STOCKS MARCH EVER higher, portfolios get ever fatter and yet the conundrum facing investors remains the same. We have no idea what will happen next to share prices—and no reliable way of figuring it out. Consider:
That said, it feels like there’s a limit to how much better the news can get. The 10-year Treasury note is barely above 2%. How much further can yields fall—and hence how much more of a lift can they give to share prices? The corporate tax rate was just cut, giving a onetime boost to company profits. It’s unlikely we’ll get another big corporate tax cut any time soon. Meanwhile, corporate profits are at 9.2% of GDP, versus a 50-year average of 7%. Can we really expect profit margins to widen further?
Where does all this leave us? If you’re under age 45, I’d just keep shoveling money into the stock market, both here and abroad. Even if you have a substantial sum in stocks, you’ll likely save as much—if not more—over the next 20 years. Any decline in share prices could ultimately rebound to your benefit, as you buy at lower prices.
But if you’re older, let me put in a plug for an idea that might be dubbed “over rebalancing” or “goal rebalancing.” This harks back to an idea I’ve discussed before—and which I purloined from friend and fellow author Bill Bernstein. As Bill says, “When you’ve won the game, stop playing with money you really need.”
The notion: If you’re comfortably on track to meet your retirement goal, maybe you should dial back the amount of risk you’re taking, so there’s less chance your financial future will unravel because of horrible markets.
To get a handle on the topic, all you need is a relatively simple financial calculator. Suppose you’re age 50, you have $375,000 socked away for retirement and you plan to save $15,000 a year over the next 15 years. Your goal is to retire at age 65 with a $750,000 nest egg, which should be enough to generate $30,000 in annual retirement income, assuming a 4% withdrawal rate. This would be on top of Social Security and any pension income. To calculate your target nest egg, simply multiply your desired annual retirement portfolio income by 25.
We’ll ignore inflation and do the calculation in today’s dollars. There will, of course, be inflation in the years ahead—and, to compensate, you’ll need to step up the sum you save each year with inflation. Let’s also assume you have 75% in stocks and 25% in bonds, which you figure will give you a blended real rate of return averaging 3.25% a year—with the stocks clocking a 4% real annual return and bonds notching 1%. Remember, these are after-inflation rates of return: If we get 2% annual inflation in the years ahead, you’ll need a nominal return above 5% to make the numbers work.
Result? At age 65, assuming that 3.25% real return, you’d have $890,000 in today’s dollars, comfortably above the $750,000 you were hoping for. What if you dropped your target real rate of return to 2.5%, which is what you might earn if you had your portfolio 50% in stocks earning 4% and 50% in bonds earning 1%? You’d still reach age 65 with $812,000, more than your $750,000 target.
So should you over-rebalance? I think it’s a matter, in part, of individual temperament. Do you want to lock in your financial future—or continue taking risk in the hope of an even more comfortable retirement?
I also think you need to consider your personal margin for error. What do I mean by that? If a big market drop would put your retirement at risk—and you fear you couldn’t compensate by working longer, saving more or spending less in retirement—I’d be more inclined to declare the game won and favor a less risky portfolio.
Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include A Penny Saved, Tax Rate Debate and That’s Enough. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.
Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.
For an investor who uses a “target retirement date” fund, is it as simple as moving to a closer target date (e.g. shift $ from target 2035 to target 2025)?
That could be a smart strategy — but I’d only do it if your target fund was in a retirement account and hence there would be no immediate tax bill.
A great column, and raises an interesting semi-conundrum. Given the notable and significant outperformance of large US growth ETFs and mutual funds (as representative examples the S&P 500 and Nasdaq 100), could an argument be made to overweight (as opposed to the “over-rebalance” noted in this column, if I’m reading it correctly). Using recent historical performance (I know, I know, just hear me out) as example going back 6 months – 3 years. Then, hypothetically, model in a recession that drops the value of the investment by 20%. How would this “growth portfolio” fare relative to a total stock market index-type fund given those same parameters, but MINUS the recession. I’m not good enough at either math or programming to run that scenario, but my off-the-cuff guess is that, even including a significant setback, like a recession, the outsize appreciation of this current crop of large cap growth stocks is so large that even with a significant setback an investor might largely still keep pace with the overall market. And on a more likely case, that the broad market would fall as well when growth stocks tank, then the recovery may be even better for large cap growth. Any thoughts?
It’s an interesting question and nobody knows the answer. My hunch is that large-cap growth will have its reckoning one of these days — but that day could be next week or next decade.
Now within a few years of retirement and at 65% equity, with most of the remainder actually in cash rather than bonds. From time to time I become frustrated by watching the market hit ever new highs while we continue to add pretty much all new money to bonds or my 401k’s stable value fund. This is a good reminder to just keep doing it and be happy.
All that said, I suppose the remaining question is whether it makes more sense to continue to overweight cash (stable value fund) over bonds with the new $, or to grow the bond allocation. The noise on the future of bonds and interest rates baffles me a bit (and of course no one knows). Fortunately the “how much to stable value v. to bonds” question isn’t nearly as consequential as the “how much in equities” one.
This is a great article Jonathan. Rather than the 4% rule, I like to use a “How Long Will My Money Last” calculator. (https://assetbrief.com/resources/how-long-will-my-money-last-g9r365r) I think it’s a bit more granular than the 4% rule. Especially if you think your investment returns will be lower, which in the current financial climate it looks like it could be. For example, a $750,000 nest egg, with a 4% withdrawal and 2% investment return will only last for 22 years…