By Bob Wood
A client recently asked me how an investor nearing retirement should alter his allocation and risk exposure in the stock market. My response will, no doubt, surprise many of you and may even seem wrong, since it flies in the face of conventional wisdom. With that thought in mind, let me repeat to you that I believe an investor preparing to retire should make few, if any, changes.
An investor who has â€œproper allocationsâ€ in the â€œright asset classesâ€ has little reason to become more defensive just because he will no longer receive a paycheck. The concept about becoming more conservative as you get older is just another â€œnugget of wisdomâ€ that has become readily accepted as sound financial thinking. But it is not foolproof wisdom! Itâ€™s not even close!
And hereâ€™s why. First, I ask what really changes when an investor leaves the work force. Sure, his paycheck stops, and he no longer has discretionary income to add to savings. And certainly, the diminution of his investment portfolio as he draws income from it regularly becomes a cause for discomfort. A long-term downtrend in the size of his investment portfolio could result in the availability of less income in ensuing years, as the cost of living inevitably rises.
But I think these may be the lesser of the evils that could befall a retiree. Maybe other threats, such as the power of inflation, slowly eroding the value of the dollar and the purchasing power of savings, may be more important reasons for worry. Unexpected costs for health care or even long-term care are also concerns. With these thoughts in mind, how can anyone rationalize that a retired investorâ€™s portfolio no longer needs to grow?
Something I learned early is that retirement is not an end date for investors. Just because you stop working doesnâ€™t mean you are in the â€œfinal throesâ€ of life. These days, the possibility exists that the new retiree may still have many years to live. Will a conservative portfolio, as it pays out monthly distributions, maintain its purchasing power over a 20-, 25- or 30-year time frame?
The retiring breadwinner of the family must also consider the expected life spans of his surviving spouse and children. Many parents continue to help their adult children financially. In life, few things are certain, and one of them is that â€œstuff happens.â€ Few people ever find themselves with too much money in the later stages of life, and outliving your savings remains one of lifeâ€™s greatest fears. And then there are legacy concerns. Some investors would like to leave as much of their holdings as possible to surviving children and grandchildren.
For any of these reasons, I advocate a long-term investment horizon for any investor. Planning how best to allocate your savings for the next 100 years may sound strange, but consider how it plays out.
Of course, staying with a more aggressive allocation requires a firm investment foundation. â€˜â€™Properly allocatedâ€™â€™ investments are those invested in value-oriented holdings, which are in the midst of secular, long-term bull markets. This is the stuff of investor dreams. Why would anyone with potentially 30 or more years to live want to bail out of strongly performing markets or asset classes?
Some of you, of course, may still be unable to accept my aggressive view on this subject and prefer to believe that, at some point, conventional wisdom will actually prove more valuable. Well, I will admit that becoming more conservative as you get older isnâ€™t the worst thing you can do. So let me offer a compromise solution.
Consider the â€œThree Pot of Moneyâ€ strategy, one I learned as a comprehensive financial planner, which works nicely here. Simply put and true to its name, this strategy involves separating your savings into three different pots. You can illustrate the concept yourself by taking a sheet of paper, turning it sideways and drawing three circles.
Draw the first circle to be about two inches in diameter. To the right of it, draw a second circle slightly larger, and, to the right of that, draw the third circle, larger than the middle one. Between the circles, draw two small arrows, each pointing from the larger circle to the smaller one on its left.
The first and smallest circle represents the cash you expect to need in the first three years of retirement. Since money required in the short-term should not be subject to market risk, this first pot consists of low-yielding assets like cash, money market funds, CDs and very short-term bonds.
The second pot holds assets needed in retirement years three through seven. With the added time available, taking some additional investment risk with this money could add a higher potential return. This pot could hold relatively safe investments like utility stocks, balanced mutual funds, bond funds and investment grade bonds. For those of you with philosophical objections to bonds, dividend-paying stocks would work too.
The third pot holds riskier assets, those not needed for at least seven or more years into retirement. It contains more typical investments and offers higher return potential. Typically, stocks and stock mutual funds are held here.
As our retiree depletes the first pot of money, dividends and capital gains earned from assets in the second pot can be diverted to re-filling the first pot. And assets in the second pot can also be sold over time to raise cash, which then flows into the short-term pot. In this way, annual transfers from the mid-term pot continually help to refill the short-term pot.
As the second pot of money is depleted, gains from the third, growth-oriented pot can be diverted to re-filling the second pot and then re-invested in less aggressive investments. Should the stock market drop unexpectedly in value, those assets would probably have sufficient time to recover, since the investor hasnâ€™t been taking money from the assets that, at the same time, have been falling in value. This long-term pot of money always remains just that, so market volatility remains a smaller concern with these assets.
With such a strategy, a retired investor can feel more secure, knowing that he has the ability to ride out market volatility with funds that wonâ€™t be needed for a few years. Added comfort comes from having enough in the short-term pot for emergencies or monthly withdrawals. Since this money is meant for such purposes and is not subject to volatility, it adds predictability.
The second, or mid-term pot allows time for adding dividends and asset appreciation, permitting the third pot, with its riskier allocations, to grow as expected. Using this process, a retiring investor who was properly allocated for growth will have few regrets about having sold stocks or mutual funds that rose far higher in price in the months and years after he became less involved with them.
Have a great week,
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.