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Financial planners used to recommend that you use 100 as the oldest age you might live to for the purpose of determining the stocks-to-bonds mix of your retirement investments. Now it is recommended to use 110 or even 120. This is due to people living much longer, on average, than they once did.

Using the 110 figure, the stocks vs. bonds calculation is done as such:

  • Current Age: 65 | Bonds: 65/110 = 59% | Stocks: (110-65)/110 = 41%
  • Current Age: 45 | Bonds: 45/110 = 41% | Stocks: (110-45)/110 = 59%

This isn't the only method for determining your stocks-to-bonds mix but it is a simple one and it works well for any current age. The concept of holding both stocks and bonds is partially rooted in the fact that the trading values of stocks and bonds tend to move in opposite directions. When stocks rise, bonds tend to fall. When bonds rise, stocks tend to fall. The concept is also rooted in basic diversification, which lessens risk. Simply put, you want certain variety in your investments.

The older you are, the more bonds you are supposed to hold in your portfolio. The younger you are, the more stocks you are supposed to hold in your portfolio. This is because bonds exhibit more price stability over time whereas stock prices are more volatile, though stocks generally have a higher CAGR (compound annual growth rate) than bonds, with dividends included. For example, from 1871-2011, the CAGR of the S&P 500, with dividends included, was 8.88%. (6.66% less inflation.) As of 9/18/12, 10-year U.S. Treasury notes were yielding 1.81% and 10-year U.S. Treasury notes do not appear to have yielded more than 8.88% since 10/11/90. 10-year U.S. Treasury notes serve as a good benchmark because 10 years is a middling bond term and the U.S. is viewed as extremely unlikely to default on these notes, so very little adjustment is made to the yield to accommodate for potential loss of principal in figuring average expected total return.

As you age, you should take fewer risks with your retirement investments so you don't run out of money too soon. The fact that the S&P 500 index dropped from 1565.15 to 676.53 (i.e., -57%) due to the last U.S. recession well illustrates the greater risk in investing in stocks. When you are younger, you should lean more toward stocks due to their greater appreciation potential. The appreciation in stocks is due to dividends and capital gains and has been fairly consistent when measured over certain longer time periods.

S&P 500

From

Thru

Years

CAGR

Inflation-Adjusted

1871

2011

141

8.88%

6.66%

1882

2011

130

8.86%

6.30%

1892

2011

120

9.24%

6.19%

1902

2011

110

9.32%

6.05%

1912

2011

100

9.66%

6.18%

1922

2011

90

10.30%

7.19%

1932

2011

80

10.75%

7.02%

1942

2011

70

11.35%

7.17%

1952

2011

60

10.46%

6.59%

1962

2011

50

9.28%

4.96%

1972

2011

40

9.86%

5.28%

1982

2011

30

11.03%

7.84%

1992

2011

20

7.82%

5.20%

2002

2011

10

2.87%

0.38%

Calculated via moneychimp.com. (The author has no association with this website.)

The inflation-adjusted CAGR figures to the left aren't surprising, as they are about equivalent to an average corporate profit margin. The profits that a company does not return to you as dividends are invested by the company (in its own operations or acquisitions) in an attempt to increase the company's earnings in subsequent years. Also, the company can generally raise the prices for its products and/or services and, hence, its earnings, by about the rate of inflation. In these ways, stocks are designed to appreciate in value, even without dividends factored in.

Bonds are not designed to appreciate in value without their interest payments factored in. Generally, if you hold a bond until maturity (and there is no default) you get the same amount that you paid for the bond back in principal payment. During the life of a bond, the trading value of the bond rises when interest rates fall and falls when interest rates rise; interest rates are, theoretically, equally likely to head in either direction. Furthermore, bonds default sometimes. Sometimes these defaults are partial (e.g., 50% of principal) and sometimes they are in full (i.e. 100% of principal).

The degree to which bonds tend to default varies by the type of bond, etc. For instance, investment grade U.S. municipal bonds have an extremely low historical default rate because the municipalities simply raised taxes as needed. (In the future, more municipalities may default.) On the other hand, corporate junk (non-investment-grade) bonds have a relatively high historical default rate―although this default rate can vary a lot from time period to time period (e.g., from a recessionary period [more defaults] to a growth period [less defaults]).

This helps to explain an old saying―one which I have not heard for a long time, but which remains usually true today: It is better to own the company than it is to lend money to it.

The stocks vs. bonds calculation applies to your retirement portfolio and/or money you are managing in a separate retirement portfolio for someone else (e.g. a son or daughter). If the retirement portfolio is for someone else, you would, of course, use their (rather than your) current age in doing the stocks vs. bonds calculation. If you have money in addition to that necessary or desired for retirement, you can view this money as your more speculative portfolio (rather than your retirement portfolio), and the stocks vs. bonds calculation need not apply. Also, within your retirement portfolio you can choose to overweight either the stock or bond portion of the portfolio (at the expense of the other portion), within limits. (What constitutes "within limits" is a big enough topic to warrant a separate article, as is what exact "oldest age" you should use in calculating your stocks vs. bonds mix, bond default rates, etc.)

As an alternative to or in conjunction with underweighting stocks or bonds, you can choose to make more conservative investments in the category. For instance, instead of or in conjunction with underweighting bonds, you can hold three-to-five-year CDs (Certificates of Deposit) as a part of your bond portfolio instead of U.S. Treasuries. (Unless you keep too much money in the same financial institution, you cannot lose your principal in a CD, if you hold it until maturity.) In the current environment, investors from many nations should consider overweighting stocks and/or making more conservative bond investments.

Index mutual funds and ETFs (exchange traded funds) with low expense ratios can be good investment vehicles for building and maintaining your retirement portfolio. The following are some ETFs well worth considering in building or maintaining your portfolio in the current environment. (This list is geared toward U.S.-based investing because I live and work in the U.S.)

Ticker

Fund Name

Expense Ratio (ER)

ER Less Waiver

Comments

VTI

Vanguard Total Stock Market ETF

0.06%

NA

Tracks almost the entire U.S. stock market.

IWR1

iShares Russell Midcap Index Fund

0.21%

NA

Tracks the about 201-1000 largest stocks in the U.S. market.

VO1

Vanguard Mid-Cap ETF

0.10%

NA

Tracks the about 301-750 largest stocks in the U.S. market.

IJH1

iShares S&P MidCap 400 Index Fund

0.21%

NA

Historically the known sweet spot in terms of investment gains.

VXUS

Vanguard Total International Stock ETF

0.18%

NA

Tracks developed and emerging markets outside the U.S.

PZA

PowerShares Insured National Muni Bond Portfolio

0.28%

0.35%

MLN

Market Vectors Long Municipal Index ETF

0.24%

NA

AMT-free (U.S.-Alternative-Minimum-Income-Tax-free)

LQD

iShares iBoxx $ Investment Grade Corporate Bond Fund

0.15%

NA

Easier to purchase at no or a smaller premium to NAV v. VCLT.

VCLT

Vanguard Long-Term Corporate Bond ETF

0.14%

NA

Often trading at a high premium to NAV.

1 Enables you to weight your stock holdings more toward the mid-cap space, which has exhibited superior performance.

You may notice that I did not list the SPDR S&P 500 (SPY) ETF above. (SPY is by far the most held and traded ETF.) This is because I do not think there is sufficient cause to overweight the S&P 500 within the U.S. stock space. In the nearer-term future, I may think that emerging market or European stock ETFs ought to be included on this list to enable these stock market spaces to be overweighted. Currently, I do not. What do you think?

Source: Your Retirement Investments: Stocks Vs. Bonds