|Not too long ago, there was a lot of talk in the media about how retirement was going to be such a breeze for a lot of folks, and they might even decide to retire earlier than they had previously planned. I don't hear that any more. Do you? Instead, I hear people wondering aloud how long it will take for them to accumulate the wealth to retire comfortably, and whether they're going to be able to retire at all in a reasonable period of time. So what went wrong? The market crash? I've always thought retirement plans were well thought out and able to withstand bad times in the market. Isn't that what financial planners are for, after all? |
Unfortunately, too many financial planners are out there merely to make money. They're not all like that, though. There are good planners who have their clients' interests in mind, but many have misled investors closing in on retirement, promising them withdrawals of more than $60,000 per year with a 3% increase every year to account for inflation. But because of the beating that the market has taken, that $60,000 has been cut almost in half. Worst of all, such a situation isn't surprising or unusual.
During those times when the markets are going higher and higher, there is no thought of a downside. There is, however, much discussion about the high returns that investors are earning, numbers that seem fueled mostly by the news media. Of course, the logic then becomes, if everybody is making such high returns on equities, why not put it all into equities? Don't do it! It may seem like a good idea at the time, but don't try it, especially if you're close to retirement.
Unfortunately, many of today's financial planners use tested models to determine the optimum asset allocation for their clients. There's nothing wrong with coming up with an asset allocation strategy. After all, studies have shown that asset allocation has a lot to do with enhancing returns. But that's not where the problem lies; it lies in the creation of the model. Too much emphasis is placed on historical performance. According to Henry K. Hebeler of Analyzenow.com, "The problem is that the financial planning community assumes the future will be like the past." And it is this past that is used to compute the average returns and inflation.
But what else can you use? The markets are unpredictable, and the best you can do is to prepare yourself for all possible scenarios. Most of all, though, be realistic. You need to be aware of the consequences if the worst happens, and arm yourself with as stable a retirement portfolio as you can.
BACK TO THE BASICS
Allocating your assets among various classes is a necessity for long-term investing. Putting all your investments in one stock is only going to expose you to the volatility the markets are renowned for, but dividing it among various instruments will certainly bring down that risk. The object of diversification is to stabilize your portfolio, not necessarily to bring you higher returns. It is this balance between risk and return that we continually strive for. Given all your options, whether large-cap, small-cap, mid-cap, emerging markets, foreign stocks, high-yield bonds, short-term bonds, or any of the other umpteen possibilities, how are you supposed to find that balance?
We're often encouraged to select investments in such a way that when one security goes down, another will move up. For example, bonds are supposed to be a good alternative when stocks fall. This may be true, but to gain the benefits, "You need to have your investments in bonds when the stocks start to fall," says Hebeler. This becomes analogous to market timing, which is not the same as asset allocation. You actually have to spend time analyzing the markets and moving from one investment class to another, which is a separate topic. Sticking with asset allocation and finding those securities that are not correlated is not easy. Look at the current market performance; trying to find an asset class that is performing differently from the broader indexes is like picking up that proverbial needle from a haystack. When the broader market indexes are sinking, it's likely that they're taking most of the sectors down with them.
SEARCHING FOR STRATEGY
As I look at my retirement portfolio, I can't help but wonder if there's a strategy I could use to prevent my returns from plummeting. Of course, time is on my side — I hope — but even my relatively youthful retirement portfolio has witnessed a bull and a bear market. To prevent it from performing the way it did during the 2000 crash, I thought it would be best to look at different scenarios. Since it was my retirement account, I was limited to the funds offered in my plan. I attempted several iterations that included altering percentage allocations and adding different subclasses. After several attempts, I came up with what I thought was the ultimate preretirement plan.
I had created a plan that was adaptable to various market conditions. There were separate asset allocation percentages for bullish, neutral, and bearish markets: During bullish markets I would invest 60% of my portfolio in US growth stocks, 25% in foreign stocks, and 15% in fixed-income instruments. During times when sentiment was neutral, I would decrease my US equity holdings to 50%, keep international investments unchanged, and increase my fixed-income investments to 25%. During bearish markets I would keep 50% in US equities, 10% in international investments, and 40% in fixed-income instruments.
Then came the test of time. The overall performance for the last four years beat the fixed 80% equity and 20% fixed-income strategy, but not by a significant amount, which I found rather disappointing. I'm sure it would have been significant had the time period been longer. What if I had started my retirement nest egg in 2000? The results would have been very different.
My plan may have worked under current circumstances, but there's never any knowing how the markets are going to perform. It's easy to see, in hindsight, what I could have done to avoid sudden drops, but it's close to impossible to try to create a plan based on future performance. Not only that, but there is an often-overlooked factor in the markets luck. The market might be rallying when you are ready to make withdrawals from your nest egg, but then again, it might not.
After thinking about these things, I looked at my plan again. What if I eliminated the most volatile of my investments? That would leave me with just two asset classes — US growth stocks and fixed-income instruments. Allocating between two classes would, if nothing else, simplify my job. Why worry about all the different subclasses? After this simple allocation, I'd only have to make minor adjustments, such as giving the bond portion more weight as I get closer to retirement. I can live with that. I may have to sacrifice some returns, but I don't need the volatility. This is a retirement plan, and I'm in it for the long term.
Editor Jayanthi Gopalakrishnan may be reached at Jayanthi@Traders.com.
REFERENCES AND RELATED READING
Hebeler, Henry K. . Your Winning Retirement Plan, J.K. Lasser series, John Wiley & Sons.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
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