How to Sabotage Your Road to Retirement

No one wants to sabotage their retirement planning, unfortunately, it’s pretty easy to do. Would you invest all of your money in the stock market? Too Risky? How about all of your money in bonds? Not enough risk? How about all of your money in your mattress? Too many bedbugs? Too many termites?

In this article we will contrast and compare the returns that you might get when you invest using various investment models. Investing too much in stocks might be gut wrenching; investing too heavily in bonds might not allow you to retire. Perhaps the most important investing decision is your asset allocation. Not which stocks to buy, not which mutual funds to buy, but your asset allocation.

An asset allocation is just a fancy term for how much of your investment is allocated to each investment category. For instance, you might invest 50 percent in stocks and 50 percent in bonds. That would be a 50/50 stock-to-bond asset allocation. It’s really just that simple. Investment advisors, those in the financial marketplace, and even your investing buddies might try to make everything sounds more complicated than that, but that’s really all there is to it. Decide how much you want to invest in stocks, how much you want to invest in bonds. Invest every year, no matter what. Periodically reallocate your portfolio, if you choose to. Rinse. Repeat. Wait 40 years. Retire.

Earthquake impact

Source: Mike Campbell via Flickr

How to Sabotage Your Portfolio
So how can you sabotage this? Easy. Simply invest too little or too much in stocks. Bonds are needed, to minimize the cracking that a dramatic stock market decline can cause on your road to retirement. Most of your gains will come from stocks. Bonds mainly serve to limit how much you can lose in a year. Yes, the larger your investment allocation is in bonds, the less impart market gains will have on your portfolio, but they are also lessening the losses. Just think back 7 or 8 years ago.

Stock Market Implosion
In 2008 and 2009, the financial markets imploded. The stock market lost 38.5 percent in 2008. If you had all of your money invested in an S&P 500 index fund, your portfolio would have lost more than one-third of its value that year. Ouch! Bonds served to mitigate that decline.

Below is a chart which illustrates what you returns might have been based upon various stocks-to-bond asset allocations. The chart, courtesy of Vanguard, looks at historic returns over a 90-year period, from 1916 through 2015.

There are a lot of numbers in this chart. Each line considers an asset allocation, starting with an extremely conservative allocation — an allocation of 0% in stocks and 100% in bonds — increasing the stock allocation on each succeeding line, eventually reaching the reverse, a complete stock allocation — 100% stocks and 0% bonds.

Stocks Bonds Annual Return Best Year Worst Year Years with a Loss
0% 100% 5.40% 1982 32.60% 1969 -8.10% 14 of 90
20% 80% 6.70% 1982 29.80% 1931 -10.10% 12 of 90
40% 60% 7.80% 1933 27.90% 1931 -18.40% 16 of 90
50% 50% 8.30% 1933 32.30% 1931 -22.50% 17 of 90
60% 40% 8.70% 1933 36.70% 1931 -36.60% 21 of 90
80% 20% 9.50% 1933 45.40% 1931 -34.90% 23 of 90
100% 0% 10.10% 1933 54.20% 1931 -43.10% 25 of 90

As you can see in the third column, as you increase you asset allocation towards stocks, the average annual return increases as well. An all-bond portfolio over the past 90 years has had an average annual return of 5.40% each year. That might seem incredibly high today given recent bond returns. (Today, the 30-year US Treasury is yielding just 2.65%, somewhat above it’s all-time low of 2.25% set in early 2015.)

More Risk, More Return
As you increase your stock allocation, the return steadily increases. A 60/40 stock/bond allocation — an allocation which many financial advisors suggest as being optimal for many people — has returned 8.70%.

The most interesting data in this chart is the best and worst yearly returns. As I stated above, the financial market meltdown in 2008 resulted in a 38.5% decline  that year. That decline is dwarfed by the 43.1% decline during The Great Depression. Having all of your money in stocks can dramatically squeeze your net worth.

Building in a Safety Net
If you had a 60/40 stock/bond allocation in 2008, you would have lost about 21% that year. While still significant, it’s far less than the 38.5% that anyone with a 100% allocation to stocks experienced.

On January 1, 2008, the 30-year bond was yielding 4.33%. If you had $100,000 on that day invested in a 60/40 stock/bond allocation, your S&P 500 index fund and 30-year bond investment portfolio would have ended the year with a market value about $78,650. Someone who had all of their money in an S&P 500 index fund would have ended the year with a portfolio worth just over $61,530.

I am never going to suggest that you have an portfolio that is heavily weighted towards bonds. Investing in bonds typically does not allow you to keep up with inflation. The money that you are investing will likely not be worth as much years later when you need it. Bonds primarily just serve to cushion down years in the stock market.

You Never Know
You never know when the stock market will have significant losses. Imagine if you retired in 2007 and started withdrawing money from your investment portfolio the following year. You would be depleting your retirement portfolio at the worst possible time. Since it’s quite difficult to time the market, you need to have a margin of safety so that when it comes time to take money out of the market, you likely won’t have to take out as much from stocks during down years.

What Asset Allocation is Right For You?
You need to decide on an allocation plan that you are comfortable with and then stick with it. Some people increase their bond allocation as they age. Some people choose to invest 40 percent in stocks for their entire investing lifetime, others are somewhat more aggressive and invest 50, 60, or even 70 percent of their money in stocks. Benjamin Graham, author of The Intelligent Investor (probably the most-respected investment book ever written), has one suggestion. He advocates:

  • Using a 50/50 stock/bond allocation as a baseline, and
  • Shifting as far as 25/75 in either direction, based upon current market conditions.

Time the Market?
I wouldn’t suggest that you try to time the market, but I would agree with Graham that you should have at least 25% allocated to stocks and no more than 75% in stocks. An asset allocation outside these boundaries would likely sabotage your retirement. You would likely either not have enough cash when it came time to retire due to too heavily investing in bonds or you might stumble upon  a major market correction and have your heavily stock weight portfolio take a significant hit. Most people are much better off with an allocation at/or near the middle of the allocation spectrum.

If you were to invest with a goal of 50 percent in stocks and 50 percent in bonds, you would make periodic investments putting half in stocks and half in bonds.

Mutual Funds or ETFs?
I would suggest that if you are not going to closely monitor your portfolio, you are probably better off in index funds. They funds are low cost and typically have low turnover. You could invest using either mutual funds or ETFs (Exchange-Traded Funds). The primary difference between the two is that mutual funds (including index funds) are priced once a day, after the market closes. ETFs can be bought and sold at any time during when the stock market is open. To avoid the temptation to trade too often, I’d suggest that most people would be better off with index funds instead of ETFs.


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