It's almost an axiom of retirement planning: As you grow older, you should cut back on your risk. It sounds simple, but is it the right move?
That's the question Rob Arnott of Research Affiliates asked recently. After studying actual historical results over the past 140 years, Arnott came to what many would deem a highly unexpected answer: Owning stocks later in life yields better overall results.
The basics of asset allocation
The idea behind what Arnott calls the "glidepath" approach to retirement is pretty simple. Early in life, you can afford to take a lot of risk with your investments, because you have plenty of time before you'll need to use the money. As a result, most financial advisors recommend high allocations to risky assets like stocks for young investors. Later, though, as you approach retirement, your time horizon shrinks. Typical asset allocation plans call for you to scale back on risk by replacing stocks with bonds.
As intuitively appealing as the glidepath approach may be, Arnott found that it doesn't produce optimal results. Doing the exact opposite of the glidepath approach -- that is, investing conservatively early in life and then taking more risk as you get closer to retirement -- actually produced far better results in terms of higher account balances at retirement age and more favorable distributions. When you look at the results, you'll notice that the worst-case scenarios tend to be roughly the same across all strategies, but the upside is much higher for those who take risk later in life.
Arnott's results may seem backward, but when you think about them for a while, they make more sense. Maximizing returns early in life doesn't do much good because you have very little investment capital built up, so those returns apply only to a very small portfolio. Later in life is when you have the most assets at your disposal, and therefore you stand to gain the most by investing more aggressively to maximize returns.
A simpler message
Unfortunately, Arnott doesn't test a fourth scenario: simply keeping a high allocation to stocks throughout life. But a 2008 Hartford Investment Management study looked at the issue in a simpler way, comparing various asset allocations held for varying numbers of years.
The study found that after just eight years, an 80% stock/20% bond portfolio beat out a 50% stock/40% bond/10% cash portfolio, even when you considered returns in the poorest 5% of the historical distribution. In other words, even in nearly worst-case scenarios, the more aggressive portfolio outperformed the "safer" alternative -- and when things went well, the stock-heavy strategy did much better.
How to sleep at night
With those higher returns, though, often comes the nervousness of higher volatility. For those nearing retirement, an aggressive portfolio might maximize returns, but it may also come with plenty of sleepless nights.
That's why it's important to come up with your own strategy to smooth out your returns. For some, high-yield bonds or preferred stock can bring the prospect of better returns than high-credit-quality bonds, without the full risk of a common-stock investment. For instance, investors in Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) common shares bear the full risk of changing conditions in the mortgage REIT market, but their preferred stock offers a good yield, along with more insulation from adverse circumstances.
For others, low-volatility stocks can help boost returns. For instance, McDonald's (NYSE:MCD), Merck (NYSE:MRK), and Altria (NYSE:MO) all have the benefit of dividend yields of 3% or more while having beta values of less than 0.5, implying more gentle movements than the overall market. The established nature of their business models, while not entirely forgoing growth, gives a measure of security to risk-averse investors seeking better returns than are available from bonds or cash investments.
Don't give up on stocks
Of course, it's far easier to depend on stocks after a long bull market. The same high-equity approach got many target retirement funds in trouble back in 2008 and 2009, when their returns suffered.
As important as it is to start investing early, your pre-retirement years will be the time when you have the most to gain or lose from your investment strategy. Take the time to tailor a strategy that matches up with your needs, and you'll be much happier with the overall outcome.
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Fool contributor Dan Caplinger has always owned stocks. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of McDonald's and Annaly Capital. Motley Fool newsletter services have recommended buying shares of McDonald's and Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never argues.