Cookie-cutting the investing process does not work. Take for example someone who is a Federal government employee and we know what that entails – a rock-solid job security with access to an equally rock-solid pension plan.
So, assuming she continues to work there till she retires, should she ever own bonds?
And we know the deal with bonds – stable prices with near-guaranteed income but with long-range returns far lower than what we can expect from stocks.
And why expect anything else? Why should we expect to get paid more for stuffing our savings under a proverbial mattress? We shouldn’t because capital preservation and growth doesn’t exist. And it shouldn’t exist.
Stocks will test your will from time to time, but they are what you need by the boatload if you ever want to retire well.
And even with stocks, there is a range of outcomes we can expect. Small company stocks should earn us more than large company stocks because they are risker. So should emerging market stocks over say developed market ones because again, they are riskier.
But there are no guarantees. Because if there were any guarantee, these investments wouldn’t be any riskier.
So, going back to that Federal employee, should she ever own bonds? Almost always never.
She does not need to own bonds because her pension is the best ever bond replacement. Not only that, that pension is likely inflation-linked so an even better deal than just plain old bonds.
At the other extreme, say instead of working for the Federal government, she worked for a hyper-growth startup. Or say she worked in sales. Or on Wall Street as an investment banker.
She is now exposed to all the vicissitudes of an economic cycle – both on the upside as well as on the downside.
Her livelihood is now near-perfectly correlated to the stock market. She is more like a stock whereas her alter-image, the Federal employee is more like an inflation-indexed bond. A big decline in the stock market would likely cause the Wall-Streeter to lose her job whereas the Federal employee will remain unscathed.
So now that we have the context, clearly these two sets of employees cannot own the same portfolios. They could but that would be sub-optimal.
And that is the problem with cookie-cutter investments like the age-based portfolios that happen to be the default choice in many of our workplace retirement plans. These funds start out aggressive with an heavy allocation to stocks and steadily get conservative with a greater allocation to bonds as we near our goals.
And they (the funds) do all this mechanistically without knowing what else is going on in your life because they cannot know about your life. All they do know is that you have this one account in which you have picked this one investment and that is all.
Take another scenario where say you have $5 million socked away (I know a big number but hear me out) in an age-based portfolio after a lifetime of aggressive savings and even if you needed a ‘mere’ $100,000 a year to live on, these portfolios will still move a big chunk of your savings into bonds. You’ll certainly own a less volatile portfolio but is that optimal?
No because $100,000 a year off a $5 million portfolio is a 2% withdrawal rate, a rate that could easily be achieved with an all-stock portfolio with plenty leftover.
Plus imagine giving up on all that growth that an all-stock portfolio is certainly likely to deliver over time? You might not need the money but your heirs or your preferred charity would be glad you didn’t make a sub-optimal choice.
One size does not fit all. Every situation is different and hence every allocation, every plan should be different.
No problem sticking with these pre-packaged portfolios early in your savings journey assuming you are aware of some of their eventual flaws. But as you get up in assets with time, you’d certainly want to revisit these choices to reformulate a plan that is yours.
Thank you for your time.
Cover image credit – Jéshoots, Pexels