MW My wife and I are 78. This is how we manage investment risk without panicking.
By Paul A. Merriman
Many retirees take the wrong level of risk because they don't understand it or they don't want to think about it
My wife and I are 78 years old, and like most retirees, we want to make sure we won't ever run out of money.
Too many retirees take the wrong level of risk, either because they don't understand it or because they don't want to think about it.
In this article, the fourth installment of Investor Boot Camp 2024, I'll tell you how we figured this out for ourselves, then show you how you can figure it out for yourself, whether you're saving for retirement, about to retire, or already retired.
In November 2023 through March 2024, the U.S. stock market experienced five straight profitable months, with the major indexes reaching new highs time and again. In fact, the S&P 500 SPX hit new highs on 22 separate days in the first quarter of this year.
At a time like that, who wants to think about risk? Not many investors.
At a time like that, who should be thinking about risk? Most investors.
To recap, the first article in Boot Camp 2024 made the case that over the long term (based on the past 96 years of history), investors have been far better off in stocks than in bonds.
In the second installment I showed how small changes in the makeup of your stock portfolio can make substantial changes in the money you'll have after you retire. And I made the case for combining 10 equity asset classes to create a portfolio that historically has produced much higher returns with little or no additional risk.
Installment No. 3 showed historical returns and risks of a variety of combinations of those asset classes.
Today, using the choices my wife and I have made, I'll show you how to find a combination of stocks and bonds that is likely to work for you.
I'll start with this disclaimer: This is not rocket science, and there is no perfect answer. Sorry, but the future is made up of too many unknowns.
You don't know what the markets will do, or when.You can't know for sure in advance how you will react and respond.You don't know how your needs will evolve as you get older.You don't know how long you will live.
I've been an investor for more than 60 years, and I don't know these things any more than you do.
However, I do know a lot of financial history.
I know that $100 invested in U.S. government bonds would have grown to somewhere between $2,000 and $12,000 over 96 years, depending on the maturity of the bonds.
I also know that the same $100 invested in stocks would have grown to somewhere between $1 million and $14 million, depending on what asset classes were chosen.
In order to achieve long-term results, investors have to stay in the game through multiple money-losing periods lasting for months, years, and sometimes decades.
Anyone who invests exclusively in stocks should be prepared to stomach a loss of 50% or more. In the past, the main U.S. stock indexes have always recovered from losses like that. But the recovery can take a long time, and there's no ironclad guarantee it will happen at all.
If you can't endure the short-term and medium-term pain, you won't achieve the long-term gain.
How we deal with this
After lots of thought and reflection, we decided we're comfortable taking the substantial risk of the stock market with half of our portfolio, but not more.
With the other half, we seek the comfort and relative stability of short-term to intermediate-term government bond funds.
We made this choice after studying a table that I've been publishing and updating annually for more than a quarter-century. This table shows 54 years of annual returns (starting in 1970) for bonds, for stocks (using the S&P 500), and for nine combinations of the two.
Of more use to investors, this table shows the interim losses that an investor had to endure in order to achieve those long-term returns. You can find the complete table here.
That's a very lengthy table, and for this discussion, let's look at some information that pertains only to the S&P 500, without other asset classes. We'll see returns from an all-bond portfolio, an all-stock portfolio and four combinations.
Historical returns and losses, combinations of S&P 500 and government bonds, 1970-2023
Percent in stocks 0% 20% 40% 60% 80% 100% Annualized return 6.7% 7.7% 8.6% 9.4% 10.1% 10.7% Worst 12 months -10.5% -11.4% -18.6% -27.6% -35.9% -43.3% Worst 36 months* -3.0% -0.3% -2.4% -6.7% -11.2% -16.1% Worst drawdown -6.1% -9.1% -19.6% -31.3% -41.9% -50.9% *Annualized Source: Merriman Financial Education Foundation
When you look at those numbers, remember: they show history, not the future. However, they also show the well-known relationship between risk and reward.
As you can see, every additional 20% in the allocation to stocks increases the long-term return. At the same time, the worst 12-month loss goes up as well.
My wife and I, by adopting a 50-50 mix of stocks and bonds, are in effect agreeing to tolerate a one-year loss up to approximately 23% of our portfolio.
While a loss of that magnitude would be most unwelcome in the Merriman household, by accepting that possibility, we can hope for a long-term return of around 9%.
(In our case, the numbers are somewhat different because we have diversified into many asset classes beyond the S&P 500. But that is a topic for another time.)
How you can use this information
Although there is no foolproof formula, here's a process I might suggest.
Using the link above to the full table, start by focusing on the risks more than the returns. Try to imagine how much of a one-year loss you can tolerate without bailing out, then find a column that matches that. Do the same with three-year and five-year losses.
This will probably lead you to a column between all-bonds and all-stocks, and that is likely to be a good starting place for allocating your portfolio.
In case you're not sure, here are three quick-and-dirty guidelines that might help.
If you're young (perhaps under 40) and accumulating assets, consider a 100% stock portfolio. When the market goes down, that doesn't hurt you; on the contrary, it lets you buy more stocks at lower prices.If you're near retirement or already retired, consider an allocation of 40% to 60% in stocks. This is likely to keep you out of major trouble.If you are really nervous, or if you have a history of bailing out when times start to get tough, you could limit yourself to 30% in equities. If you do that, you may need to save more before you retire or live on less when you retire - or both.
The topic of risk is a big one, and I've created a couple of interesting resources that you may find helpful. First, a podcast to accompany this discussion. Second, a video that covers this topic.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of We're Talking Millions! 12 Simple Ways to Supercharge Your Retirement.
-Paul A. Merriman
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May 01, 2024 13:29 ET (17:29 GMT)
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