This surprising choice can have a big impact on your wealth in retirement
Reprinted courtesy of MarketWatch.com
Published: Dec. 2, 2017
To read the original article click here
After a long, profitable run, the stock markets fell in 2018, then headed upward early this year before retreating to current levels.
What’s an investor to do? When should you head for the exits?
When should you hold tight?
Of course there is no way to know these things until after the fact.
Investing in equities is all about accepting and managing risk.
It might seem like a daunting task, but it’s actually quite possible if you’re willing to examine some investment returns from the past, then examine your own psyche — and see how they fit together.
This is our topic today.
It’s well known that, in broad terms, risk and reward go together.
If you want high returns, you have to take significant risks. And if on the other hand you want to seriously minimize your level of risk, you’ll need to settle for lower long-term returns.
There are many ways to tweak your risks, but the most important one by far is to adjust the balance of your portfolio between stocks and bonds.
For most investors, the ideal portfolio is likely to include both equities (for growth) and fixed-income funds (for income and portfolio stability).
To illustrate the trade-offs, I’ll make some comparisons using only the S&P 500 SPX, 0.06% to represent stocks and only intermediate-term Treasury bonds to represent fixed-income investments.
This simple combination is not what I recommend for most investors, but it’s a good way to illustrate how risks and rewards work together.
The following comparisons of returns and risk factors are based on market data for 49 calendar years, 1970 through 2018.
Here’s the basic question: How much of your portfolio should you hold in equity funds and how much in fixed-income funds? (When I refer to funds, I mean to include mutual funds and exchange-traded funds or ETFs.)
Let’s compare returns and a few risk factors from 1970 through 2018.
In table 1, You’ll see the results over this period for three quite different allocations: 20% equities for the very conservative investor, 50% equities for the moderate investor, and 100% equities for the aggressive investor.* In each case the remainder of the portfolio is in intermediate-term Treasury bonds.
Table 1: Three choices of bonds vs. equities
| PERCENT IN S&P 500 | COMPOUND RETURN | STANDARD DEVIATION | WORST IN 12 MONTHS | WORST DRAWDOWN |
| 20% | 7.7% | 4.6% | -8.6% | -8.9% |
| 50% | 8.8% | 8.0% | -23.2% | -25.9% |
| 100% | 10.2% | 15.1% | -43.4% | -50.9% |
These three variations make it obvious that higher returns — and higher risks — go along with higher proportions of equities in a portfolio.
I have long believed that a moderate allocation of 50% in equities may be suitable for many — perhaps even most — investors, including those who are retired. This is the approach I take with my own investments.
But younger people can afford to take more risk, and they should do so while they are accumulating assets. Likewise, some investors are quite uncomfortable with equities; for some, a 20% to 30% equities stake is all they want to take on.
Fortunately, there are lots of choices. You’ll find other combinations, in 10% increments of equity exposure, in the full table.
Large institutional investors such as insurance companies and pension funds traditionally adopt an allocation of 60% equities and 40% fixed-income funds. These large investment pools need growth to stay ahead of inflation, yet they also need ample protection from catastrophic losses so they can meet their obligations to retirees.
In table 2 below, I show the results of such a 60/40 portfolio with the same parameters as those in table 1 above.
Table 2: 60% equity, 40% fixed income
| PERCENT IN S&P 500 | COMPOUND RETURN | STANDARD DEVIATION | WORST 12 MONTHS | WORST DRAWDOWN |
| 60% | 9.1% | 9.3% | -27.6% | -31.7% |
When you compare these numbers with those of the 50/50 portfolio in table 1, they bear out one of my consistent observations over the years: Every 10 percentage point increase in equities, over the long term, results in an additional 0.2% to 0.5% increase in return.
That might not seem like much of a difference, but an initial $10,000 investment at 9.1% (table 2) will grow in 40 years to $325,829. At a rate of 8.8% (the 50% equity portfolio in table 1), that $10,000 will grow to “only” $291,847.
