The “Smart” strategy for older investors
The Importance of Diversification
The Strategic Wealth Advisor team believes that for ourselves and most others, it makes sense to invest essentially 100% in stocks until age sixty or sixty-five. The questions is, “What does history indicate to be the “smart” strategy for older investors?”
The performance of four core asset classes can be measured back to 1926:
- U.S. bonds
- U.S. large-cap stocks
- U.S. small-cap stocks
- cash
These asset classes represent the building blocks of a retirement portfolio. Let’s look at each assets class and consider their relative merits and potential roles.
We’ll start with U.S. bonds. Over the 89-year period from 1926 through 2014, U.S. bonds averaged an annualized return of 5.4 percent with a standard deviation of 5.7 percent; this is based on the Ibbotson U.S. Intermediate Government Bonds index from 1926 through 1975 and the Barclay’s Capital Aggregate Bond index from 1976 through 2014. The worst one-year return for U.S. bonds was -2.9 percent, in 1994. Over the 89 years, there were nine years in which U.S. bonds had a negative return—or just over 10 percent of the time. The average loss was negative 1.3 percent during those down years for bonds.
U.S. bonds have done a good job avoiding losses (in nominal terms) over the last eight-plus decades. However, bonds have also experienced protracted periods of very low returns, which creates a distinct challenge in a retirement portfolio if the returns are below the withdrawal rate. For instance, U.S. bonds experienced a 29-year period (from 1941 through 1969) where the average annualized return was a mere 2.2 percent. During those same years, large-cap U.S. stocks averaged annualized gains of 12.8 percent and small-cap U.S. stocks averaged annualized gains of 18.6 percent. This simple observation reminds us of the value in diversifying, particularly during the retirement years.
Large-cap U.S. stocks (as measured by the S&P 500 index) produced an average annualized return of 10.1 percent from 1926 through 2014, but with a standard deviation of return of 20.1 percent. Large-cap stocks endured 24 negative years, or 27 percent of the time since 1926. The largest loss was 43.3 percent in 1931. The average loss was 13.6 percent.
Small-cap U.S. stocks (as measured by Ibbotson’s Small-Company Stock index from 1926 through 1978 and the Russell 2000 index from 1979 through 2014) have an even more colorful past. Over the past 89 years, small U.S. stocks have produced an average annualized return of 11.4 percent and a standard deviation of 31.8 percent. The biggest one-year loss was 58.0 percent, which occurred in 1937. Small U.S. stocks have experienced a one-year loss 28 times since 1926, or nearly 32 percent of the time. The average loss during those 28 years was 16.8 percent.
Finally, there is the performance of cash (as measured by 90-day U.S. Treasury bills). From 1926 through 2014, cash had an average annualized return of 3.6 percent and a standard deviation of return of 3.3 percent. Its worst one-year return was a decline of 0.02 percent, which occurred in 1938. This was the only year with a nominal loss (in inflation-adjusted terms) for cash.
The Key Question
So, what combinations of these assets are best suited to carry a retiree through the retirement years without running out of money?
To answer that question, let’s examine an analysis of various retirement portfolios built with different asset classes or combinations of asset classes. These examples are based on the book "7Twelve: A Diversified Investment Portfolio With a Plan" by Craig Israelsen (John Wiley & Sons, 2010) and updated through year-end 2014. This study looked at six index-based retirement portfolios:
- Portfolio #1: 100% Cash—allocated to 90-day U.S. Treasury bills from 1926 through 2014.
- Portfolio #2: 100% U.S. Bonds—allocated to the Ibbotson U.S. Intermediate Government Bonds index from 1926 through 1975 and the Barclay’s Capital Aggregate Bond index from 1976 through 2014.
- Portfolio #3: “Age-in-Bonds”—alloca-tion to U.S. bonds (as defined in Portfolio 2) was equal to the age of the investor from age 65 to age 99, with the remaining balance allocated to the S&P 500 index. Thus, when the investor was age 80, the portfolio was 80 percent U.S. bonds and 20 percent large-cap U.S. stocks. When the investor was age 99, the portfolio was 99 percent in U.S. bonds and 1 percent in stocks.
