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Common wisdom suggests that those in their 40s and 50s who are earning a good living and saving money each year should put most of their investment portfolio in stocks, and not bonds. But what about those approaching or already in retirement? Does an equity-oriented portfolio continue to make sense? A provocative piece in the New York Times recently argued that even retirees should keep most of their funds in stocks, and that the best allocation nearly all the time is 100 percent stocks. What supports this recommendation? Are there good reasons this advice is seldom followed?

100% Stocks in Retirement? Not so fast.

The author of the Times piece notes that “reams of data” show that the stock market has bested the bond market by a very wide margin -more than 4% a year- over the past 90 years. While retirees have far less time than this, data show that even investors with a 20-year time horizon have almost always done far better in stocks than in bonds. Indeed, over periods as short as five years, stocks have done better than bonds more than 70 percent of the time.

The past is clear, and the author is confident that stocks will continue to be comparatively rewarding in the future as well. Mutual funds provide ready access to thousands of mostly well-run corporations. Research and development push technology ahead. Rising educational and training levels enhance worker productivity. Economic growth never declines over long periods of time. Those chary of stocks may be blind to these seemingly ineluctable forces.

While the Times piece anticipates reader objections, they are wanly refuted. There are in fact good reasons investors with shorter time horizons should calibrate their appetite for risk carefully. Not least of these is the recognition that in looking at stock returns in the United States over the past 90 years the author is seemingly taking it as a given that America’s markets will continue to lead the world. Leadership can in fact rotate in surprising ways. As recently as 1989, for example, the most valuable stock market in the world was that of Japan. Over the next 25 years the Japanese market fell by almost 80 percent. Did owners of Japanese bonds lose money, too? No, they did not. The risk of negative returns over long time periods may seem small, but those who would plan carefully do not dismiss it out of hand.

More importantly, if those in retirement spend down a portion of their portfolio each year, persistently negative cash flow is a given. The attendant reduction in portfolio value can either be offset by good portfolio returns or magnified by bad markets. As such, even if long-term rates of return are assumed to be in line with historical averages, the sequencing of returns can have a major impact on a retiree’s wealth. Returns in the earliest years of retirement, when the portfolio is presumably largest, are proportionately more important than returns earned after the portfolio may have been substantially reduced via consumption. If you plan on retiring tomorrow, the most important year for your portfolio is just about to begin.

At the risk of cherry picking an unusually adverse time period, the table below measures a conservatively balanced portfolio (40% stocks and 60% bonds) and a very aggressive portfolio (90% stocks and 10% bonds) during this 21st century. Owners of these portfolios are assumed to be in retirement and spending 6% of the value of the portfolio each year to meet obligations. Although stocks and bonds have had fairly similar annual returns thus far this century, with bonds at 5 percent per year and stocks at 4 percent, the aggressive investor has been greatly disadvantaged by the fact that two major bear markets occurred in the first decade of retirement. The shaded years, imagining future returns in which stocks best bonds by 5 percent per year (reflected in hypothetical portfolio returns of 2% for the conservative portfolio and 5% for the aggressive portfolio), suggest that the consistently more aggressive investor is unlikely ever to catch up with the more cautious investor when both annual distributions and terminal portfolio value are considered. This particular time period might well be written off as one of unusually bad luck, but otherwise financially secure investors on the cusp of living without a paycheck for the first time in decades might just as well be inclined to look at this data and think, “that’s precisely the kind of risk I intend to mitigate.”

Terminal Value.

Total Withdrawals.

Total Withdrawals.

Total Withdrawals.
Total Withdrawals.

A third if not final reason to limit one’s allocation to stocks is simple psychology. Few investors in retirement are able to endure substantial portfolio losses and maintain confidence in a successful long-term outcome. Years of unanticipated financial anxiety and emotional stress increase the likelihood of switching to a more conservative portfolio at a bad time. The chart above only shows portfolio values at the end of the year, but most of us look at our portfolio values more often than that. Ask yourself what decision you might have made if eight years into retirement your $1 million portfolio had been reduced to $345,000, about where it would have been before the recovery began in March 2009. How reassured would you have been to know that over long time periods the odds were in your favor? In fact, for many investors selling at the bottom does not signify psychological weakness; it is a matter of necessity dictated by sober recognition that a continued decline in the stock market may well lead to financial ruin.

The Times piece cites Warren Buffett to inform this discussion, noting that he has established a trust for his wife which will include an allocation to bonds of just 10 percent. Far be it from us to take issue with Warren Buffett’s asset allocation decisions, but we note that if his wife is heir to just 1 percent of his estate, and if she in turn has only 10 percent of that 1 percent in bonds, then her allocation to bonds will still be worth roughly $60 million. Just as the sequence of returns and one’s potentially diminishing tolerance for volatility need to be taken into account, investors are wise to honor the primacy of personal financial planning exigencies, including both cash flow requirements and also the desire to preserve and/or grow wealth for heirs and beneficiaries. Your next door neighbor’s asset allocation is likely more suitable for you than is Mrs. Buffett’s.

Stocks are very likely to outperform bonds for those with medium and long-term investment time horizons, and they should form a key building block even of retirement portfolios. Extremely high allocations to stocks within a nest egg subject to constant withdrawals is every bit as risky as it seems, however, and there are good reasons almost no one invests in this way. Having said that, if you are confident you will be prominently featured in Warren Buffett’s estate plan, by all means go ahead and let it rip.

Filed under: Investing

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