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One thing that we point out to our readers is that if you don't have stocks in your portfolio, you expose yourself to inflation risk.
That's true. By owning stocks you do mitigate inflation risk, but of course, you're exposing yourself to equity risk to do it. It's sort of like all these people who are now buying dividend-yielding stocks because Treasury bonds don't have any yield; they're exchanging a riskless asset for a risky asset.
But there's another asset class that people really don't think about when they think about inflation protection, which is short, high-quality bonds with a maturity of less than three years. If we ever do get an inflationary shock, investors will demand a high real short-term rate of return. It's what happened during the late '70s and early '80s.
Even though interest rates are terrible right now, if inflation recurs -- as I think it probably will -- short-term bonds are a fine place to be, as are individual Treasuries or certificates of deposit. Since they mature soon, you can replace them quickly with newer, higher-interest bonds.
Interest rates usually more than keep up with inflation. It's true that real yields right now are historically low, but as a student of financial history I have to believe that's not going to last forever.
Okay, so stocks are risky at retirement. What about when I'm young?
For the average person, you'll want a very high stock allocation. Let's imagine you start working at age 25, and let's say for the sake of argument you have 35 years worth of human capital -- that is, 35 years of salary left in you. That's an asset that you own. What you've saved in one year for retirement is still minuscule compared to that 34 years of earning and saving that you have left.
So even if your investment capital when you're 26 years old falls by one-half, your total worth has fallen by only a couple of percent because you still have that 34 years of human capital left. Your ability to earn and save dwarfs the loss in your portfolio.
And what about when I'm in the middle of my career?
That's the key phase. You need to start bailing out of risky assets as you get closer to achieving that liability-matching portfolio—when you can "win the game" without taking so much risk.
Instead of cutting your stock allocation one percentage point a year -- the standard formula -- in a year with absolutely spectacular returns, you might want to take 4% or 5% off the table. In a series of years when stock returns have been poor, you don't take anything off the table. And over time you start laying down a floor of safe assets with the proceeds from the stocks you've sold.When exactly am I doing this?
Getting close to hitting your number is usually going to happen during a bull market, so the psychology of doing this right is tricky. It's hard to cut back on risk and accept lower returns when your neighbors are getting rich.
If you're very lucky and very frugal, hitting your number might happen when you're 45. In the worst-case scenario, you do everything right and still come up short at 65, so you wind up working longer or greatly paring back your expectations.
It sounds like retirement success depends on when you were born.
Yeah, that is certainly true. Young people should get down on their knees and pray for a brutal bear market at the beginning of their savings career, because that's going to enable them to buy a large number of shares cheaply. Having a sequence of bad returns first, followed by strong returns, is the best-case scenario.
I did a little thought experiment in which I calculated how many years it took people starting work in different years to make their number. I realized that the cohort that started working during the worst of economic times is the one that did the best.
by George Mannes., CNN Money | Read more:
