Conventional wisdom says that investors should determine the percentage of their portfolio they invest in stocks by subtracting their age from 100. The rest of their portfolio should be spread between bonds and cash. According to this wisdom, a 30-year-old investor will have 70 percent of his assets in stocks and 30 percent in bonds and cash, and a 65-year-old investor will hold only 35 percent in stocks and the rest in bonds and cash.
This approach, which is used by many individuals and old fashioned defined benefit retirement plans, emphasizes reducing investment risk and producing enough bond interest to pay benefit checks when workers retire.
However, it has a problem. The interest earned on bonds and cash is not enough to support a comfortable lifestyle for the average retiree today.
The facts are that:
_ Investment-grade bonds have averaged only 5.7% annual return over the last 70 years and are currently earning even less. After fees and expenses, the return can be quite small. And worse yet, money market funds are currently paying almost nothing.
_ Retirees need to plan on their money lasting a long time. A person who retires at 62 today may be alive and well in 35 years and still have bills to pay.
_ Inflation erodes the real value of the rate of return over time. Even a moderate inflation rate can cut the real earnings rate in half, so that 5.7% becomes less than 3%.
_ Very few people have saved enough in their retirement accounts that they could support their lifestyle throughout retirement if they earned so little on their investments. When we prepare a financial plan, we assume that a retiree will earn at least 6% per year on their investments after all fees and expenses. You would need to be truly rich or extremely frugal to live on a portfolio predominantly invested in bonds if you retired today.
We think retirees should strive to earn a higher rate of return by holding more stocks and fewer bonds so that they can afford a comfortable retirement. We think that with reasonable safeguards a retiree can hold 60% to 70% of their portfolio in stocks, and be able to ride out the ups and downs of the stock market.
_ Over the same 70-year period as noted above, stocks have earned an average annual rate of return of 11%.
_ Only nine times in the last 74 years has the stock market been down over a five-year period. (Four of those were during the Great Depression and two were in the last three years.)
_ Not since 1939 has the market been down for a 10-year holding period.
But what about the short term?
Safeguards must be in place because investors retiring today cannot tolerate three to five years of negative returns while �living off of their investments.� After five years of living off of their principal, they would have little money left to grow back once the stock market finally turned around.
To protect against this problem, we make sure that retirees do not need to draw heavily on their principals. We do this by making sure that 60% to 80% of the money retirees draws from their accounts comes from income earned in the form of interest and dividends. To earn this income, we invest in bonds, preferred stocks, stocks with higher-than average dividends and real estate investment trusts, all of which have high yields.
This approach allows the principal to ride through the troughs and the retiree to enjoy the long term advantages of stocks over bonds.