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Investing for Retirement Requires a Disciplined Approach

by Jerome Clark

Investing For Retirement Requires A Disciplined Approach Splash image

Over the past decade, equity investors have been blindsided by two severe bear markets, a global financial crisis, and the worst recession since the 1930s. As a result, they have seen generally meager investment returns.

So it is not surprising that many had been fleeing stocks and equity mutual funds. Since the stock market peaked in October 2007, industry-wide net outflows from equity mutual funds totaled several hundred billion dollars through 2010.

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Jerome Clark , CFA, is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc., and a portfolio manager in the Asset Allocation Group.
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Historically, investors often have abandoned the stock market during steep downturns, missing out on subsequent recoveries. This time, the bulk of the outflows occurred in 2008, before the S&P 500 index skyrocketed 93% (from March 9, 2009, through the end of 2010).

Moreover, an annual survey by the Investment Company Institute shows that the percentage of investors willing to take above-average or substantial risk has declined steadily over the past decade through 2009, especially among young investors.

Those saving for long-term goals such as retirement, however, should consider the implications of reacting to recent events by reducing their equity allocations—and therefore reducing the growth potential of their portfolios.

Diversification, of course, cannot assure profits or protect against losses in a declining market. A new T. Rowe Price study, however, shows the benefits of maintaining a well-diversified portfolio with significant equity exposure through thick and thin.

Three Investors

The study focused on three hypothetical retirement investors, ages 35, 45, and 55, who expect to retire at 65. For illustrative purposes, each pursues an asset allocation strategy that takes into account their respective time horizons until retirement. In each case, the portfolio’s emphasis on equities is gradually reduced as investors near retirement.

The 35-year-old investor, with a 30-year time horizon to retirement, starts out with an asset allocation of 90% stocks and 10% bonds. For the 45-year-old, the allocation is 78% stocks and 22% bonds, and the 55-year-old starts with 67% stocks and 33% bonds.

The equity portion for the three investors is systematically reduced so that by age 65 they have the same allocation—55% stocks and 45% bonds.

December 31, 1949, to December 31, 2009
Time Horizon 30 Years 20 Years 10 Years
Number of periods 31 41 51
Median return (%) 10 9.8 9.8
Best period return (%) 12.9 15.3 16.5
Worst period return (%) 8.9 6.4 1.9
Number of losing periods 0 0 0
Percentage of periods      
   beating inflation 100 100 80
 
Number of Periods With Returns Ranging From:
0% to less than 5% 0 0 5
5% to less than 10% 14 21 22
10% to less than 15% 17 18 21
15% to less than 20% 0 2 3
 
The table reflects the historical performance of various portfolios of stocks and bonds based on the respective time horizons of three hypothetical retirement investors. Performance is measured over all rolling 10-, 20- and 30-year periods since December 31, 1949, calculated on an annual basis. The portfolios follow a 30-year asset allocation program that has the following stock/bond allocation at the beginning of each period: 90% stock/10% bonds for 30 years, 78%/22% for 20 years, and 67%33% for 10 years. The equity portion of each portfolio is reduced by 1.17 percentage points per year so that each has 55% stocks/45% bonds at the end of the period. Maintaining a significant equity exposure generally enhanced returns in most periods. The best 30-year period ended December 31, 2004, while the worst ended December 1984. The best and worst 20-year periods ended December 1998 and December 1981, respectively. The best and worst 10-year periods ended December 1991 and December 2008, respectively. Stock and bond returns are based on the S&P 500 index and the Barclays Capital U.S. aggregate index. Past performance cannot guarantee future results.
 

Taking each investor’s time horizon into account, the study examined the historical investment results based on all rolling 30-year, 20-year, and 10-year periods on an annual basis from 1950 through 2009.

Rather than measuring just the most recent period for each investor, this approach reflects performance over a wide range of market environments, including the hyperinflation of the 1970s and the stock market bust of the past decade.

The results are reflected in Table 1 and Figure 1.

Young investors with very long time horizons can take heart that the median annualized return for the 30-year periods was 10% and even the worst 30-year period (ended in 1984) had an annualized return of 8.9%. It also is noteworthy that every period handily beat inflation, with a median annualized real (inflation-adjusted) return of over 5% (not shown).

For the 45-year-old investor with a 20-year time horizon, the asset allocation strategy produced a median return of 9.8% over the 20-year periods, and the return for even the worst period (ended in 1981) was 6.4%. All of the periods beat inflation with a median annualized real return of 5.7%.

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The strategy for the 55-year-old investor with a 10-year time horizon showed the greatest volatility, but all periods produced positive returns. Only one in five of these 10-year periods failed to outpace inflation.

Note that as time horizons lengthen, the variation in returns among the periods is reduced and the chance of incurring unsatisfactory results is lowered.

Equities Have Outperformed

Even over 10-year periods, maintaining substantial exposure to equities improved results more than 80% of the time compared with investing only in bonds. Of course, stocks are more volatile than bonds.

Indeed, equities have outperformed bonds not only in more than 80% of all rolling 10-year periods since 1950 but also in all of the 20- and 30-year periods. There is no assurance, though, that past trends will continue.

The study underscores the importance of maintaining a disciplined strategy and of keeping recent performance trends in perspective.

