While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs” when setting up our mandatory retirement accounts. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.
Kelly Greene from the Wall Street Journal explains in her article, titled “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should invest in stocks in a “U-shaped” pattern in which they invest more heavily in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,
“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”
This makes sense given the fact that many baby boomers are expected to live into their 80s, meaning that if they retire at the traditional age of 65 they may require a retirement account that could last them upwards of 15-20 years. In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.
It seems that stocks should remain a critical part of ones portfolio even after retirement, so what portion of one’s portfolio should one keep in stocks when one is far from retirement? In his article “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” Professor Kimball explained that 100% of his paper assets are currently diversified stock market index funds. If we look at this decision using knowledge gained from Burton Malkiel’s “A Random Walk Down Wall Street,” this appears to be a strategy that returns relatively high rewards for low risk. Why? First, there is the decrease in risk that comes with investing in a diverse index fund. By splitting up the investment among dozens of different companies, one can reduce the probability of losing a substantial amount of money in the presence of a random occurrence such as a hurricane or a not-so-random occurrence such as bankruptcy. According to Malkiel, a portfolio of around 60 well-diversified securities (meaning their returns are largely independent) will eliminate nearly all of the unsystematic risk (risk that your portfolio will be in jeopardy after a calamity hits one stock). The systematic risk, or risk that may occur as a result of stock market shocks, can be further diversified away by investing in many different markets, such as by investing in U.S. and European stocks. Kimball’s investment in the Fidelity Spartan International Fund allows him to reduce the risk that a collapse in one stock market or one economy will negatively impact his annual returns. Beyond risk, it’s also important to consider the rate of return of the fund when choosing where to place one’s savings. In his book, Malkiel cites the research of Jeremy Segal, the author of the investment book “Stocks for the Long Run.” Segal calculated the returns of a variety of assets from 1800 to 2010. He concluded that if one invested $1 in the stock market in 1800, after compound interest that $1 would have grown to over $10,800,000 in 2010. If one had invested that same dollar in bonds, which was the next largest gainer, it would have only grown to $27,604. This demonstrates that out of all basic investment instruments at the disposal of the average investor stocks bring the highest returns. So by investing in a well-diversified international stock fund, such as the Fidelity Spartan International Fund, an investor may expect much higher returns with a relatively low level of risk.