The difference is significant, and when it is applied to more dollars and more years, it can be life-changing.
Still, we cannot know what the future holds. All we can know is the past.
There are so many ways to slice and dice the returns and risks of the past that you can cherry-pick whatever numbers will support the conclusion you’re looking for.
Many brokers and advisers engage in a variation of this by focusing just on the good times:
• See how much money this strategy can make!
• See how great this fund is!
By contrast, when I present past investment results I like to dig a bit deeper. For example, I always look for the rocky spots, the bumps in the road. Many times I have issued a guarantee that investors who take my advice will lose money along the way.
In the past, such losses have turned out to be temporary, at least for investors who stayed in the game. But not everybody can stay in the game when losses are severe or prolonged.
That’s why I make a point to highlight the worst returns in periods ranging from three months to 60 months. I also calculate and report the worst drawdowns, the declines from high points to lows before recovery begins.
This can give investors a sense of what they may have to withstand in order to earn the expected long-term rates of return.
Accordingly, tables 1 and 2 contain figures for the worst 12 months and the worst drawdowns.
In the full table, I have these and other data points for various combinations of stocks and bonds.
Briefly, here are three other points to note from these 49-year results.
1. I think the 10.2% return of the S&P 500 over this period is reasonable as an expectation for future long-term periods. But I find it hard to believe that fixed-income investments will continue to advance at 6.9%. From 1926 through 1969, government and corporate bonds returned only 2% to 3.3%.
2. With the benefit of knowing how things turned out, it’s very easy to decide that the risks of equity investments were worth taking. But “staying the course” meant sucking it up enough to accept severe bear-market losses in 1973-74 (37.4%), 2000-2002 (-37.8%) and again in 2008 (-37.1%). And this doesn’t even mention a sickening one-day loss of 22.5% in October 1987.
3. There’s no evidence at all that anybody can predict the timing or severity of such losses. However, the evidence is clear that fixed-income investments mitigate those losses. If you use bond funds to provide an extra measure of fixed-income, you should expect lower long-term returns. But if smaller interim losses keep you in the game, the reduced return can be a price that’s very worthwhile to pay.
There’s much more to say about all this, and I encourage you to check out my podcast “What every investor should learn from the Fine Tuning Table.”
NOTE: Figures cited here for the S&P 500 index are for the index itself, which is not directly available to investors. In the full table, returns in all the portfolio columns, including that for 100% invested in the S&P 500, are reduced by 0.1% to reflect possible expenses of owning the assets through index funds or ETFs.
Richard Buck contributed to this article.I’ve been studying the long-term investment options that make sense for workers in their 20s, and I was surprised at what the numbers revealed.
It turns out that in the long run, your choice of employer may have the biggest impact on your nest egg at retirement. The reason: some employers are much more generous in their retirement plans than others.
Obviously, most young people don’t — and probably shouldn’t — start their job searches by shopping for retirement plans.
But retirement plans can make so much difference that they should be a factor in deciding where you will work.
I’ll build my argument step by step so I can support it with credible numbers.
To do that, I assume an investor starts at age 25 and invests $5,000 a year for 40 years, with the final contribution at age 64. For now, I’ll assume there is no “company match” and that the investor’s retirement portfolio is based only on their own contributions.
Below are four options for this situation. I have given each of them a “comfort score” based on a scale of 1 (extremely uncomfortable) to 5 (should be very comfortable). These scores are totally subjective, reflecting my personal judgment and experience.
Option 1: $1,601,406
As I’ve written before, the target-date retirement fund (TDF) is among the greatest modern inventions that benefit individual investors.
Read: 7 ways to improve target-date funds
So for a baseline reference point, I assume your employer offers such a fund, and you use it exclusively for 40 years. I also assume that particular fund achieves a compound return of 8.8%. That’s the historic return for investments that replicate Vanguard’s TDF approach by using index funds and keeping expenses low.
Under all those assumptions, you’d be able to walk out the door at age 65 with a retirement fund worth $1,601,406.
