"The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological." -Howard Marks
The conventional wisdom for a soon-to-be retiree is to “de-risk” their portfolio by allocating more towards fixed income (bonds, CDs etc.) and less to equities. Some may be familiar with rules of thumb such as “age in bonds”, meaning if you are 65 years old you would allocate 65% of your money to bonds.
Age in bonds is flawed, as it would suggest a 35-year-old should have 35% of their money in bonds. As a 35-year-old myself, I would consider that…. suboptimal. Many have caught on that age in bonds is not great advice, which is why it has commonly been tweaked to “age minus 20 in bonds”.
Rules of thumb are convenient for easy decision-making but are unlikely to be an optimal approach for most people.
The common belief is that bonds are less risky than equities, and when someone’s human capital is exhausted they cannot afford portfolio value declines like they could during their working years.
If you are invested in a target retirement fund (i.e. The Vanguard Target Retirement 2025 Fund), you will automatically be investing more in bonds as you get closer to retirement. This might make someone feel warm and fuzzy, but is it a good idea?
Below is the approach used by Vanguard to construct their target retirement funds glide path. You will see that the allocation never goes below 30% in equities. A 20-year-old having 10% in bonds? What’s the point of that? It does very little in terms of reducing risk but can drag on returns over time.
Further, would 50%-70% in bonds for a retiree possibly be TOO much? I’d argue yes.
Let’s determine if bonds are truly LESS risky than equities by looking at some data.
Above we see an image from Professor Jeremy Siegel’s 6th Edition of Stocks for The Long Run (a wonderful resource for the finance enthusiast), which utilizes an extensive data set of asset prices ranging from 1802 - 2021.
The graph shows the holding period in years at the bottom with the best annualized return after inflation at the top of each bar, and the worst at the bottom, for stocks, bonds, and treasury bills.
Once you get to a 10-year holding period you see that the worst-case scenario in Stocks has actually been better than that of Bonds and T-Bills.
That begs the question, if your holding period is expected to be longer than 10 years are Bonds and T-Bills truly safer than stocks after accounting for inflation? The data would clearly suggest they are not (at least historically speaking).
On a 30-year holding period the WORST return for stocks was 2.6% annually ABOVE the rate of inflation, while the worst 30 year holding period return for bonds was 2% BELOW the rate of inflation.
What happens to your money if it erodes at 2% annually for 30 years? You have erased over 45% of your real wealth. In an era where a 30-year retirement is not out of the question, do we still feel good about a bond heavy retirement portfolio?
It would appear that Bonds and Bills are safer short-term investments but have been riskier than equities in the long run due to their long-term inflation risks. Thus, one needs to strongly reconsider if long-term money (>10 years) should be allocated to Bonds and Bills at all.
In November of 2023 a paper written by Aizhan Anarkulova, Scott Cederburg, and Michael S. O’Doherty sent shockwaves throughout the advisory industry.
The paper, Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, challenges the conventional wisdom of target retirement fund glide paths and whether investors should allocate more to bonds both pre- and post-retirement. Some might consider the findings shocking:
The authors found that an even mix of 50% domestic stocks and 50% international stocks held throughout one’s lifetime vastly outperformed age-based, stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests.
Incredible!
Not only has a 100% equity portfolio helped accumulate more wealth for retirees than a strategy that puts more in bonds as years go by, but it also did much better in preserving wealth and supporting retirement consumption.
Before you run out and sell all of your bond holdings to buy equities, more consideration is required.
News is scary, always. Why? As Morgan Housel puts it “progress happens too slowly to notice, and setbacks happen too quickly to ignore”. News can’t report on the incredible, but slow, progress society has made over hundreds of years. So, they report the scary stuff that happens quickly.
So, what’s my point? While every past market drop looks like a grand buying opportunity in HINDSIGHT, every current market drop feels like it’s going to get worse for the equity investor. A moderate volatility portfolio that one can stick with is probably better for an investor than a high volatility portfolio that will only cause them to capitulate and sell when down 40%.
It’s quite easy to look at a long-term chart of equity markets and conclude to “just ride out the frequent but temporary downturns”, as it might be easy to navigate a potential plane crash in a flight simulator. In the actual moment, it’s different.
Even the “passive” equity investor lagged the very funds they were investing in by 1.43% annualized during the 10-year period ending 12/31/2022. While passive funds beat active funds, the investors in the passive funds underperformed the investors in the active funds! How can this be? Investor behavior problems.
An equity heavy portfolio is not for the faint of heart, which is where having a good investment advisor can be quite helpful (Read A Ulysses Contract by Meredith Wealth).
The above shows the largest US Stock Market declines from 1935-2023 and how long one would have been “underwater” waiting for it to return to an all-time high. The longest underwater period was 6 years and 3 months (during The Great Depression), before accounting for inflation.
If a retiree, with no future potential for earning an income, had been all equities in that scenario, they would be unlikely to keep their faith after years of going nowhere and drawing down their principal while seeing a decline in their principal value of over 40%.
Given the potential behavioral risks of being 100% equities, what would be a happy medium between 100% equities and owning too many bonds?
Asset allocation recommendations are often set in percentages, such as 60/40 (60% equities, 40% bonds), 70/30, 80/20 etc. etc.
That isn’t too specific to anyone’s situation, but again a rule of thumb that can make for easier decisions.
Knowing the data we’ve seen above that an all equity portfolio has been more optimal, yet that there are potential behavioral issues that could deter us from that plan and cause anguish during bad market environments, what does one do? An approach that I believe allows one to take an equity heavy approach, yet secure future income needs from market risk, is commonly referred to as “bucketing”.
Start with your “war chest” bucket, where you place 3-10 years of portfolio withdrawal needs (depending on personal risk preferences). This should be invested into assets with very minimal risk to principal value (CDs, Treasuries, short-term bonds etc.).
For example: You have a $1 million portfolio, and you will need $40k a year from that portfolio. You consider yourself a moderate risk taker and are comfortable socking away 5 years' worth of withdrawals into your war chest ($200k).
That leaves you with $800k for the growth bucket. This breaks down to an 80% equity 20% bond mix, which is far different than what is suggested in target retirement funds but is closer in line with what the research suggests to be optimal.
When you take your withdrawals, if equities are doing well then that’s where you source your withdrawals. If we’re in a bear market, you tap into the war chest so you aren’t forced to do a fire sale on your equity positions and allows them time to recover. The war chest is replenished when equity values come back.
If you have achieved a level of financial security to where you are withdrawing less than 3% of your initial portfolio value each year in retirement, you will likely be fine no matter what stock-bond mix you utilize (assuming you have a 30-year retirement horizon).
For people that fall into that camp and plan to leave a nice gift to the next generation one day, they can balance their portfolio in a manner that both gives them peace of mind and grows their future bequest.
The late Harry Markowitz formulated modern portfolio theory, which suggested portfolio assets could be assembled in a manner where expected returns are maximized for every given level of risk.
Markowitz famously said in a 1998 interview with Jason Zweig that he does not utilize his own research to construct his personal portfolio. Rather he split his portfolio 50% into stocks and 50% into bonds. When asked why he chose to invest in this manner he responded:
"I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. My intention was to minimize my future regret.”
Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Consult with a financial advisor before implementing any strategies. Past performance does not equal future results. Meredith Wealth Planning does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy. You cannot invest directly into an index, and index returns do not account for real life fees and transaction costs.
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