The Biggest Retirement Risk Is Not Taking Enough Risk

Posted On February 21, 2018 1:42 pm

Yesterday I explained why bonds can be far more dangerous to your retirement portfolio than you think. That’s because bonds have no ability to grow income, and thus are incredibly interest rate sensitive. And since we’re just come out of a period of the lowest interest rates in human history, this means that rates can likely only go up, especially if strong economic growth brings a return to more normal levels of inflation (2% to 2.5%).

However, there is another important aspect to retirement planning that causes me to take a dim view on bonds. Specifically that bonds are far better at preserving wealth over time, but a poor means of building an actual nest egg. In other words, if you want to become rich, you need to invest like rich people do. After all, if you don’t have any wealth to preserve, then “playing it safe” is the best way to stand still and miss your financial goals by a mile.

So how exactly do wealthy people invest? Personal Capital is a website where over 800,000 people have listed their portfolios. Of those 165,000 or so have between $100,000 and $2 million in their portfolios. Perhaps they aren’t “rich” but most of them are well on their way to a comfortable retirement.

Source: Personal Capital Study

Note that under the rule of thumb that “risky” stocks should make up (100 – your age)% of your portfolio, a 55 to 64 year old would have 55% to 64% of their retirement portfolio in “safe” stocks. Instead, those who actually achieved the financial dream, even at the age where retirement is well in site, have that flipped, with nearly 2/3 of their portfolios in stocks and very little in bonds. What about those who are already well into retirement (and living comfortably while doing so)? Surely they must be taking the “safe” route? In fact, their portfolios look pretty much the same.

Source: Personal Capital Study

Are these people crazy!? Don’t they worry about preserving capital? This portfolio looks almost like the standard 60/40 stock/bond allocation that modern portfolio theory (basis of the 4% rule), advocates! Why is it that people are achieve financial success take so much risk? Well, for one thing they might believe in a kind of “if it isn’t broken, don’t fix it” mentality.

S&P 500 Rolling Average Total Returns Over Time

These are people who have been investing a LONG time, as much as 50 to 70 years. They know that stocks go up most of the time (74% of any given year), and that over longer stretches a stock heavy portfolio is almost always going to make money. In fact, even including the Great Depression, when stocks fell 90% peak to trough, there has never been a single 20 year period where the S&P 500 has failed to generate a positive return.

But screw long-term history, how are you going to live if the market tanks like it did in 2000 or 2008?! Well notice that the affluent retirees or near retirees have 14% in cash. That’s likely enough to live on for two to three years. That’s enough time to ride out a bear market in stocks (average length 1.4 years, average peak decline 41%), and thus allow these individuals to keep far more of their money working for them in the asset class that has generated the best inflation adjusted returns (7% since 1871).

Need further proof? Ok, let’s focus on a more recent period, a manageable stretch of 10 years, that we all remember. 2004 to 2014, a time period that spans both two bull markets, a period of rising rates, and a period of rates near zero. And of course it also includes the second most severe market crash in history, second only to the Great Depression. In other words, a near perfect representation of all possible economic, interest rate, and market environments.

Here’s how the stock market did during that time:

  • S&P 500: 8.11%, inflation adjusted: 5.61%

Pretty meager, as one might expect given the 55% peak to trough crash of 2007 to 2009. But what about bonds?

  • High-yield (junk bonds): 7.98%, inflation adjusted: 5.48%
  • Emerging market bonds: 7.78%, inflation adjusted: 5.28%
  • Long-Term Corporate (investment grade) bonds: 6.97%, inflation adjusted: 4.47%
  • Long-Term Government Bonds (US Treasuries): 6.78%, inflation adjusted: 4.28%
  • Investment Grade Corporate Bonds (all maturities): 5.49%, inflation adjusted: 2.99%
  • All Bonds (Barclays US Aggregate Index, what many bond funds track): 4.62%, inflation adjusted 2.12%

Note that if you invested in a diversified low cost bond ETF, then your inflation adjusted total returns would have been 51% lower PER YEAR than if you had just stuck it out in a low cost S&P 500 ETF like VOO. And keep in mind that bonds have been in a 35 year bull market, which peaked after the financial crisis when the Federal Reserve bought nearly $4 trillion in US treasuries and mortgage bonds. In other words, even with the Fed printing money by the bucket full (as were central banks in Europe, the UK, and Japan) and causing 10 year treasury yields to fall to their lowest level ever (1.26% post Brexit), bonds STILL lost to stocks.

And guess what? With rates now rising, bonds will continue to lose to stocks. Why? Because bonds have no potential for income growth. Stocks are pieces of living, breathing companies, a collection of hundreds or thousands of people united in an effort to generate exponentially growing earnings, cash flows, and dividends. Income producing assets with exponentially growing income must always, over the long-term, appreciate in value. What’s more the rate of growth will always be greater than assets with fixed income that can only be eroded by inflation.

The bottom line is that if you aren’t rich enough to retirement comfortably now, you’ll never get there by “playing it safe” and owning too high an allocation in bonds. Do you need to take into account market volatility? Of course, that’s why all those rich people, even the 75 to 89 year olds, have 14% in cash. So they can sleep at night and never worry about being a forced seller in a market crash.  And if you build a quality, high-yield, and highly diversified income portfolio? One that yields 5% and generates long-term dividend growth of 7% (2 to 3X inflation) then you can be 100% in stocks at all times, because you never have to sell at all (100% price insensitive). Personally that is my plan, and what I’ve dedicated my life to building.


About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I currently write for both Seeking Alpha, Simply Safe Dividends, and DividendSensei.com My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams, and enrich their lives. With 22 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams. I'm currently on an epic quest to build a broadly diversified, high-quality, high-yield dividend growth portfolio that: 1. Pays a 5% yield 2. Offers 7% annual dividend growth 3. Pays dividends AT LEAST on a weekly, but preferably, daily basis

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