experience, less than a handful of people who have actually said that they intend to spend all of their money before they die actually accomplish this. The reality is that the assets will be left to children or other family members, friends or charities – extending the horizon anew.

But what if there’s a bear market? “So what” is the answer. We had a severe bear market in 2008-09 and today the stock market is at all-time highs. Over the long run, the stock market goes up. It just doesn’t go up in a straight line. We need to understand this and get used to it.

Sometimes you may have to sell something when the market is depressed, but other times you’ll be selling when the market is elevated. On average, you’ll be liquidating your positions at average prices and, over time, you will earn around the average performance of the stock market. And a diversified collection of stocks will outperform the average performance of bonds over the course of any normal retirement (20, 30, 40 years) to be expected today.

As long as you don’t panic and sell most of your holdings at the worst time, and the annual withdrawals from your portfolio are reasonable and limited, then you should not really worry about fluctuations in the stock market.

The greater risk in retirement is that you invest too conservatively and run the risk of and outliving your assets. In 13 of the past 15 years, cash has produced a negative return after adjusting for inflation. So you were actually falling behind by holding cash, rather than preserving wealth. Bonds may provide steady income (and can act as “ballast” to a portfolio and limit overall volatility to make it easier to stay invested), but all you get from a bond is a particular yield for a period of years and then your original principal is returned. There is no growth to be expected. And the yield is subject to taxation (potentially) and the effects of inflation. The value of a bond is also subject to change based on the wherewithal of the issuer and rising interest rates, so bonds are by no means risk-free.

Over 20 – 40 years, you will need some growth to keep up with inflation. You will need to be invested in stocks. The question is how much?

The long term returns from the stock market actually help us answer this question. From 1950 through 2015, the worst 20 year period for the S&P 500 was a positive 5% per year (the average was 11.1%). By contrast, the worst 20 year period for the bond market was positive 1% per year (and the average was 6.0%).

If you were relying on a reasonable 3 – 5% withdrawal rate from your retirement portfolio, being invested in primarily in bonds (or cash) may actually drain your retirement assets more quickly than a portfolio more heavily weighted to stock over the course of a normal retirement today.

Academically, better outcomes are associated with higher allocations to stocks, but this doesn’t mean that you need to be in 100% stocks either. A 100% portfolio of stocks has the potential for higher returns, and all of the volatility associated with the stock market.

A better path for most retirees who are relying on their portfolio is something more balanced.

 

You may not need to invest all of your money in stocks to meet your goals.

 

Allocation                             50% stocks/40% bonds/10% cash

Best year                             76.57%

Worst year                          -40.64%

Best 30 year return               11.64% annualized

Worst 30 year return             5.84% annualized

Average annual return           7.93%

 

Data Source: Ibbotson Associates, 2016(1926–2015). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only and does not represent actual or implied performance of any investment option.

 

Having a reasonable mix of stocks (40% to 70%) and bonds may provide enough of return, either on average or in a worst case, and after factoring inflation and income taxes, to provide sustainable portfolio withdrawals in retirement. A smoother ride along the 20 to 40 year time period for a normal retirement today may help to keep you invested, which is ultimately the key to long term performance.

Staying invested during periods of volatility is challenging, but timing the market is very difficult, even for professional investors. The primary reason being that the best time to invest is inevitably when conditions are the most precarious. As a recent example, on August 24, 2015, the Dow Jones Industrial Average closed down 588 pts., which was significant enough to spook many investors.  On August 26, 2015, however, it closed up 609 pts.  This is a quick lesson on staying invest as over the course of these few days, those who did nothing missed nothing.  The reality of annual stock market returns is that they are typically comprised of only a handful of individual trading days in any given year.  Missing those days, by getting out of the market, has a material impact on investment performance.  Over the past 20 years (thorugh December 2016), missing just the 10 best days in any given year reduces the average 7.68% return of the S&P 500 by almost half to 4.00%. 

Trying to time the market and missing the best trading days can ruin even the best laid plans.  In my experience, even the best investment management can be ruined by bad planning. Common investor mistakes of not staying invested, chasing returns when they are hot and avoiding managers when they are not in favor (i.e., they are on sale) are mistakes I see routinely. Bad planning and investment mistakes (or bad advice) have much more impact on the outcome than the fee you are paying or your overall asset allocation.

What’s important is that the investment strategy chosen is suitable and appropriate for each investor’s needs. Retirement is a long term time horizon and for many retirees, choosing to be balanced and remaining invested should help you to be successful.