Archives for July 2011

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Should You Own Stocks in Retirement?

Historically, stocks have earned significantly higher returns than less volatile investments like bonds, cash, and CDs. And that makes sense–their higher volatility should be compensated in the form of higher expected returns.

What I find particularly interesting is that, despite the additional expected return that stocks get you, they don’t really allow you to (safely) increase your retirement spending by very much–at least not in the early part of retirement.

“Safe” Withdrawal Rates

The withdrawal rate figure most often suggested for a 30-year retirement using a typical stock/bond portfolio is 4%. That 4% withdrawal rate isn’t exactly bulletproof though. For example, as researcher Wade Pfau recently explained, while the 4% rule has worked reasonably well in the U.S., it’s had significantly worse results in other developed economies:

“In the years since 1926 and for a 50/50 asset allocation, the 4% rule would have failed retirees in 10 of the 17 developed countries more than 25% of the time. Remarkably, the 4% rule would have failed more than 70% of the time in Spain and Italy.”

In contrast, consider a hypothetical, very low-risk portfolio (consisting primarily of TIPS, with some short-term Treasuries and CDs thrown in the mix). If that portfolio can earn a zero percent real return every year (that is, it matches inflation but never surpasses it), it would safely fund a 3.33% inflation-adjusted withdrawal rate over 30 years (because 100% ÷ 30 years = 3.33%).

That’s only 0.66% lower than the not-entirely-safe 4% withdrawal rate from a portfolio that allocates a significant amount to stocks.

What About Annuitizing?

If we throw a lifetime annuity into the mix of the low-risk portfolio, the gap gets even smaller. Based on Vanguard’s quote provider, even with today’s low interest rates, a married couple (both age 65) could get a single premium immediate lifetime annuity (with inflation adjustments and a 100% payout for the surviving spouse) with a payout of 4.25%.

If we assume half the portfolio is allocated to such an annuity and half is allocated to the other low-risk investments discussed above, that would allow for a withdrawal rate of 3.79% (the average of 4.25% and 3.33%). That’s pretty darned close to 4%, and we haven’t allocated a dime to stocks or other high-risk investments.

So Why Would Anyone Own Stocks in Retirement?

While allocating a part of your retirement portfolio to stocks doesn’t dramatically increase the amount you can spend each year at the beginning of retirement, it does get you two things:

  1. The possibility of higher spending in the later stages of retirement, and
  2. The possibility of leaving a big pile of money to your heirs.

For example, with a significant portion of your portfolio allocated to stocks, you might find that after 15 years of retirement, your portfolio has actually grown in inflation-adjusted value to twice its original size (something that just wouldn’t happen with a portfolio comprised exclusively of super-low-risk investments).

At that point, with 15 fewer years remaining and a larger portfolio than you started with, you can probably safely increase the rate at which you’re spending. Alternatively, you could keep your rate of spending the same in order to leave a large inheritance to your kids or other loved ones.

In other words, the compensation for taking on risk by including stocks in your retirement portfolio isn’t that you automatically get to spend a great deal more from the outset of retirement. The compensation is that you might get to spend a great deal more during the later stages of retirement.

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Components of Investment Risk

The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.

Time as a Component of Risk

When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.

For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.

Why is he thinking about that?

He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.

When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.

Probability of Loss

The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.

Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.

Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.

Magnitude of Loss

The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.

Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.

Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.

When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.

In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.

About the author: Neal Frankle is a Certified Financial Planner in Los Angeles and runs Wealth–a personal finance blog for people interested in making smart decisions about their money.

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