Published September 21, 2011
Long-term stocks investment planning is essential to maintain an even keel in volatile markets, writes TARA SIEGEL BERNARD
(NEW YORK) JUST as you caught your breath after the stockmarket mayhem of 2008 and 2009, it has become increasingly clear that this ride isn't over just yet.
Changing risk perception: When you need to begin withdrawing savings, stockmarket valleys can appear deeper and more turbulent than earlier ones you've seen
This is particularly worrisome for people who are nearing retirement, as well as those who have already left the work world, many of whom are probably spending a fair bit of time wondering if the world markets have suddenly become a riskier place.
When you need to begin withdrawing savings, the stockmarket valleys can appear deeper and more turbulent than the ones you experienced earlier in your career because there is often little time to recoup your losses.
'What changes, and very radically, is risk perception,' said Dave Yeske, a financial planner in San Francisco. 'The scariness of short-term volatility disproportionately blinds us to the long-term scariness of inflation,' he added, saying that the recent inflation rate of 3.6 per cent would erode your purchasing power by half in 20 years.
The latest bout of volatility is no exception. The summer was punctuated by rounds of dysfunctional politicking and then, on Aug 5, the unprecedented downgrade of the US credit rating. Concerns about a double-dip recession continue to linger, while the debt crisis in Europe is another wild card.
Not surprisingly, the markets reacted. Look at a stock chart during the week after the downgrade: The zigs and zags form a distinct W, which took shape when the Standard & Poor's 500-stock index plummeted nearly 7 per cent, and then, in the days following, rose about 4.7 per cent, gave up 4.4 per cent, then rose 4.6 per cent once again.
Stress test for investors
Further market gyrations are inevitable. So to protect your portfolio from yet another risk - your emotional impulses - during these unsettling times, you might consider reassessing whether your money is invested in a way that you can truly handle for the long haul. Start by trying to answer these questions: How much risk can I tolerate? Although the most recent downturns are painful, they have served a purpose.
'It did provide a nice stress test for investors,' said Fran Kinniry, a principal at Vanguard's Investment Strategy Group.
How did you do? Were you able to ride out the crash in 2008 and 2009 (or perhaps even the debt ceiling debate) without touching your investments - or did you fold and go to cash? If it's the latter, then you were invested too aggressively, experts say.
'If they were at 60 per cent in stocks and 40 per cent in bonds going into the bear market, and sold during the downturn, then that is above their tolerance for risk and they shouldn't go back to the level,' said Rick Ferri, author of All About Asset Allocation and founder of money management firm Portfolio Solutions. 'Perhaps 50-50 or 40-60 is more appropriate - that is, if they need to take that much risk based on their situation.'
At financial planning firms across the country, advisers have been re-evaluating their clients' stomach for volatility.
'We moved a lot of our retirees who exhibited lower risk tolerance during the last crash to lower equity exposures once the recovery was well under way,' said Rick Kahler, a financial planner in Rapid City, South Dakota. 'In the last year, many wanted to return to their previous portfolio that had the higher equity exposure, and we discouraged them.'
That sort of flip-flopping can be attributed to a behavioural phenomenon known as recency bias - the tendency of investors to weigh recent events more heavily than those in the past.
Although advisers say that many of the 'risk tolerance' questionnaires available on the Web are an overly simplistic gauge, many of them use FinaMetrica, a 25-question tool that combines psychology and statistics and generates an investor risk profile illustrating where they stand relative to others. While it is geared for advisers (and costs US$45 for consumers), it could prove to be an educational exercise, or serve as a conversation starter for couples with different outlooks.
How much stock do I need? The amount of stock funds you can tolerate may not necessarily match what's recommended to reach your retirement goals. (But you generally want to take as little risk as you need to reach those goals.) The optimal allocations will vary depending on your specific circumstances, and how much money you need to withdraw for annual expenses not covered by Social Security, pensions and other income sources. Since retirement does not come with a 'do-over' option, it often pays to visit a certified financial planner, particularly one who charges an hourly rate or a flat fee, to help you sort this out.
Target-date funds
Still, even among investment professionals, the recommended allocations tend to differ. Consider the varying allocations of target-date funds - whose investment mix becomes more conservative as you age - for people who recently retired or are nearing retirement.
Schwab's Target 2010 fund, for example, holds slightly more than 38 per cent in domestic and foreign stocks, while Vanguard's 2010 target-date fund is nearly 46 per cent in stocks. Fidelity's Freedom 2010 has 47 per cent, and T Rowe Price's Retirement 2010 fund has 53 per cent. Meanwhile, a Vanguard fund for people who have already retired or are over the age of 69 has a stock allocation of 30 per cent.
