Raise your hand if you've heard something like this before:
"Invest $10,000 today in the stock market, and, earning its 10% historical rate of return, you'll be a millionaire in just 49 years."
Financial professionals will throw out statistics like this to show the benefits of compounding interest, and there's nothing wrong with that. Compounding interest is an essential part of understanding how you can build wealth over time.
But compounding interest statistics can also be misleading to investors planning for retirement. Seriously.
Into the Wayback Machine ...
Meet Chuck. In March 1978, Chuck was 40 years old, had saved $92,500 over the years, and had a goal of retiring at 65 with $1 million in savings.
Chuck's broker gave him some great news: "Chuck, with your current balance of $92,500, if you earn the market's historical return of 10% each year for the next 25 years, you'll reach your goal of $1 million." The financial professional then went on to recommend full investment in the Vanguard 500 Index Fund (VFINX), which tracks the S&P 500 and holds tried-and-true blue chips ExxonMobil (NYSE: XOM ) , IBM (NYSE: IBM ) , Abbott Labs (NYSE: ABT ) , and Hewlett-Packard (NYSE: HPQ ) .
Ecstatic about the prospects of having the million dollars he always wanted, Chuck followed his broker's advice, put 100% of his savings in the 500 Index and thought nothing of his investment for another 25 years. After all, he was earning the market's rate of return. He had nothing to worry about. Right?
25 years later ...
The day after his retirement party, Chuck called his broker and asked for his million dollars. The financial professional hemmed and hawed and finally broke the bad news: "Chuck, your account is worth $577,362."
What happened?!
Here's how things went wrong.
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March 13, 1978
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March 13, 2000
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March 13, 2003
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Closing price of Vanguard 500 Index
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$12.30
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$127.72
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$77.04
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From 1978 to 2000, Chuck's investment was doing well, earning an annual average of 11.2%. Indeed, he was sitting pretty at that point with $959,765 in unrealized gains -- just short of his $1 million goal.
Then the market began to take a turn for the worse, sending his balance down 39.7% in the three years before his retirement date, leaving him $423,000 short of his goal.
In the end, Chuck's actual annual return (excluding dividends) turned out to be 7.6%, well below the historical 10% rate mentioned by his financial professional. And while this is an admittedly simple example, it shows the dangers of not reallocating your portfolio to more conservative fare as you approach retirement age.
By remaining fully invested in stocks, Chuck left his nest egg to the market's whims right up to the end. Of course, the S&P recovered quite a bit in the years between 2003 and 2007, so if Chuck had given the market just four more years, he would've gotten his million -- unless he'd repeated his mistake and suffered more losses in the current bear market.
But what if Chuck didn't have the luxury of giving the market four more years -- or worse, the market hadn't ever recovered at all?
Here's a better way
Unlike Chuck's broker, most financial professionals will suggest that you become more conservative with your investments as you approach retirement age in order to preserve your capital and reduce your risk exposure. For instance, the Vanguard Target Retirement 2030 Fund, which is designed for investors looking to retire in 2030, owns shares of McDonald's (NYSE: MCD ) , Oracle (Nasdaq: ORCL ) , and Coca-Cola (NYSE: KO ) just like the S&P 500 fund does. But it also has a 14% fixed-income allocation that is supposed to eventually grow to over 50% when 2030 finally rolls around.
It's important to note that bonds don't have the sheer growth potential of stocks, but they do reduce portfolio volatility and produce income in the form of dividends.
It's essential, therefore, for you to consider the probability that you won't be fully invested in stocks forever, which means your portfolio's growth potential will diminish as you add more bonds to the mix.
In other words, don't treat the stock market's historical return of 10% as a fixed rate to be accumulated throughout your retirement savings years. Instead, break down your savings years into three distinct stages with different allocations of stocks and bonds.
As an example, let's once again assume an investor with a 25-year time horizon. We'll also assume the 10% historical rate of return for stocks and 5% historical return for Treasury bonds.
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Years
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Expected Annual Return
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Growth Stage (85% stocks/15% bonds)
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1-15
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9.25%
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Conservative Growth Stage (65% stocks/35% bonds)
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16-20
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8.25%
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Preservation Stage (50% stocks/50% bonds)
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21-25
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7.50%
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Weighted Average
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8.7%
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The allocation between stocks and bonds can be adjusted to fit your risk tolerance. So, if you're more tolerant of volatility, you might want to hold 65% stocks in your preservation stage, or if you're less aggressive, you may want 50% bonds during your conservative growth stage.
Foolish bottom line
Regardless of your risk tolerance, this method of estimating portfolio growth is more conservative than simply assuming 10% annual growth based on the stock market's historical rate of return. The benefits of conservative growth estimation will give you a more realistic picture of what to expect upon retirement and will thus help you plan better.
The 10% versus 8.7% growth estimate might not sound like much of a difference, but over a 25-year period with an initial investment of $92,500, the difference is a staggering $257,000 -- enough to buy a retirement condo or generate income for a few more years. A miscalculation of that magnitude can certainly throw a wrench in your retirement plans.
Incidentally, if our friend Chuck had followed the above strategy and used the mix of the 500 Index and Treasury bonds, his annual return would have been approximately 8.4% (before stock dividends) -- better than his return with 100% stocks and with considerably less risk.
If you're looking for some more retirement tips, you can take advantage of a special pass to our Rule Your Retirement service. Try it out for a month free of charge and see how you can avoid mistakes on the way to a comfortable retirement. Click here to grab your free ticket.
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