Protecting Your Portfolio
As you get closer to retirement, you'll want to take less risk but maintain solid growth. Here's how to tend your nest egg
Call it a Catch-65. As baby boomers get closer to retirement age, they're being bombarded with two conflicting messages. One is that, as they approach 65, boomers should keep the majority of their investments in stocks. The other is that after an average annual return of 20 percent for stock funds since early 2003, it may be time to get more conservative.
So which is the safer course? Should you dial down your stock exposure to guard against an economy and a bull market that are showing their age? That might not be so smart. A study by T. Rowe Price found that even though a portfolio with only 40 percent in equities might last for 20 or 30 years--provided you withdraw only a tiny amount annually--inflation will chew away at that nest egg's purchasing power over time. Or should you hang on to your stocks to fight the long-term battle against inflation?
Fortunately for risk-averse investors, you may not have to choose. There are ways to tweak your retirement portfolio and lower your risk--by emphasizing different types of stocks--without giving up the historically higher returns of equities.
No bargains. One reason to stick with stocks is that there may not be a great alternative at the moment. "It's very hard to find undervalued asset classes right now," says Nick Nanda, asset-allocation specialist with the investment-management firm GMO. In recent years, just about every other asset class--including gold, commodities, and real estate--has shot higher, as the Federal Reserve has sought to reflate the economy following the 9/11 terrorism attacks and the 2001 recession. And bonds, the normal safe haven for aging investors, are even more overvalued than stocks, many believe. Indeed, while 15 percent of money managers surveyed by Merrill Lynch think equities are too expensive, 67 percent consider bonds to be overpriced.
Remember, this is not an attempt to swing for the fences. Instead, you are trying to reduce risk in your portfolio by emphasizing undervalued asset classes while lightening up on pricey ones. Don't make too many dramatic shifts, cautions James Peterson, vice president of the Schwab Center for Investment Research. Stay within 5 or 10 percentage points of your normal allocations. If you generally keep 40 percent of your investments in large, blue-chip stocks, say, then don't go below 30 percent blue chips or above 50 percent.
Get dividends. Of course, this raises the key question: What types of stocks and bonds should investors favor or shun to reduce their risk in today's market? One simple answer is to tilt your portfolio toward dividend-paying stocks, says Colorado Springs, Colo., financial planner James Shambo. Not only are dividend payouts usually a sign of financial health--as companies that pay dividends typically generate more cash than they need to plow back into the business--but dividends offer a cushion should the stock market decline. A company whose shares decline 2 percent but which pays out a 3 percent dividend would post a positive total return of 1 percent.
One way to increase your stake in dividend payers is to put more money into mutual funds focusing on companies that consistently raise their dividends. Among the better-known and low-cost options are Vanguard Dividend Growth and T. Rowe Price Dividend Growth. And Barclays iShares offers an exchange-traded fund that tracks the Dow Jones Select Dividend Index.
What group might you lighten up on to shift more money into dividend payers? Well, stocks of small companies have had quite a run, and they typically pay out fewer dividends than the stocks of large companies. While the Russell 2000 index of small stocks sports a dividend yield of just 0.99 percent, the Russell 200 index of the nation's biggest companies pays out 1.95 percent, almost twice as much.
What's more, small companies have been on a tear for more than five years. While the Russell 2000 has returned 10.5 percent a year on average for the past five years, large stocks have delivered less than 0.5 percent. Even if small caps continue to run, there's still an argument to reduce one's stake in this group. Small stocks have historically been more volatile than shares of large companies. Consider: The worst three-month loss for the average small-cap fund was a drop of 25.5 percent, in the summer of 1998, according to Morningstar. The worst three-month loss for the Fidelity Dividend Growth fund was only 16.1 percent. Meanwhile, that fund's best three-month gain was nearly 22 percent, which almost matches the best three-month gain for small stocks.
Go abroad. Another risk-reducing option is to move beyond the U.S. border. The typical 401(k) investor has only 4.4 percent of his or her assets in international equities, according to a Hewitt Associates study. But foreign stocks, because they do not move in perfect lockstep with domestic issues, help diversify your portfolio.
While there is a 92 percent correlation between movements in large U.S. stocks and small-cap shares, there's only an 85 percent correlation between large U.S. and large foreign stocks, according to Morningstar. The correlation is even smaller between large U.S. stocks and foreign small company equities.
Financial planner Ron Roge says investors should consider putting around 20 percent of their portfolios in international securities. Foreign stocks are cheaper in general than domestic shares. The average holding in a U.S. small-cap growth fund, for instance, trades at a price-earnings ratio of nearly 24, while the typical European stock fund's average holding sports a P/E ratio of only 15.4. And Asian stocks are even cheaper.
Many believe that after a decade of U.S. stock dominance in the 1990s, foreign shares are likely to be a solid investment for years to come. GMO forecasts that international equities are likely to return around 1.3 percent a year, after inflation, for the next seven years. By comparison, large U.S. stocks are forecast to lose 1.4 percent annually in real terms. Of course, these are just estimates.
Avoid junk bonds. On the fixed-income side, investors aren't being paid much at all to take risks, so many bond experts say now is a good time to stick with treasury bonds and high-quality corporate securities. Lower-quality junk-bond funds have performed remarkably well in recent years, posting returns of nearly 12 percent a year over the past three years. But should the economy slow down considerably, the likelihood of junk-bond defaults would rise. And junk bonds often move in close correlation with stocks. So if your intent is to reduce equity risk in your portfolio, high-yield bond funds aren't the best choice.
Bond investors must also be mindful of a different type of risk: interest rate risk. That's the risk inherent in holding long-term bonds. Typically, the market rewards investors for buying long-term bonds by promising higher interest rates. But in recent weeks, short-term bonds have actually yielded more than long-term debt. So this is probably a good time to stick with short- and intermediate-term treasuries, rather than extending your portfolio into extremely long-term bond funds. Roge thinks investors would also be wise to have some exposure to inflation-protected treasury bonds, which maintain their value even if inflation flares up.
Perhaps the biggest way to reduce risk in your portfolio is to keep a closer eye on your investments. Recent studies have shown that the vast majority of 401(k) investors leave their investments untouched for years at a time. But if you're making tactical decisions to reduce volatility in your nest egg, you will have to revisit your portfolio more frequently. At the very least, check on your holdings every quarter or two. Then, rebalance your portfolio back to your comfort zone on an annual basis.
Your retirement may well end up being a 30-year journey. Over the decades, the economy and the markets will pose new challenges, but your need to grow your portfolio while managing your risk will never change.
This story appears in the March 13, 2006 print edition of U.S. News & World Report.