Mr Ferri, the author and money manager, suggests some investment mixes in his book that could serve as a starting point. For example, a person who is about 3-5 years from retirement and has a moderate tolerance for risk may consider a diversified portfolio evenly split between stocks and bonds, he said, while a conservative investor may keep only 30 per cent of his portfolio in stocks.
Once retired, moderate investors may dial down their stock allocation to 40 per cent, Mr Ferri said, while more aggressive investors may still decide to keep 60 per cent in stocks.
'These examples probably cover 80 per cent of retirees,' he said. 'There are some people who can and should be more aggressive, and those who should be more conservative. It all depends on how much they have saved and whether that's enough, or if they have much more than enough and are really investing for someone else.'
How much should I have in cash? People nearing or in retirement might consider setting aside anywhere from 1-5 years of their expenses in a safe and cashlike account, experts said. This may help you rest easier since you know that your immediate needs will be met.
Alan Moore, a financial planner at Kahler Financial Group in Rapid City, South Dakota, said some investors do not like seeing a sizeable chunk of money sitting on the sidelines, but he called it market insurance.
'We set up direct deposits into their checking account for their monthly expenses,' he said, 'and each year we replenish the cash reserve.' If the market is on the decline, and a retiree isn't comfortable selling, they wait.
Am I keeping my risk level in check? Over time, market swings will inevitably throw your portfolio out of balance, so you need to establish a strategy to periodically recalibrate your investment back to your targets. For most investors, it usually makes sense to rebalance either annually or semi-annually, when a particular investment category - say, large-cap stocks or bonds - deviates about 5 percentage points from your target, according to a study by Vanguard based on historical market returns.
It's a counterintuitive strategy: you are generally selling your winning investments and buying the laggards. The study, however, found that investors who rebalance after big market drops have typically been rewarded over the long term. Increasing your stock allocation (especially when stocks are cheap) can position you for an eventual rebound, which can help returns over time. But at its core, rebalancing is not about maximising your returns.
'Rebalancing is about maintaining risk tolerance and objectives of the portfolio,' Mr Kinniry said. 'What we do know is that over long holding periods, the portfolios that are allowed to drift have slightly higher returns, as expected, as the average equity position is larger. But it has significantly more risk.'
Am I focusing on the big picture? This is admittedly hard to do during periods of uncertainty. But consider the recent performance of a diversified portfolio. Since the market peaked in October 2007, a portfolio split evenly between stocks and bonds had a cumulative return of 5.9 per cent through Sept 6, while a portfolio with 30 per cent stocks and 70 per cent bonds had a cumulative return of 15.8 per cent. An all-stock portfolio, meanwhile, lost 18.9 per cent over the same time period, according to calculations by Vanguard.
Rewind 30 years, and the same evenly split portfolio returned an annualised 10.3 per cent from July 31, 1981, through the same date this year, while the 30 per cent stock portfolio earned 9.9 per cent, and the 100 per cent stock portfolio yielded 10.9 per cent annualised.
What's my contingency plan? Â If your retirement date happens to coincide with a significant market downturn, it can do long-term damage to your plan since the money you withdraw will not be invested for a potential recovery.
'A person considering retirement should determine how much of a contraction he or she could withstand and still be able to meet their retirement spending goals,' said Troy Sapp, a financial planner at Commencement Financial Planning in Tacoma, Washington.
For Chris Gruber, a 63-year-old research psychologist in Long Beach, California, and his wife, Diane, a retired surgeon, the market swings have underscored their need to remain flexible. The couple finished paying off their son's college bills and her medical debt a little more than a decade ago.
They saved aggressively in the years that followed, and they both planned to work part-time for a year or so after they gave up their full-time positions. But when his wife's retirement date rolled around 2-1/2 years ago, he said her employer eliminated many part-time slots - just as the market crashed. 'My wife and I say we chose the worst time in 75 years to retire,' he said.
Fortunately, his part-time prospects were much better, and he discovered that he enjoyed working part time, especially since he was able to give up many administrative duties. But in light of the market swings, he said they've already done some belt-tightening.
His wife's pension and their Social Security will cover about 60 per cent of their annual expenses once they're fully retired, with the remainder coming from their savings, which is largely invested in stock funds.
'On any given day, I can tell you how much I have over my nut to spend,' said Mr Gruber, who has created a spreadsheet tracking how close their funds match their spending goals. Right now, they're about 30 per cent below their targets, which is well below his comfort zone. 'I manage my risk by readjusting what I can do for the rest of my life,' he said.
The couple's goal was to keep their four-bedroom ranch for 10 years, but now they may stay only five, which will allow them to spend more time in Colorado, where they have an apartment near their son's family. 'We are willing to downsize as it becomes necessary.' - NYT
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