Building your retirement roadmap involves many critical decisions. When should you start saving? How much should you save? How long will you work? How long will you live in retirement? What will you spend in retirement?
Another critical factor is investment return. But how do you control the markets? You don’t, of course. But there is one thing you can control, which could greatly affect your investment return: your mix of investments.
Invest too conservatively and it will be extremely difficult to reach your retirement goals. Invest too aggressively and you take on more risk and are susceptible to the market’s twist and turns. But if you’re young, with many years until retirement, and are comfortable with the risk, you should be able to recover from market downturns—as long as you stick with your asset allocation.
“In general, people should be more aggressive in their asset mix when they are younger—that is, tilt more toward stocks,” says Steven Feinschreiber, senior vice president of Strategic Advisers, Inc. (a Fidelity Investments company that is also a registered investment adviser).
Why a substantial allocation to stocks?
Consider Lily, a hypothetical investor who starts saving at age 25 in a 401(k) plan and expects to retire 40 years later at 65. How should Lily allocate her retirement assets based on her time horizon and risk tolerance?
Lily understands that risk and return generally go together. To help her decide on her allocation, we analyzed historical monthly returns from January of 1926 through December of 2013 for three different portfolios:1
- Conservative: 20% stocks, 50% bonds, 30% short term
- Balanced: 50% stocks, 40% bonds, 10% short term
- Aggressive growth: 85% stocks, 15% bonds, 0% short term
The portfolios were constructed using the Standard & Poor’s 500 Index (S&P 500® Index) to represent stocks, the Barclays U.S. Intermediate Government Bond Index to represent bonds, and U.S. Treasury bills to represent short-term instruments. It is important to remember that these are unmanaged indexes and no fees are incorporated in the analysis. It is not possible to invest directly in an index.
Risk may be measured in many ways, but one simple way is to look at the minimum, maximum, and average return for different portfolios. First, we looked at returns over each one-year period, based on 12-month rolling periods.
While the median one-year return for an aggressive portfolio is 12%, it comes with a worst single-year loss of 62%. A balanced portfolio has a median one-year return of 9%, three percentage points lower than the aggressive portfolio, but its worst single-year loss was 41%. A conservative portfolio only fell 18% in its worst year, but its median return was only 6%.
But Lily has 40 years until retirement. Indeed, until she is 59½ she cannot withdraw her retirement savings without paying taxes and being subject to potential penalties. So Lily probably shouldn’t worry too much about what happens year to year but should look to the long term.
We ran the analysis for a 40-year time horizon, matching Lily’s time to retirement.
Over this very long time horizon, the risk-return story is very different. While the median annualized return for the aggressive portfolio falls slightly when viewed year over year for 40 years, from 12% to 10%, the minimum and maximum returns shrink dramatically: The highest return for each one-year period, based on 12-month rolling periods, was a gain of 136%, whereas over 40 years, the return would have been a maximum of 12%. But to get the 12% average return in this hypothetical example, an investor would need to hold the portfolio for the entire 40 years. Likewise, the lowest one-year return shifts from a 62% loss over a one-year period to an 8% annual gain over 40 years.
Notice how the minimum annualized return observed for the more conservative portfolios was lower than the minimum return for the more aggressive portfolios. In some ways, it may be riskier to be more conservative when planning for very long time horizons.
Lesson 1: If retirement is many years away, consider a significant allocation to stocks.
What about the short-term risk?
So what should you do when markets have short-term downturns? If you’re investing for a far-off goal like retirement, we believe you should stick with your asset mix if it still makes sense and matches your goals, financial situation, and risk tolerance. It may be painful for a while, but eventually you should potentially be better off by maintaining an appropriate asset mix.
But how long can the pain last? Using the same monthly return data, we looked at three poor market scenarios: the Great Depression, the early 1970s, and the recent Great Recession.
If you were invested in an aggressive portfolio of 85% stocks and 15% bonds during the recent Great Recession, your portfolio would have lost around 44% from October of 2007 to February of 2009. However, by April of 2011 the portfolio was back to its 2007 high. It took 42 months for the portfolio to move from its high to its low and back to its prerecession value. While almost four years is a long time, in the context of a 40-year investment horizon, it seems less daunting. On the other hand, it took 13.75 years for the market to recover during the Great Depression. The graph below shows all three scenarios.
Lesson 2: Stick to an appropriate asset mix, which is especially important during market downturns.
The bottom line
Being young has many benefits, one of which is a long investment horizon. For people with 40 years until retirement, it’s important to build potential growth into their portfolio through a significant allocation to stocks.
But while this may be an intuitive course for some, other young investors are still hesitant to invest for the long term. In our Retirement Savings Assessment,2 we found that 52% of young people (Generation Y, born 1978–1988) had 50% or less allocated to stocks. These investors would likely be in a better position to meet retirement expenses if they held more age-appropriate, stock-centric portfolios.
We believe that investors should continue to review their financial situation throughout their lives. As retirement comes into view, they would likely want to reduce the risk to their portfolio. Historically, shorter periods carry greater risk of a large drop in stocks. A large drop close to retirement could severely affect a plan without allowing the market time to rebound before withdrawals are required.
Combined with a strong saving discipline, your investment mix is a key pillar in building your retirement foundation. Having the appropriate mix for your age and financial situation could greatly improve your ability to meet your retirement needs.
- Help create a roadmap toward retirement with our Income Simulator (NetBenefits® login required).
- Create a retirement income strategy that matches your goals with Retirement Quick Check.
- See whether your investments are on track with Portfolio Review.
- Get more retirement planning strategies with our Retirement Roadmap.
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