June 25, 2006
$tarrBuck Report by R. M. Starr
What’s in your retirement portfolio?
Everyone has heard the litany: A good retirement portfolio contains a well-diversified collection of common stocks balanced with bonds and other fixed income assets. That’s the principle of not putting all your eggs in one basket.
The statement leaves as many unanswered questions as it resolves: Why choose common stocks? What’s sufficient diversification? What’s the right balance?
Why choose common stocks?
Common stocks historically have the yield advantage of the “equity premium”.
Bonds and fixed income assets historically return on average about 2% annually above the rate of inflation. If you hold them in an IRA, 401(k), or other tax-deferred account you can reasonably expect to double the purchasing power of your saving in 35 years. If you hold them in taxable form you’ll be lucky to break even after inflation.
Common stocks historically have return on average 9% (including dividends) annually above the rate of inflation, but with a lot more variability (risk) than bonds. That 7% differential is the “equity premium.” In the same 35 year horizon — in a tax-deferred account — the typical common stock portfolio will grow in value by more than tenfold, net of inflation, with dividends reinvested. It will do almost as well in taxable form if it’s invested tax-efficiently (very little turnover in the portfolio). The equity premium reflects the reward received by stock market investors for accepting risk and the costs of buying and selling shares when they need to cash out.
The risk in common stocks is not small: In October 1987 a typical common stock portfolio lost one third of its value in the space of a week; it recovered all it lost — if the owner didn’t sell out at the bottom — in two years . In 2000-2002 the typical portfolio lost four tenths of its value over the course of two years; it recovered all it had lost (including dividends reinvested) — if the owner didn’t sell out at the bottom — in four years. In 2000 the typical NASDAQ (more speculative market) portfolio lost three quarters of its value; it has yet to recover. Yet over every fifteen year interval since the 1940s, the leading stock market averages have held their own, and over some periods have profited very handsomely.
What’s sufficient diversification?
Most investors do not have enough time, luck, or training to choose their own investments. We should employ professionals to do that. That’s what mutual funds are for. The most appropriate single choice is a mutual fund holding a broad variety of common stocks of leading companies traded on major US stock exchanges: Fidelity Magellan, Fidelity Large Cap Growth, Vanguard Index 500. Each of these funds will hold a broad variety of common stocks. A portfolio filled with just one of these mutual funds is already well diversified. Holding a variety of similar mutual funds provides no additional diversification; it just makes it harder to keep track of your investments.
Additional diversification can be arranged by adding an international fund and a value fund (my own favorite is Third Avenue Value Fund). If there’s a sector (e.g. energy, Japan) that you want to overweight, add a little of a fund with that specialty.
Dollar cost averaging
The most convenient retirement investment plan is setting aside a fixed dollar amount each month to go into your choice of mutual funds. Maintain that plan in bull markets and bear markets. That means that you’ll be buying more shares when their price is low. This sound practice is called dollar cost averaging.
None of us is clever enough successfully to pursue the alternative strategy: timing the market. They don’t ring a bell to let you know when it hits bottom.
What’s the right balance between stocks and fixed income?
At this point, a financial professional will say, “So what’s your tolerance for risk?” The correct answer for that is “I don’t know. What should it be?” The answer depends on your age, wealth, income, and your other assets. Part of the question is how you feel. Any year that you’re in the stock market, there’s a good chance that your common stock holdings may decline in value by 20%. When that happens, can you maintain the confidence to pursue your investment plan? Not to sell out? To keep buying the mix of stocks and bonds you’ve already planned on? Set your investment plan so that the answer is “yes.” The best time to buy is when everyone else is selling. You should be secure enough in your holdings that you can stay the course.
Do you own your house free and clear; have a defined-benefit pension plan; social security; ten years to retirement, a few months income saved in cash? Then you hold a lot of safe assets already — including the flexibility to schedule your retirement. You can afford to take profitable risks. Build up your equity (common stock) portfolio to the level of several years of income; then you can add fixed income assets.
Do you have forty years to retirement? No significant financial or real estate assets? Then you really need a rainy day fund. Build that up in safe assets before investing for retirement.
Are you in your nineties, with enough money to comfortably live out the next decade, but little to spare? Now is not the time to take chances. Your investments belong in fixed income.
(c) Copyright R. M. Starr 2006
