What’s in your retirement wallet?
If your retirement portfolio is following the old axiom “your age in bonds” (that is, the-percentage-of-your-portfolio-allocated-to-bonds-should-equal-your-current-age) you may want to reconsider.
Bonds certainly present less volatility than stocks, but that is not the only consideration when building a retirement portfolio. The portfolio needs to control downside risk while achieving a reasonable rate of growth.
Why Diversification Matters
Also, the order in which your investment returns occur has a dramatic impact on how long the money in your portfolio will last. Low returns in the early years when you begin drawing money out can be disastrous for a retired investor. Consequently, a retirement portfolio must also be sufficiently diversified to minimize what’s known as “timing-of-returns” risk.
(MORE: A 15-Minute Portfolio Checkup)
In short, building a retirement portfolio with a very large allocation in any one asset class is simply asking for trouble. For evidence, take a look at the results of a recent historical analysis I did comparing returns of three types of investment portfolios from 1926 to 2014 to see how likely they’d last to age 100, assuming the investor began retirement at 65.
Comparing Durability of 3 Types of Portfolios
The first portfolio consisted of 100 percent U.S. bonds. Over the 89-year period from 1926 to 2014, U.S. bonds averaged an annualized return of 5.41 percent.
The second portfolio was an “age-in-bonds” model which allocated 65 percent to U.S. bonds at the start of the retirement simulation (when the retiree was 65) and increased the bond allocation to 66 percent the next year, 67 percent the next year, and so on; the remaining allocation each year was in large-cap U.S. stocks. (These stocks, as measured by the S&P 500 Index, produced an average annualized return of 10.12 percent from 1926 to 2014, and had negative years 27 percent of the time.) So, at age 80, the age-in-bonds model was 80 percent in bonds and 20 percent in large cap U.S. stocks. At age 90, it was 90 percent U.S. bonds and 10 percent large cap U.S. stocks.
(MORE: Is Your 401(k) Too Stock Heavy?)
The third portfolio was an equally-weighted, annually-rebalanced mix of four major asset classes (U.S. bonds, U.S. large cap stocks, U.S. small cap stocks and cash). Over the past 89 years, small U.S. stocks produced an average annualized return of 11.40 percent and experienced a one-year loss nearly 32 percent of the time. From 1926-2014 cash (represented by U.S. Treasury bills) had an average annualized return of 3.60 percent.
The equally-weighted four-asset portfolio averaged 8.55 percent over the 89-year period; its worst one-year return was -23.59 percent.
The objective of this analysis was to determine how often each retirement portfolio remained solvent for a full 35-year period (from age 65 to 100) over 55 rolling, 35-year periods from 1926 to 2014. A retirement portfolio that remains intact until an investor is 100 is a noteworthy achievement and represents a reasonable, if not admirable, goal for any investor.
As part of the analysis, I compared results with three annual withdrawal rates — 3 percent, 4 percent and 5 percent (with an annual cost-of-living adjustment of 3 percent) — and arbitrarily set the starting portfolio balance in retirement at $250,000.
(MORE: Asset Allocation Advice for the Sandwich Generation)
Here’s what I found:
A 100 percent bond portfolio with a 3 percent withdrawal rate had a success ratio of 69 percent — that is, it lasted a full 35 years in 38 out of 55 rolling periods — or 69 percent of the time.
By comparison, both the age-in-bonds and the four-asset portfolio lasted a full 35 years in all 55 rolling periods, which led to a success ratio of 100 percent for both models.
What Happened With Higher Annual Withdrawal Rates
When the withdrawal rate was increased to 4 percent (the traditional rule-of-thumb withdrawal rate), the all-bond portfolio survived for a full 35 years in only 44 percent of the periods. Furthermore, in 16 periods, the all-bond portfolio was out of money before the investor was 90.
By comparison, with the 4 percent withdrawal rate, the age-in-bonds portfolio had an 82 percent success rate and the four-asset portfolio a 98 percent success rate.
At a withdrawal rate of 5 percent, the all-bond portfolio survived for 35-years only 31 percent of the time, the age-in-bonds portfolio had a somewhat better success ratio of 55 percent and the four-asset portfolio survived for 35 years a full 89 percent of the time.
The importance of a diversified portfolio during retirement is clearly illustrated —particularly as the initial withdrawal rate increased from 3 to 5 percent.
For retirees seeking an initial withdrawal rate of 5 percent or higher, it will be incumbent to build a diversified portfolio with growth potential and prudent downside protection — the hallmarks of what diversification can achieve.
An all-bond approach and, to a lesser degree, the age-in-bonds approach ignore the virtues of diversification when it is arguably needed the most: during the retirement years.
There is no perfect retirement portfolio, of course, because every investment faces some type of risk. The key is to build a portfolio assembled in such a way that it addresses each unique risk while maintaining adequate exposure to needed portfolio growth.
Diversification across asset classes is one such way. While it’s not perfect, a lack of diversification is likely to be far less perfect and far more risky.
Next Avenue Editors Also Recommend:
- Should You Bother to Rebalance Your Portfolio?
- What Your Investment Portfolio Is Likely Lacking
- The Retirement Risks You Can’t Predict
- 3 Retirement Rules of Thumb That Really Work
Next Avenue brings you stories that are inspiring and change lives. We know that because we hear it from our readers every single day. One reader says,
"Every time I read a post, I feel like I'm able to take a single, clear lesson away from it, which is why I think it's so great."
Your generous donation will help us continue to bring you the information you care about. What story will you help make possible?