Investment Portfolio For 65-Year Old

Reader Question

I read your lucid March 14 analysis on why it still makes sense to buy bonds. As a 65-year-old retiree, I have been keeping five years' living expenses (20% of my portfolio) in short-term bonds/cash and the rest in broad stock index funds, on the theories that (1) a deep stock market decline is unlikely to continue more then three years and (2) buying bonds now with maturities long enough to bring even a meager 2% interest would carry a very high interest-rate risk. Am I on the right track? Or should I buy more bonds and, if so, why?

My Reply

Thank you for writing. If anybody is interested, the March 14th post you referred to can be found at http://www.longtermreturns.com/2012/03/q-does-it-make-sense-to-buy-bonds.html . First, let me translate what you wrote into the overall portfolio picture. You said 20% of your portfolio represent five years' living expenses and are invested in short-term bonds/cash and the rest is in stocks. That translates into a portfolio that's 80% stocks and 20% short-term bonds/cash with overall portfolio value of about 25 times your annual living expenses.

You have a large portfolio relative to your expenses. If history repeats itself, portfolio that size would have no trouble lasting 30 years while allowing you to grow annual withdrawals with inflation. In fact, the relative size of your portfolio to your living expenses -- the 25-to-1 ratio -- became a sort of benchmark for sustainable retirement portfolio size, thanks largely to the so-called Trinity study that formally pegged starting 4% (i.e. 1/25th) withdrawals as sustainable over 30 years. In many historical scenarios the portfolio size after those 30 years of withdrawals actually exceeded the size of the original portfolio, sometimes even in inflation-adjusted terms!

What Trinity study found and many subsequent studies -- including one I reviewed just a couple of days ago in http://www.longtermreturns.com/2012/12/putnam-optimal-asset-allocation-review.html --  confirmed is that exact starting allocation of stocks and bonds is not particularly important, as long as some (say, more that 25% of the portfolio) stocks are included and starting withdrawals are no more than 4%. There is also some evidence that holding 100% in stocks is less than optimal for portfolio longevity during withdrawals, but 80% in stocks, as you have, played out just fine historically.

Unfortunately, where we stand today, all bonds are clearly pricier (meaning will have lower returns) than historically average and, in my estimation, stocks are too. I'd guesstimate that today's bonds will under-perform their historical averages by 3% annually and stocks theirs by 2% annually. Today's bond and stock valuations are very roughly comparable to late 1950s - early 1960s. The couple of decades that followed those days were no picnic economically or financially, but a diversified portfolio of 25 times starting withdrawal size still managed to survive them, hanging on long enough to benefit from the huge bull markets in both bonds and stocks that started in early 1980s. So even by rather adverse historical measures, I believe you are very much on the right track for a well-funded retirement.

What I would be most concerned with in your case is your ability to stick to your plan should, for whatever reason, we experience another 2008-style market meltdown. Your short-term bonds would likely survive fine, but your stocks could be rapidly halved. Instead of the comfortable 25 times living expenses you would be down to just 15 times living expenses. Should that happen will you be able to hang on to your existing stock portfolio without selling low? And although you are right that usually bear markets have been quite sharp, reaching their bottoms in under 2-3 year, their rebound back to previous highs in 5 years is much less of a sure thing. With only five years' expenses buffer in bonds, of which the first 2-3 years may already be used up during the initial bear market, you would be in no position to sell bonds and buy those beaten-up stocks.

I don't expect the scenario I outline above to play out, but it's clearly far from impossible. We were there just four years ago. Although things are looking much better now, there are still plenty of uncertainties in the world, some of which dwarf the housing bubble in importance. Major recent bear markets only cut stock values in half, but there is no rule against it getting even worse. As scary as hyperinflation and rising interest rates are, most economic crises are deflationary and stocks are much more likely than bonds to take a beating. Even in the ongoing Greek economic crisis that saw interest rates skyrocket, stocks lost more of their value than bonds (about 90% versus about 70%).

Although I think your current plan is fine and although, like you, I expect stocks to outperform bonds in the coming years, the upside of having such a stock-heavy portfolio is relatively small -- if everything goes well you might be able to have an even more comfortable retirement or leave a bit more to your children or charity -- while the downside -- should something go badly wrong in the world -- can be quite significant. Personally, I would be more comfortable with more bonds and less stocks, even as I realize that doing so is likely to "leave money on the table". Say, 50-60% stocks and 40-50% bonds/CD/cash.

An easy way to make such a switch is to sell 20-30% of your portfolio that is in stocks and put 10-15% in intermediate-term corporate bonds (VFIDX) or 5-7 year CDs at near 2% APY (e.g. PenFed) and 10-15% in long-term corporate bonds (VWETX). That would  reduce your portfolio's risk for a 2008-type event and get you some extra yield from long-term bonds. And it would still keep you out of the obviously overpriced treasuries. Long-term corporate bonds, while no bargains, continue to be more reasonably priced than the treasuries. They are not as attractive as they were in March of this year -- and certainly not near as good as they were in late 2010 - early 2011 when I recommended them -- but they are not obvious duds even now. More importantly for you, they are simply less risky than stocks while still being "good enough" to assure your successful retirement.

Of course you should also max out your I-Bond purchases and maybe consider EE-Bonds instead of or in addition to long-term corporate bonds, but given your large portfolio size and their limited availability, they will not make a big difference.

Again, I don't think your current plan is a bad one and I do expect it to work out fine. But I think the sacrifice you'd make in taking up a more bond-heavy portfolio is small relative to significantly improving your downside in case of a crisis. It's a very worthwhile trade-off, in my opinion, even though I fully agree with you that stocks will likely do better than bonds in the coming years and decades.

If you absolutely do not wish to sell stocks and buy bonds, then at the very least I would make sure that the dividends your stock holdings throw off are not re-invested. Channeling those dividends into I-Bonds, CDs, and/or short-term bonds would get you another 3-4 years' "buffer" before you have to sell stocks in case of an unexpected meltdown and using fixed income for living expenses. I would also not let your stocks to grow beyond the 80% of the portfolio that they constitute now. Do annual rebalancing (doesn't really matter when), selling some of your stocks and buying bonds with the proceeds in case stocks grow beyond their 80% allowance. I would also not re-balance the other way until stocks drop to 60% or less of the portfolio but that is a less important point.