Bonds can help dampen the downside of equities, and equities can help increase the return potential of an all-bond portfolio over time. That’s the real benefit of diversification, and that’s why it is wise for investors to avoid extreme approaches investing in any asset class.

In general, investors seeking to sustain an income stream that keeps up with inflation over many years of retirement should maintain a meaningful equity exposure in their portfolios prior to retirement and throughout retirement because of the superior performance of equities over most long-term periods. Of course, investors also should always consider their risk tolerance and the time horizon of their goals when deciding how much to invest in stocks.

As for those who have been shifting from equities to bonds in recent years, there has been a protracted bull market in bonds—but, with historically low interest rates, that’s not likely to continue for long. The key to investing is to avoid staring into the rear-view mirror too narrowly: Don’t just look at performance over one period and believe it represents all of history and the future.

Jerome Clark , CFA, is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc., and a portfolio manager in the Asset Allocation Group.


Discussion

Robert from GA posted over 3 years ago:

What are your thoughts about moving your bond allocation into tips
with the prospect of an inflation cycle starting?


Charles Rotblut from IL posted over 3 years ago:

Robert,

We published an article about TIPS and inflation last year. Here is a link to it:
http://www.aaii.com/journal/article/tips-and-the-nature-of-inflation-protection

-Charles


Clifford from PA posted over 2 years ago:

With 3 years away from retirement - where is non retirement monies (not needed for 5-10 years)best allocated?


Paul from IL posted over 2 years ago:

It seems like every allocation scheme is the same. Some of us have other sources of income and don't have to dip into our investments to live on. I am 70 yrs old, retired, and have about 10% in bonds. Most of the equities I have are dividend paying, boring blue chips. What kind of allocation would you recommend for someone like me?


Henry from NY posted over 2 years ago:

Given the 35 year olds lack of the need for income and the ability to withstand the downward movement of stocks, why does that individual have any fixed income exposure?


Henry from NY posted over 2 years ago:

Paul
If I were your financial advisor I wouldn't have you change your allocation.


Warren from FL posted over 2 years ago:

Equities have a flat performance curve over the last ten years--dividends have been high. High yield bonds have outperformed equities by far over the last ten years. Yet, the potential for a "100 bagger" only exists in equities. This plus inflation means almost every portifolio needs equities.

The per centage of equities in a portfolio will differ with individual circumstances and risk tolerance acceptance. The 35year old may need money now; the retired 70 year old may not need money at all--like Paul.

Age performance charts are interesting, but only about 80% accurate, and their data entry and exit points are critical to their performance.


Warren from FL posted over 2 years ago:

Equities have a flat performance curve over the last ten years--dividends have been high. High yield bonds have outperformed equities by far over the last ten years. Yet, the potential for a "100 bagger" only exists in equities. This plus inflation means almost every portifolio needs equities.

The per centage of equities in a portfolio will differ with individual circumstances and risk tolerance acceptance. The 35year old may need money now; the retired 70 year old may not need money at all--like Paul.

Age performance charts are interesting, but only about 80% accurate, and their data entry and exit points are critical to their performance.


A Brown from CA posted over 2 years ago:

At 86 long retired. Most still in stocks, however about 20% in Annuity fund, not yet drawn on. And Maybe 10% bond and/or bond funds.
So far working, only real problem is inflation.
Drawing all of income from investments and last few years going into 'nest egg.' I charge most expenses, pay once a month all. Noted mostly same purchases, about 30% more charge each month this year than three years or so ago.
Andy


Larry Felder from FL posted over 2 years ago:

Very True with disiplined hindsight. Will a individual investor with only forsight be able to practice what hindsignt dictates? Who knows.


W Schwandt from WA posted over 2 years ago:

I started my financial career in 1936 detasseling corn for 25 cents/hour. US 1st class postage was 3 cents. Postage is up a
multiple of 15 times. Had I not started an inflation strategy then I would have never finished college, or retired in 1986 with a respectable nest egg and income. In the subsequent 26 years, I have chosen to deal with inflation by drawing the needed supplementary funds from fixed income investments, and letting the equities grow. I suggest that the allocations in your 10-20-30 year retirement estate building plans are not sufficiently related to future currency inflation.


Richard from MD posted over 2 years ago:

My view is that all three of your examples still should be planning for a longer term than assumed and should have more in stocks than. You should set your stock percentage by looking at what income you have or will have outside of investments (relative to you living expenses) and how much cash it will take to keep you from selling stocks. If you have any significant income outside of your investment, I would move all of the allocations to a 10 year older age. I believe the main risk going forward is inflation due to a government that spends far more than it brings in, cannot control entitlements , and keeps printing money. Personally, I find that dividends from stocks make me fell better when stock prices go down which allows me to keep more money in stocks.


Vern Andrews from CA posted over 2 years ago:

My view is that as the retiree approaches retirement, he or she should try to ladder his fixed investments to suppply most of his monthly reirement distribution requirements in addition to having equities. I would suggest a use of a Fexible Mix Strategy (equities/fixed investmewnts) that is changed depending on the investing economy-market such that when investing environment is declining significantly the mix is changed toward a 10/90 gradually and visa versa when the investing environment is increasing significantly. If there is tax problem with retirement distributions some considerations should be given to fixed investment minis. Website lifetimestrategies2009.com discusses this method in more detail for self-managed retirement Portfolios'


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