Retirement savers: Fine-tune your asset allocation
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
The biggest job facing any investor is managing risk. Take too much and you are flirting with disaster; but take too little and you could cheat yourself out of the returns needed to care for yourself, your family and your heirs.
Fortunately, it’s not terribly hard to get this right. You do that by allocating some of your portfolio to equity funds and the rest to bond funds. The key question is how much you should have of each. That’s what this article is all about.
At the heart of this presentation is a big table of numbers that shows year-by-year hypothetical returns for 11 combinations of investment assets from 1970 through 2013. You can click here to find the table .
At the bottom, the table shows the worst-case periods an investor would have experienced in each combination. This shows the bad times through which you must persevere if you hope to reap long-term returns like those shown in the table.
Until 2008, the worst-case scenarios shown in this table came from the bear markets of 1973-74 and 2000-02. Now, most of the worst periods involve 2008 and early 2009. The long-term return of every portfolio in the table with more than 20% equity was reduced by those losses. I think the table is now a better guide to what investors may reasonably expect.
(The numbers in this table assume the equity part of the portfolio was thoroughly diversified as described in my previous article, “The Ultimate Retirement Strategy.”)
The question now is simple: How much in equities and how much in bonds? A very simple approach is to split all investments equally between stocks and bonds. Such a 50/50 portfolio historically has an excellent record of producing a decent return with much less risk than the S&P 500 index.
The table shows other possibilities . Annual performance figures in each column are for readers who like lots of data. Each of those numbers represents a return that investors got, or would have gotten, in a particular year using a specific allocation strategy (after deducting an assumed annual investment advisory fee of 1% in all cases, except the S&P 500 index).
Let’s turn our attention to the figures at the bottom of each column that summarize the 44-year results. For example, if you trace the numbers in the 60/40 column down from the top, you’ll see the year-by-year performance from 1970 (a gain of 3.4%) through 2013 (a gain of 11.9%). And you will see that this combination produced a compound rate of return of 10%; its standard deviation, a measure of volatility or risk, was 9.2%. (Keep in mind that lower numbers mean lower volatility.)
The far right-hand column shows that the S&P 500 had a slightly higher return, 10.4%. But that came at a cost of a much higher standard deviation, 15.5%. Compared with the S&P 500, the 60/40 portfolio produced about 96% of the long-term return of the U.S. stock market while subjecting investors to only 59% of the risk.
I would also call your attention to the line near the bottom of the table showing, in percentage terms, the biggest 12-month loss you would have sustained for each allocation. The lesson is this: If you want the returns, you have to be willing and able to sustain the interim losses. Many investors learned this the hard way in 2008 after they had invested too aggressively.
In other words, in real life, you’ll never get those appealing returns if you don’t stick with the program you select. And you won’t stick with the program if you bail out when things get uncomfortable.
The whole point of the table and of this article is to let you run your fingers back and forth on those bottom lines and search for a combination of stocks and bonds that produced losses you think you could tolerate.
I’m struck by the difference between the diversified 100% equity portfolio and the S&P 500 index. The former was clearly superior, with a 15% improvement in return (12% vs. 10.4%). That difference is much greater than it might seem over a long period of years. Over 30 years, $1,000 would grow to $29,960 at 12% vs. only $19,457 at 10.4%. At the same time, the massive diversification reduces risk.
Still, any all-equity portfolio involves substantial risks. Not many investors can be sure they’ll keep their cool in the face of losses like those shown at the bottom of the all-equity columns in this table.
A long-term return of 12% may be more than you need to meet your goals. After many years of working with investors, I believe most retirees can meet their needs with a long-term return of 6% to 10%.
I think the 30% to 50% equity portfolios are worth considering for conservative investors. I personally use the 50/50 combination.
Investors often tell me they want the highest possible returns. But when I suggest that they put all their money in pork belly futures or bet their life savings on Google GOOG -2.79% stock, they quickly change their tune.
My advice is to start with the all-equity column and work your way to the left until you find a column where you can tolerate every risk item. When you find that column, you have an idea what percentage of equity allocation could be right for you.
What if you need the returns from a column that has too much risk? Your first impulse might be to go for the high return and ignore your discomfort. But I think that is just asking for trouble. If your needs straddle two columns, choose the one that has the right level of comfort.
I say this for two reasons. First, the figures in the table are not predictions, only hypothetical results from the past. And the past is a more reliable guide to future risks than to future returns. Second, it’s never a good idea to violate your risk tolerance.
If you learn only one thing from this article, I hope it is this: Never ignore your emotions or your “better judgment” to chase higher returns.
If you settle for lower returns to reduce your risk while you are still working, you might have to work longer or save more each year before you retire. But that is much better than retiring with too little money because you overexposed yourself to risk. If you are already retired, accepting lower returns might mean you will have less money to spend. But that is far better than suffering losses that put you in danger of running out of money.
For most people, finding the proper balance between risk and return can be quite challenging. Most investors can benefit from the help of a professional adviser to navigate these waters, and in fact this is one of the best reasons I can think of to have an adviser.
A good adviser not only helps an investor find the right balance of risk and return, a good adviser will do everything possible to keep the investor on the agreed upon course. With regard to hiring an adviser, I recommend you read my book, ” Get Smart or Get Screwed: How To Select The Best and Get The Most From Your Financial Advisor ,” available as a free download athttp://paulmerriman.com/ .
“It is the set of sails, not the direction of the winds, that determines which way we will go.” ~ Napoleon Hill
Whether ” Fine Tuning Your Asset Allocation ” helps you choose calm or turbulent waters, I hope you safely reach your financial destination and enjoy the results of being a savvy investor.
Richard Buck contributed to this article.