Seeking Alpha
Mutual fund manager, long-term horizon, portfolio strategy
Profile| Send Message|
( followers)  

By Kathleen M. Fisher and Tara Thompson Popernik

What should you invest in after the spigot of earned income is turned off? It’s a vexing question, especially since we expect lower stock and bond returns going forward.

The traditional bond-heavy retirement portfolio, a favorite in past generations for its safety, isn’t likely to return enough to generate the funds you need to live on in retirement, what we call your “core-capital” requirement. All else being equal, the lower your core-capital requirement, the better. You can help bring that number down by spending less, working longer ... and keeping stocks and other return-seeking assets in your investment portfolio after you retire.

The display below provides an example of a 65-year-old couple spending $100,000 a year, adjusted for inflation, from a portfolio of intermediate municipal bonds and globally diversified stocks. The left side shows they could reduce their core-capital requirement from $4.3 million to $2.9 million if they were to move from an all-bond portfolio to one that’s invested 60% in stocks. That’s a benefit of the growth that stocks can provide.

(click to enlarge)

Note, however, that an all-stock portfolio requires slightly more core capital than a 60/40 stock/bond mix. The reason is on the right side of the display: stocks’ higher risk, expressed here as the chance of a 20% peak-to-trough loss at some point over the next 20 years. Such a big loss is especially damaging if, like most retirees, you’re spending from your portfolio, because withdrawing money when a portfolio is down can permanently erode your wealth.

So while an appropriate exposure to equities is good, a greater allocation to stocks isn’t necessarily better. Of course, “appropriate” certainly doesn’t mean 60% for everyone.

Know Thyself!

As the display shows, we estimate that a 60/40 stock/bond mix has a 29% chance of experiencing a large peak-to-trough loss over the next 20 years. That’s not a particularly risky profile, but it does entail almost a one-in-three chance of losing at least 20% at some point. Understanding long-term patterns in the investment markets may increase your risk tolerance. Nonetheless, investing is always an emotional, as well as a financial, enterprise. Don’t overestimate your tolerance for risk - or you may panic when the market drops, abandon stocks altogether and miss out on the rebound. In short, you could do yourself serious financial harm.

The Wide World of Investing

The good news is that the investment universe has expanded dramatically in recent decades. Today, investors can own a broad array of assets, which we categorize as return-seeking (equities and high-yield bonds, for example), risk-mitigating (high-quality intermediate-duration bonds, for one) or diversifying. That third bucket includes a variety of investments, including hedge funds and real assets: real estate investment trusts, shares of commodity-producing firms and commodity futures, all of which tend to rise with inflation.

The mark of a diversifying asset is that its returns have been weakly correlated with stock and bond returns. As a result, the 29% chance of experiencing a 20% peak-to-trough loss in a moderate-risk portfolio could, we estimate, be brought down to 25% with the addition of real assets and inflation-linked bonds (which are both diversifying and risk-mitigating) or to 24% with the addition of diversified hedge funds (display). Adding all these components would cut the odds of a large loss even further, to only 20%, we estimate.

(click to enlarge)

On the margin, our research suggests that dynamically adjusting a portfolio’s asset mix in response to changing market risk and expected returns can even further reduce the odds that portfolio losses will exceed your personal risk tolerance.

But the key to effective asset allocation is staying the course: broadly maintaining the exposure to return-seeking, risk-mitigating and diversifying assets that’s right for you. For most investors, that’s harder than it sounds. When the stock market is soaring, the pressure to join the crowd in stampeding into stocks can be hard to resist. Likewise, when the market dives, the temptation to bail out can be very strong. But buying and selling in tandem with everyone else means buying high and selling low. It’s the opposite of a winning strategy.

Bernstein does not offer tax, legal or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

The Bernstein Wealth Forecasting System uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Kathleen M. Fisher is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Tara Thompson Popernik is the Group’s Director of Research.

Source: Investing In Retirement: Bonds Aren't Enough