The Dow surpassed the 10,000 mark in October, after hitting a 6,547 low in 2009 - a more than 50% rise in just over six months. These gyrations have many retirees calling it quits on stocks.
Big mistake. With world leaders and market pundits warning about runaway inflation, which could occur as a result of government spending, this is may be an inopportune time to leave stocks out of your retirement plans. But how can you enjoy the long-term, inflation-fighting power of stocks without getting an ulcer? Try dividing your portfolio into buckets: risky assets and safe assets. Read on to learn how this strategy can keep your savings - and your sanity - intact.
The Bucket Approach
This concept is not new. In 1957, James Tobin published a paper titled "Liquidity Preference as Behavior Towards Risk". Frank Armstrong, founder of Investor Solutions, writing for the Morningstar investor series in 1997, summarized Tobin's findings:
"Investors have a full range of liquidity preferences and therefore need to broaden their investment choices to include lower-risk assets. Tobin said investors should first determine their appetite for risk. With that level of risk tolerance in mind, investors can choose the most efficient portfolio which would be expected to deliver the greatest expected return for a given level of risk. Investors should then satisfy their liquidity and safety needs with another portfolio, called the zero-risk portfolio."
Tobin was on to something, and won the Nobel Memorial Prize for Economics in 1981. Investment advisors have taken the core of Tobin's findings and developed variations, which they refer to as the "bucket approach" to retirement savings. The simplest version has two buckets: one for risky assets like stocks and commodities and the other for safe assets like short-term, high-quality bonds, certificates of deposit (CDs) and cash or cash equivalents. Let's take a closer look at the two-bucket solution.
The Risk Bucket
Bucket one is the "risky bucket". For this bucket, investors should hold the portfolio that provides the highest return per unit of risk. Research shows that such a portfolio tends to be a global equity portfolio. This is a portfolio that holds all of the world's traded securities. Today more than ever, equity investors can achieve low-cost, easily-implemented exposure to the global equity markets using exchange-traded funds and very low cost index mutual funds.
Now maybe you're wondering, "Why can't I just put the money in that hot technology fund?" You can, but you would not be optimizing the tradeoff between risk and reward if you chose any portfolio other than the global equity portfolio.
The Safe Bucket
The second bucket is the "safe bucket". This bucket might include Treasury bonds and CDs but may also include very short-term, high-quality bonds or bond funds.
How do you determine what percent should be in the risky bucket and how much goes into the safe bucket? Questionnaires and other tools are helpful for determining risk appetite and tolerance, although they're just a starting point. In addition, you will want to make sure there is always enough money in the safe assets to cover the annual withdrawal for at least 10 years. Why 10 years? Because history says that market downturns lasting more than 10 years are virtually nonexistent. So, if you have $1 million dollars in retirement savings and expect to withdraw $40,000 per year during retirement, you need to have a minimum of $400,000 in the safe bucket. That would suggest an asset allocation of 60% global equities and 40% fixed income.
Because the assets in the safe bucket don't typically pay much in the way of interest, the assets available in this bucket will tend to decline over time. Assuming that global economies continue to grow and their equity markets do the same, the total portfolio will need to be rebalanced periodically to maintain the risky to safe asset balance.
Let's assume that the results of a risk tolerance questionnaire for the aforementioned investor suggest he or she would be comfortable with an 80% global equity and 20% fixed income portfolio. It may still make more sense to go with the 60% global equity and 40% fixed income portfolio.
Why? History suggests that with an 80/20 portfolio, you are not well compensated for the additional risk. The 80/20 portfolio (40% S&P 500, 40% MSCI EAFE, 20% Barclays Aggregate) had an average annual return of 10.39% and 13.69% standard deviation from 1979 through the end of September 2009. The 60/40 portfolio (30% S&P 500, 30% MSCI EAFE, 40% Barclay's Aggregate) had an average annual return of 10.06% per annum and 11.99% standard deviation from 1979 through September 30, 2009.The return for the 60/40 portfolio was essentially flat while the standard deviation dropped by almost two percentage points. When you are withdrawing from your portfolio, reducing volatility can be even more important than getting a higher return.
The Bottom Line
There are many variants on this strategy. Some advisors are promoting strategies that have up to five buckets! The reality is that those five buckets can be collapsed into two buckets as well - risky and safe. Keeping it simple will improve your odds of success and will prevent you from feeling out of control -which is particularly important when the markets are just that.