How Safe is Your Nest Egg?
In this entry, I make references to “bonds”. But not all bonds are created equally. In this case, I am referring to safe, government bonds, not risky, high yield (high risk!) corporate debt.
Few things are more fascinating for me, than rifling through other people’s private investment statements.
It’s not that I climb people’s backyard trees to reach their second story windows, where I break into their offices or bedrooms to—James Bond style—snap photos of their Merrill Lynch statements. It’s a lot easier than that. People volunteer. Where I work, at Singapore American School, I’ve examined the investment accounts of at least 30 of my colleagues.
And something always strikes me as odd. It’s not that most of them pay higher account fees than they should—including sales fees and wrap fees. I’m used to seeing that. Nor am I surprised that their advisors buy them tax-inefficient actively managed mutual funds (which pay their advisors and the IRS well) instead of buying index funds (which, long term, pay the investors well instead).
What surprises me is my average colleague’s bond allocation. When markets tank, bonds can be a more welcome site than a fireman to a treed cat.
I’ll be the first to admit—I’m what many people would call a wimpy investor. But I work at a private school and won’t be able to enjoy a state or provincial teacher’s pension when I retire.
For that reason, I can’t afford to take silly risks. I follow a widely accepted rule of thumb suggesting that I should have a bond percentage that somewhat equals my age. For example, as a 39 year old, roughly 40% of my portfolio is in bonds. It’s not sexy, but it can definitely protect my ass…ets during a downturn.
But pouring over my colleagues’ investment account statements is like watching my buddies going down class 5 rapids in leaking boats without life jackets. I’ve seen accounts of 60 year olds that are 100% exposed to the stock market. Without pensions, these guys are metaphorical “non swimmers” when markets fall, because their accounts have so little time to recover from a downturn, before they need to start selling off portions of their nest egg to cover life’s expenses. Bonds can act as welcome life preservers when stock markets drop.
In fact, none of the dozens of accounts I’ve seen had a bond allocation as high as my own. And most of the accounts I scrutinized belonged to investors much older than me. I would have expected higher bond allocations.
There are a handful of possible reasons that my friends have such high stock allocations—and such limited exposure to bonds.
1. In some cases, their advisors might not know any better. A young or inexperienced advisor may be innocently unaware of how volatile a stock portfolio can be. In these cases, the past year probably served as a great lesson.
2. I hate to be cynical with this one, but it’s a possibility. Under certain circumstances (depending on the financial service company you use) advisors receive higher “trailer fees” (meaning that they get paid more) for getting you into stock funds than they do into bond funds. I like to hope that nobody makes a decision on your behalf, based on their own economics. But it happens.
3. For some people, the promise of higher returns with a portfolio weighted more heavily in stocks than bonds is worth the risk. Or so they think.
This is what I find most fascinating. How educated is the average investor, based on the probabilities of what that extra risk could mean? And how great are the rewards reaped from taking on more risk?
If you had invested your portfolio 100% in a U.S. stock market index from 1973 until 2004, without a single bond index or bond fund, your annual return would have averaged 11.19% per year.
And if you had invested 60% of your money in stocks, and 40% in bonds, you would have averaged 10.49% per year. Overall, you would have been rewarded for taking on more risk, with the 100% exposure to stocks. But you’d be a bit like that gal on American Idol who auditioned in her bikini to an internationally televised audience. Her body and audacity moved her into the next round—but beyond that?
The annual advantage, if you had invested 100% in stocks, would have amounted to just 0.7% per year during this time period, compared to an account that had just 60% allocated to stock, and the rest to bonds. Like the gal on American Idol, you would have made the next round as well. But at what risk?
Ryan Seacrest may not have mocked you on national television, but the 2008 market crash may have felt like you were strung up naked from a lamppost.
A quick check on the American Funds website www.americanfunds.com reveals that their average U.S. based fund, at the time of this writing, is down more than 30%, from May 31, 2008 to May 31, 2009. When you’re down 30%, you have to gain 43% just to break even (It’s interesting math– if you’re down 50% in one year, you have to gain 100% the following year, just to break even). If you were 55 years old, and hoping to retire in a handful of years, losing 30% could be devastating.
But if you were 55 years old, and had only 45% of your money exposed to the U.S. stock market instead, you would only be down about 12% during the same one year time period. You’d only have to gain 13.6% to break even. You’d have your back against the lamppost, but you’d be fully clothed, and your feet would still be on the ground.
If you’re still comfortable taking higher risks for only slightly higher return potential, you might consider this: the U.S. markets didn’t move from 1965 until 1982. For 17 years, they didn’t appreciate. If that happens again, after a retiree or near-retiree loses 25% to 30% of their portfolio, they’re going to be hurting when they need that portfolio to cover living expenses.
Shakespeare said that nothing is either good nor bad, but thinking makes it so. I think I’d prefer to keep my clothes on, stay out of leaking boats, and keep my feet on terra firma. But that’s just me: a wimpy investor.