One of the beauties of the TDF is its “glide path” that gradually shifts your portfolio more toward bonds as you approach the magic “walk-out-the-door” date.
This is an entirely reasonable option and (under my assumptions about return and ignoring inflation) will multiply your $200,000 in total contributions by eight.
Comfort score: 5.
Option 2: $2,212,962
While the TDF is a fine option, its portfolio is unnecessarily conservative for investors with more than 20 years before retirement.
To address this in what I think is a reasonable way, you can allocate 80% of your contributions into the TDF and the remaining 20% to a small-cap value fund, assuming one is available through your plan.
This gives 20% of your portfolio the opportunity to grow at a much faster rate while the rest remains protected from the risk of small-cap value stocks. The expected return from this combination is 10%. Here’s an article with more details on this proposal.
Comfort score: 4.
Option 3: $2,039,980
In every retirement plan I’ve seen, there’s an option to invest in an index fund that attempts to replicate the S&P 500 index SPX, -0.86% .
This all-stock option will likely provide long-term growth (9.7%) beyond what you’ll get with a target-date retirement fund. Your returns will closely track what most people regard as “the market,” and you’ll be alternately grinning and cringing along with millions of mainstream investors.
It’s a very simple strategy to understand and implement.
However, this option gets a significantly lower comfort score, as it has no fixed-income funds to provide a buffer during market downturns. This deficiency is particularly important during the 10 to 15 years leading up to your expected retirement.
Comfort score: 2.75.
Option 4: $3,943,501
The 12.1% compound expected return from this option provides a lot more money than any other. Where does the higher return come from?
This all-value equity portfolio consists entirely of value funds, which have a significantly higher long-term expected return — but which are considerably more risky.
This approach has much to recommend it when you’re young, say from age 25 to 45. In those years the volatility matters much less, and the robust long-term growth will likely make a huge difference.
In the latter half of your working and saving years, your portfolio’s job needs to gradually shift toward preserving your gains, and an all-value portfolio is more risky than most investors will tolerate well as they approach retirement.
Comfort score: 2.
Those four basic choices can be mixed and matched, of course. A 50/50 combination of Options 1 and 4 could make a lot of sense until you’re 10 years from retirement, after which you could choose Option 1 or Option 2.
Read: Experts say this is the idea retirement savings timeline
The even bigger choice: Who you work for
In many workplaces, there are no matching contributions from your employer; your own payroll contributions will have to do all the work. But in many cases, your employer will match part of your contributions.
Some employers will match 100% of what you contribute, but a 50% match is much more common.
To see the final impact that a 50% employer match can have, just multiply the numbers in the options by 1.5.
Option 1 grows to $2.4 million; Option 2 grows to $3.3 million; Option 3 grows to nearly $3.1 million; Option 4 grows to $5.9 million.
These higher numbers are particularly appealing because they don’t entail any additional investment risk.
So if you have a choice among prospective employers, retirement plan details can matter enormously.
Obviously, I can’t pick an employer for you. But I can give you a few examples and point you to some resources if you want to explore what’s out there.
Short descriptions of matching benefits can be confusing because two percentage figures come into play. For example, an offer of “50% of the first 6%” means that if you contribute 6% of your pay, the company will add an additional 3% for a total of 9%.
Read: Your 401(k) match may have some strings attached
A few examples of employer matches:
•Google GOOG, -1.16% : 100% up to $3,000.
•Apple AAPL, -1.34% : 50% of the first 6%.
•Facebook FB, -0.31% : 50% of the first 7%.
•Citibank C, -0.31% : 100% on the first 6%.
•Gilead GILD, -0.19% : 100% on the first $10,000.
Here’s an article with those and other examples.
Some companies pay much more. At Microsoft MSFT, -0.48% , for example, if you contribute the federal limit of $18,000, you get a company match of $9,000.
For more ideas, on how to retire early or retire with more, check out my podcast “34 ways to get more from your 401(k)”.
Richard Buck contributed to this article.
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