Your retirement portfolio shouldn’t be more than 60% invested in stocks, even if you plan to be working for another 30 or 40 years.
This advice runs directly counter to the “glide path” strategy that most investment experts and target-date funds follow. This strategy allocates 90% or more of your retirement portfolio to equities in your younger years and gradually shifts some of this equity exposure into bonds as you approach retirement.
My advice not to follow this glide path isn’t because the stock market is overvalued (though that is also a good reason). It isn’t because of the risks inherent in the intense political polarization of the U.S. (which is another good reason to be worried). It isn’t even because aggressive strategies rarely earn enough to justify their higher risk, as I wrote in a recent column.
There’s an even more basic reason: a glide path strategy more often than not falls short of a simple, constant 60% stock/40% bond portfolio allocation.
To show this, I calculated the performance over a 40-year time horizon of a 25-year-old investor who that year began following a standard glide path until retirement. (I used an example from Vanguard Group’s website.) Specifically, this investor was 90% in equities and 10% bonds until age 45 — 20 years later — and then began shifting 2% from stocks to bonds in each successive year until age 65, at which point this portfolio was 50% equities/50% bonds. I calculated the returns using a database compiled by Edward McQuarrie, an emeritus professor at Santa Clara (Calif.) University with data going back to 1793.Related video: 5 Crucial Decisions for a Financially Secure Retirement (Money Talks News)
I next calculated what each of these investor’s returns would have been if, instead of following the traditional guide path, the portfolio maintained a constant 60/40 allocation from age 25 to 65. In 34% of the years this 60/40 portfolio had more money at retirement than a glide-path portfolio. In an additional 32% of the years, the 60/40 investor came very close to matching the glide path — lagging by less than one half of a percentage point annualized.
In other words, in two of three cases there would have been little to no reason for an investor to prefer the glide path. But there is an even stronger argument in favor of the 60/40 portfolio: less risk than the glide-path strategy. On a risk-adjusted basis, a 60/40 allocation beats the glide path 98% of the time.
It is for these and similar reasons that the late Peter Bernstein argued that the 60/40 portfolio should be our default asset allocation. Bernstein, who died in 2009, was one of this country’s best-known financial historians, economists and educators; he was the first editor of the Journal of Portfolio Management.
How the glide path landed
Given these results, you might wonder how the glide path ever came to be the unquestioned conventional wisdom. The answer in large part traces to the limited history on which most glide path research has been conducted. That history in almost all cases begins in 1926, and the stock market has far outperformed the bond market in the century since then. In the prior 130+ years, however, stocks and bonds produced strikingly similar returns.
This is illustrated in the chart above. As you can imagine when reviewing the stock and bond series plotted there, the glide path looks far superior so long as the period prior to 1926 is excluded from the analysis.
I’m not suggesting that the research was intentionally focused only on the post-1926 period in order to bias their conclusions in favor of the glide path. For several decades, the best-known and most reliable database of long-term stock and bond returns — the Ibbotson database, now owned by investment researcher Morningstar — began in that decade. This is no longer the case, however, courtesy of McQuarrie’s database that extends back to 1793.
Nevertheless, the unintended consequence of focusing on just the past century is to make the glide path appear to have a far stronger historical foundation than it really does. To continue believing that the glide path is the proper strategy for your retirement, you implicitly must believe that U.S. history prior to 1926 is not as relevant to the next several decades as is the past century.
It would be curious if that were true. McQuarrie told me that he knows of no theoretical reason why the Ibbotson database begins in 1926 and not before. “The exact same data source used [to calculate stock and bond returns] for 1926 was available for 1925, 1924, 1923, 1922 and earlier,” he told me in an email.
One significant consequence of not including those immediately prior years was ignoring the stock market crash that occurred in the early 1920s — before the infamous 1929 crash. This earlier market slide accompanied an economic downturn that James Grant, editor of Grant’s Interest Rate Observer, calls the “forgotten depression.” One prominent economist at the time pronounced that the world was then “nearer collapse than at any time since the downfall of the Roman Empire.”
Similar “forgotten” episodes occurred throughout the 19th century as well. So unless you believe that economic downturns and stock market crashes will never happen again, the pre-1926 history would seem to be very relevant indeed. Ignore this at your peril as you build a retirement financial plan.
Source: https://www.msn.com/en-us/money/