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The million-dollar investing mistake

Reprinted courtesy of MarketWatch.com.

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Millions of investors are giving up millions of dollars in lifetime gains if they follow an old rule of thumb that’s been making the rounds for as long as I can remember.

That formula: Determine how much of your portfolio should be in bonds by subtracting your age from 100. For example, if you’re 25, keep 25% of your portfolio in bonds and 75% in equities.

I don’t know whether or not many people actually follow this widely cited advice. But those who do so when they are young could be cheating themselves out of huge amounts of money, as we shall see. To its credit, this rule of thumb is a simple and easy-to-understand attempt to show investors how to do the right thing: become gradually less aggressive as they get older.

But for most young investors, owning bonds is worse than unnecessary. When you’re 25, you have an abundance of a terrific asset that you will gradually lose: time. You should use that time to take advantage of the long-term expected growth of equities.

The old formula prescribes “protecting yourself” in bonds with 25% of your money at that age. That could make sense if you already have made your fortune and you’re just trying to hang onto it.

However, most 25-year-old investors are (or should be) regularly saving money. Logically, they should take advantage of stock-market declines by using them to buy assets at lower prices. Of course, investors need a “glide path” to reduce their equity exposure as they age. Fortunately, there’s a much better way to do this than following that old formula.

There are three steps to my substitute recipe for the right glide path. First, young investors should have 100% of their portfolio in well-diversified equities. Second, when they reach their middle years, they should start pulling back and adding bonds. Third, when they retire they should limit their equity exposure to 50% or 60%.

I’ll tell you just how to do that, and then we’ll look at some numbers to see how this substitute glide path could be worth $1 million or more.

Step 1: Invest all your money in equities until you’re 35 years old.
Step 2: When you’re 35, decide whether you consider yourself a conservative investor or a aggressive investor. If you’re conservative, move 20% of your portfolio into bonds; If you’re aggressive, move only 10% into bonds.
Step 3: For the next 30 years, move another 5% of your portfolio into bond funds at five-year intervals. By the time you’re 65, you’ll have either 60% (if you’re aggressive) or 50% (if you’re conservative) in equity funds. This is a good allocation for the rest of your life.
I believe this accomplishes the goals of a proper glide path. It keeps you fully invested in equities while there’s ample time on your side. It gradually pulls back your equity exposure to start defending your savings in your middle years. And when you’re retired, it gives you adequate representation in both bonds (to defend against market declines) and equities (to keep up with inflation).

Now let’s see if this is really worth a million bucks to a typical investor.

Assuming a 25-year-old investor adds $5,000 a year for 40 years, here’s the comparison. Using returns over the most recent 45 calendar years, I assume the equity part of the portfolio earns 10% and the bonds 4%.

Age 25-29: The traditional formula prescribes 75% equity and 25% bonds; this compounds at 8.5%. My recommendation compounds at 10%.
Age 30-34: The traditional formula prescribes 70% equity and 30% bonds, compounding at 8.2%. My recommendation compounds at 10%.
Age 35-39: The traditional formula, 65% equity and 35% bonds, compounds at 7.9%. My aggressive recommendation compounds at 9.4%.
Age 40-44: Traditional formula: 7.6%; my aggressive recommendation: 9.1%.
Age 45-49: Traditional formula: 7.3%; my aggressive recommendation: 8.8%.
Age 50-54: Traditional formula: 7%; my aggressive recommendation: 8.5%.
Age 55-59: Traditional formula: 6.7%; my aggressive recommendation: 8.2%.
Age 60-64: Traditional formula: 6.4%; my aggressive recommendation: 7.9%.
Age 65 and beyond: Traditional formula: continues to decline as more and more bonds are substituted for equities. My aggressive recommendation, constant at 60% equities, 40% bonds, compounds at 7.6% for life.
Throughout this period, the returns from my recommendation exceed those from the traditional formula by at least 1.5 percentage points.

Assuming $5,000 is added every year for 40 years, at age 65, the portfolio would be worth $1,048,873 following the traditional formula. Following my alternate recommendation (aggressive), the portfolio would be worth $1,571,395.

That gets us more than half way to qualifying for a “million-dollar mistake.”

Depending on how aggressively this investor decides to withdraw money during retirement (and, of course, on how long he or she lives), the total of all distributions plus the portfolio’s value at death could easily turn out to be two to four times as high following my recommendation.

Even if only $5,000 is invested for 40 years — which is below what most people will actually do — this lifetime result of my aggressive recommendation will be at least $1 million greater.

Without doing the actual math, I’m confident that will be the case with my conservative glide-path recommendation as well.

The $1 million difference doesn’t result from investing more money. It doesn’t result from investing in risky securities or speculating in gold or individual stocks. It results only from adding a bit to your annual returns by reducing your bond exposure in the pre-retirement years.

In this case, we added 1.5 percentage points to a lifetime of returns. Even doing one-third as much can make an enormous difference over a lifetime, as I wrote last year.

One popular alternative to the traditional formula is the target-date retirement fund. But I think it’s a poor alternative. For details, check out my podcast “Three Ways Target Date Funds Fail Investors”.

Richard Buck contributed to this article.