Portfolio Strategies for a Shaky Market
As retirement nears, avoiding major losses is essential
In her head, Gail Hoffmann knows it's too soon to panic. While the recent market sell-off has pushed stock prices down by as much as 10 percent, the Morris County, N.J., marketing manager understands that this is nothing compared with the bear market of 2000-2002, which cut the value of the Standard & Poor's 500 index in half.
And as frightening as stocks can be, as an older baby boomer, Hoffmann knows all too well that she needs equities in her portfolio to keep her money growing over the course of a long retirement.
But in her heart, Hoffmann says she can't help but worry, what with the Dow Jones industrial average swooning 1,000 points or more recently from its highs and with talk of recession creeping back into the headlines. At the very least, she says, "I find myself paying more and more attention to the news on the ride to and from work."
With good reason. While most investors are taught to shut out the day-to-day noise of the stock market—and to invest for the long haul—older boomers like Hoffmann find themselves in a different situation.
While it's true that retirement can last more than 30 or even 40 years, hitting a small speed bump early on in retirement can dramatically shorten your nest egg's life expectancy. For instance, say you had retired at age 65 in 1963, with a $1 million portfolio—half invested in stocks and the other half in corporate bonds. Now let's assume that you tapped $70,000 from this account every year for 30 years. Even after three decades of withdrawals, you'd still be left with $784,000 in your account by the time you turned 95, thanks to rising stock values and the effects of compound interest.
But let's tweak this example slightly. Instead of retiring in 1963, say you stopped working one year earlier, in 1962, while keeping the same mix of investments and level of withdrawals. In this case, instead of having more than three quarters of a million dollars at 95, you'd have run out of money by that age.
Why? Simple. In 1962, the first year you would have tapped your nest egg, the stock market lost about 12 percent. And since you withdrew an additional 7 percent of your original $1 million (or $70,000), your portfolio was reduced by almost a fifth in just your first year out. But in 1963, the stock market rose 19 percent. Instead of losing ground in Year 1 of retirement, your portfolio actually grew to $1.1 million, despite your $70,000 withdrawal.
Bear tracks. It goes to show that "your start point is important," says Philip Cooley, a professor of business administration at Trinity University and an expert in retirement withdrawal strategies. As bad as 1962 was, the year 2000 was even worse for retirees—"probably the worst possible time to choose to leave the workforce," says Cooley, "because you went through three years of the worst bear market in modern history at the same time you were taking money out of your account."
So how can older boomers like Hoffmann, with retirement on the horizon and the stock market looking shaky, avoid a similar fate?
Mike Scarborough, president of the Scarborough Group, a 401(k) advisory firm that helps workers with their retirement accounts, says his company is fielding calls from clients asking just that. "They're not jumping off the cliff," he says, "but within three sentences, they're mentioning the 2000-2002 time period. They don't want to revisit it."
While it's dangerous and foolhardy to make wholesale changes to your investment plan simply because of market jitters, here are ways to reduce the chances of major losses early in your retirement:
Don't hold individual stocks. It's not the individual stocks and bonds you own, research shows, but your mix of stocks and bonds that determines long-term investment success. So why take the risk of owning individual securities when you can invest in an array of diversified mutual funds or exchange-traded funds, which are baskets of stocks that trade the way a single security does?
That's what Steve Rozich, 62, of Laguna Niguel, Calif., recently asked himself. A few weeks ago, Rozich pruned his portfolio of individual stocks, including blue-chip shares like Walt Disney and Hilton Hotels. He replaced them with a cross section of mutual funds that invest in various types of equities to maintain his overall exposure to stocks. "I'm completely out of individual equities now," says Rozich, who runs a small business that helps companies with their employee rewards programs. "I can sleep better at night," he says. "I don't have to get up every morning and check where those prices are."
Rozich understands that in any given year, individual stocks can easily outpace the market. In fact, both Hilton and Disney shares nearly tripled the returns of the Standard & Poor's 500 in 2006. But any stock can lag behind, too. Plus, holding baskets of stocks is less risky, says Phillip Cook, a financial planner in Torrance, Calif.