- Portfolio #4: 40 percent Stocks/60 percent Bonds—a 60 percent allocation to the Ibbotson U.S. Intermediate Government Bond index from 1926 through 1975 and the Barclay’s Capital Aggregate Bond index from 1976 through 2014 and a 40 percent allocation to the S&P 500 index from 1926–2014. This portfolio was rebalanced annually to maintain the 40/60 weighting.
- Portfolio #5: 60 percent Stocks/40 percent Bonds—a 40 percent allocation to Ibbotson U.S. Intermediate Government Bonds index from 1926 through 1975 and the Barclay’s Capital Aggregate Bond index from 1976 through 2014, as well as a 60 percent • allocation to the S&P 500 index from 1926 through 2014. This portfolio was rebalanced annually to maintain the 60/40 weighting.
- Portfolio #6: Four-Asset Portfolio—an allocation of 25 percent to the S&P 500 index, 25 percent to small-cap U.S. stocks (Ibbotson Small-Company Stock index from 1926 through 1978 and the Russell 2000 index from 1979 through 2014), 25 percent to U.S. bonds (as described in Portfolio 2), and 25 percent to 90-day U.S. Treasury bills. This portfolio was rebalanced annually.
The time frame of this analysis of retirement portfolio durability was 1926 to 2014, over which there were 55 rolling 35-year periods. The start of each 35-year retirement period was assumed to begin at age 65. Each portfolio was analyzed over all of the 55 rolling periods. A starting balance of $250,000 at age 65 was assumed. Five different initial rates of withdrawal were employed, ranging from 3 percent up to 7 percent. The initial withdrawal rate specified the amount of the first year’s withdrawal from the portfolio. Thus, using an initial withdrawal rate of 3 percent, the first year’s withdrawal was $7,500. The next year’s withdrawal was determined by the cost-of-living adjustment (COLA), which was assumed to be 3 percent in this study. The COLA is the equivalent of an inflation factor. Based on the 3 percent COLA, the withdrawal in the second year was $7,725, in the third year $7,957, and so on. The annual withdrawals occurred at the end of each year.
The “survival” analysis of all six retirement portfolios is reported tables 1 and 2, below.
Chart 1
Table 1. Likelihood of a Retirement Portfolio Lasting 35 Years
The data below shows the frequency at which each portfolio lasted until a person retiring at age 65 lived to age 100, given a specified withdrawal rate. The withdrawal rate was the initial distribution taken from a starting balance of $250,000. Subsequent withdrawals were taken annually and were increased each year by 3% to account for increases in the cost of living. The data is based on analysis of 55 rolling 35-year periods between 1926 and 2014. Values below 100% indicate the portfolio ran out of money during at least some of the rolling 35-year periods.
Table 2. Likelihood of a Retirement Portfolio Lasting 20 Years
The data below shows the frequency at which each portfolio lasted at least 20 years when retiring at age 65. The withdrawal rate was the initial distribution taken from a starting balance of $250,000. Subsequent withdrawals were taken annually and were increased each year by 3% to account for increases in the cost of living. The data is based on analysis of 55 rolling 35-year periods between 1926 and 2014. Values below 100% indicate the portfolio ran out of money during at least some of the rolling 35-year periods.
The importance of building a diversified portfolio for retirement has been clearly illustrated—particularly at higher initial rates of withdrawal.
Chart 2
For those retirees seeking an initial withdrawal rate of 5% or higher, it is essential to build a diversified portfolio that has growth potential combined with prudent downside protection—the hallmarks of what diversification is able to achieve. An all-bond portfolio or an age-in-bonds approach ignores the virtues of diversification when it is arguably needed the most—during the retirement years.
There is no perfect retirement portfolio because every investment faces some type of risk, whether it’s volatility risk, interest rate risk, inflation risk, currency risk, etc. The key is to build a portfolio that is assembled in such a way that it contains asset classes that address each unique risk while maintaining adequate exposure to needed portfolio growth.
Once again, it’s hard to make an objective case for any asset class other than equities when investors are in their 20s, 30s, or 40s. However beyond age 60 or 65, the need for predictable income becomes increasingly important and diversification across a combination of asset classes is prudent.
A simple reading of the data from 1926 through 2014 indicates that the Four Asset portfolio has been a consistent winner. That doesn’t means it’s the answer for you; it simply means that it’s one of the possibilities to discuss with your financial advisors.