How Much Stock to Put in Stocks?

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Back in March 2012, the Wall Street Journal ran a cover story by NewRetirement Advisor Dr. Zvi Bodie, and Dr. Rachelle Taqqu, concerning the dangers of investing in stocks to build wealth for retirement.  The crux of the argument was that while the prevailing Wall Street wisdom is that stocks always outperform bonds over the long term (having done so in every thirty year period since 1861), the fact is that building your retirement plan around the stock market — whatever your diversification — is inherently risky, as the longer you hold stocks, the greater your chances of running into an inconvenient, if temporary, bear market, which if timed near the end of your retirement plan, can ruin decades of careful wealth management.

Anyone who was in the stock market around 2008 can certainly attest to that much, but the article has generated a great deal of discussion, with the Journal posting a followup piece containing readers’ objections to the authors’ thesis, and other sites such as Seeking Alpha posting their own thoughts on the endless debate as to what the perfect portfolio should really look like.

Risk vs Gain

The key point to this debate (like everything to do with investment) is the proper calibration of risk vs. gain in one’s investment strategy.  Dr. Bodie and Taqqu aren’t claiming that stocks have no place in a portfolio, but that too many people employ them too freely, relying on old adages like “stocks always outperform bonds over the long term” (see above) instead of looking at what the actual risks of their investments are.  Their position is that most people underestimate the risks of stock ownership, and their suggested solution is additional investment in I-Bonds or TIPS (Treasury Inflation-Protected Securities), extremely low-risk securities indexed to the inflation rate, commonly used as a hedge against bear markets or as inflation protection for already-accumulated assets that need to retain their value for a long time.

Of course the flip side to this argument (as the follow-up articles point out) is that reducing risk has a corresponding effect on one’s ability to amass wealth, and that while removing stocks (or reducing them proportionately) in one’s portfolio will lower risk and reduce volatility, it will almost certainly also reduce the overall amount of money one ends up with.  TIPS and I-Bonds definitively do not grow at all beyond the inflation rate, and other low-risk investments, such as standard bonds, have traditionally yielded less than stocks, especially over the short-medium term.  How then to make up the shortfall?  Remember, we are talking about retirement savings amassed over the course of decades.  A difference of a few percent in average yearly growth can make a massive difference in the endgame, and while “saving more” can help, most of us cannot easily increase our savings rate by 30%.

What is the Best Strategy for Avoiding Risk AND Gaining Value?

So what do you do?  Well obviously, there’s no one answer to that question (all three of the pieces above take pains to point that out), but one element that’s key to a lot of modern thinking on retirement is the idea of weighting risk relative to age.  Longterm retirement planners often advise people to take different thresholds of risk at different ages, investing more heavily in risky stocks early on, when the negative effects of risks can be more easily mitigated, and switching progressively to bonds or even TIPS later on, when a sudden downturn like the recent recession could be devastating without enough time to recover.

However, more and more advisors are recommending a more nuanced approach to retirement investing. For example, you might determine your baseline retirement income needs and invest extremely conservatively to cover those needs and then take some risks with the nice to have money.  Learn more about these approaches in the following articles: 3 Steps to a Retirement Income Plan and Focus on Income Not Assets for Retirement Security.

Assessing Your Portfolio Now

Of course none of this matters if you’ve already suffered major losses to your retirement plan.  However, if you have seen gains, now may be the time to reallocate your portfolio for greater security.

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