Indeed, the worst three-month loss for an investment in an S&P 500 index fund—a collection of 500 stocks—was a 17 percent drop in the summer of 2002. Yet in the past month, shares of several mortgage companies have lost way more than that in a single day.
Rebalance routinely. It may sound simple, but rebalancing your portfolio periodically—resetting your mix of stocks and bonds—can help cut your risk without upsetting your long-term strategy.
Let's say you decide that the best mix of assets for you is 60 percent stocks, 30 percent bonds, and 10 percent cash. Over time, that mix will change on its own, as stocks, bonds, and cash appreciate at different rates. Because stocks have historically outpaced bonds (a 10.4 percent yearly return on average versus 5.9 percent), your portfolio's weighting in stocks will almost surely grow over the long term, says Christine Fahlund, senior financial planner with T. Rowe Price.
Assume you started off with the 60-30-10 mix of stocks, bonds, and cash on Dec. 31, 1984. And let's say you never rebalanced your account. By March 2000, your 60 percent in stocks would have soared to 86 percent.
But if you're routinely selling winning stocks to reset your asset allocation, won't you lose out on gains? In the short run, probably yes. But over time, investors who rebalance give up very little in returns—and enjoy a much smoother ride.
T. Rowe Price recently crunched some numbers and found that a 60-30-10 mix, left unrebalanced, would have returned 11.1 percent a year from the end of 1984 through June 2007. But if you had rebalanced your portfolio back to that 60-30-10 mix every time your stock allocation rose or fell by more than 5 percentage points, your returns would have been nearly the same: 10.9 percent annualized. But your portfolio would have been 18 percent less volatile.
Yet less than 1 in 5 retirement investors rebalanced 401(k) accounts last year, according to Hewitt Associates, an employee benefit research firm. "Rebalancing is sort of like the flossing of investing," says Barry Glassman, a financial planner in McLean, Va. "It's so important, yet not that many people do it enough."
Change the types of stocks you own, not the amount. Afraid to reduce your exposure to stocks because you're worried you might outlive your nest egg? Here's an easy fix: Change the types of stocks you own to a safer mix.
For example, when the market averages are bouncing around wildly from day to day, as they have in recent months, strategists recommend that investors stick with shares of large, industry-leading companies. The stocks of big companies not only have trailed the broad market in this decade (which means they have less room to fall), but they also tend to sway less than shares of fast-growing, small companies.
The worst three-month loss for small-cap stock funds in the past decade was 25.3 percent in 1998, according to the fund tracker Morningstar. But funds that invest in large, blue-chip stocks dropped no more than 16.7 percent, in 2002.
Another option is to hold stocks that pay out dividends. That income offers you some cushion against losses when stock prices tumble. In the recent sell-off, the WisdomTree LargeCap Dividend fund didn't escape declines. But it beat the S&P 500 by 1.4 percentage points over the past month.
Don't slam on the brakes too hard. If you find that a stock sell-off is so unnerving that you lose beauty sleep, you can cut back on stocks. But don't go overboard. "You don't have to go entirely to cash," Scarborough says. "Just back your portfolio off a little."
Even just tweaking your asset allocation might be enough to ease your jitters. The Vanguard Group compiled data on asset allocation strategies going back to 1926. It found that a portfolio consisting of 60 percent stocks and 40 percent bonds produced an average annual return of 8.9 percent. But this portfolio lost money in 20 calendar years between 1926 and 2006—diving nearly 27 percent in its worst year, 1931.
By downshifting slightly, to a 50-50 stock-bond mix, you'd have earned nearly as much: 8.5 percent a year. Yet you would have lost money in only 16 calendar years, and your worst yearly decline would have been 22.5 percent, again in 1931.
Whichever strategy you choose, the key for older boomers is to do the little things now that will prevent larger losses once in retirement. As people live longer, retirement may turn out to be an extended journey, but the last thing you want to do, Cook says, "is dig yourself a big hole that makes it difficult to come back from."
This story appears in the September 10, 2007 print edition of U.S. News & World Report.