If your retirement is still in the distance, now’s the time to consider tweaking your savings strategy to generate better retirement returns. You need to be prepared for what lies ahead with the stock market. Implementing the following strategies can help you position your portfolio to weather any storms that may be on the horizon.
The stock market moves in cycles, and periods of big returns are often followed by spans of less-than-stellar performance. A report from McKinsey suggests that investors may soon need to rein in their expectations where their portfolios are concerned. According to the study, U.S. equities are set to generate annual inflation-adjusted returns of approximately 4% to 5% in the next 20 years, compared to a return of 8% over the previous three decades. Even more startling, the report projects that fixed-income markets will see a drop of 400 basis points, resulting in a return of a measly 1%. (For more, see Stock Basics Tutorial.)
One option for combating shrinking returns is to make a shift in your asset allocation. Moving more of your holdings toward index funds or exchange-traded funds (ETFs) that have low expense ratios can increase diversification while reducing the amount of returns that are diminished by fees. In a study from Morningstar, for example, the research showed that actively managed funds tended to have asset-weighed expense ratios that were four times higher than their passive index fund and ETF counterparts. (For more, see Active vs. Passive ETF Investing.)
Not only that, but Morningstar’s research also suggests that passive investments are more likely to outperform actively managed funds. Between 2004 and 2014, passive index funds consistently produced higher returns. The data also showed a correlation between cost and performance. With the exception of U.S. mid-cap value stocks, the least expensive fund investments generated the best returns for investors and vice versa. If your portfolio is concentrated heavily in stocks, incorporating passive index funds and ETFs offers the potential to boost your returns while still keeping your investment costs low.
“The approach that we follow at our firm is a core-satellite approach, or what we call strategic and tactical investing. For the core it’s best to use the lowest cost index passive options, as decreasing fees will improve returns. For the tactical satellite we use sector ETFs or other more specific ETFs, such as dividend-paying stocks or a high growth area like tech ETFs,” says John Eiduk, CPA, CFP®, managing partner, Elite Asset Management, Rolling Meadows, Ill.
Adding index funds and ETFs to your investment holdings doesn’t mean you should completely shy away from investing in individual stocks. In fact, you should actually be taking a closer look to see what kind of opportunities are out there. For example, small-cap stocks are generally viewed as being higher risk, but according to Morningstar’s Active/Passive Barometer, if you’re able to lock in a company that has the potential for sustainable growth, you could benefit in a big way if the stock’s value soars.
“With interest rates expected to rise in the near future, a greater allocation of stock funds should be considered for a higher equity return and to counter a lower bond fund yield historically,” says Daniel Schutte, MBA, wealth manager, Credo Wealth Management, Denver, Colo.
If you’re feeling even more adventurous, you might think about moving toward something that carries a higher risk, such as options trading. Done correctly, options trading can increase your returns while also limiting your exposure to market volatility. That being said, it’s not something you should jump into without first doing your research. (For more, see Options Basics Tutorial.)
Dividend stocks may also be worth a look if you’re interested in securities that pay out consistent income. Stick with established companies, such as those included on the dividend aristocrats list. Look for stocks that have a lengthy track record, which can give you some sense of how they may perform in the future – though no one should rely on past performance as a sure guide to the future. (For more, see 6 Rules for Successful Dividend Investing.)
Unless you have a crystal ball, it’s impossible to predict how the market is going to fluctuate from one day to the next. With that in mind, one of the most important move you can make to improve your return potential over the next 20 years is to stay focused on the things that are in your scope of control, beginning with your savings rate.
If McKinsey’s forecast is accurate, Millennial workers who are setting aside 10% to 15% of their income would have to almost double their savings rate to keep pace. Let’s say, for example, that you’re 30 years old and making $60,000 a year. You’re saving 10% of your salary in a 401(k), and your employer matches 100% of the first 3.5% you contribute. Assuming an 8% annual return, you’d have more than $1.45 million accumulated by age 65. If returns top out at 5%, on the other hand, you’d only have around $750,000. To still hit that $1.45 million mark, you’d need to step up your savings rate to approximately 23%.
If bumping up the amount you’re saving by a significant percentage isn’t realistic, the next thing you’ll have to consider is how long you’ll have to stay in the workforce. Retiring at 67 or 68, for instance, may have to replace retiring at 63 or 64. While that means working a bit longer, you also get the advantage of seeing your Social Security benefits increase for every year you’re still on the job after reaching full retirement age until age 70.
“If you are able to work for an extra few years or work part-time during a portion of your retirement, you can offset a significant portion of your living expenses, which will help you stretch your current retirement savings. You may also be able to bump up your Social Security benefits if you are earning more than any one of your top 35 years of earning used in the benefits calculation,” says Jamie Ebersole, CFA, CFP®, founder and CEO of Ebersole Financial LLC, Wellesley Hills, Mass.
If you’re worried about where the stock market may take you over the next few years, the worst thing you can do is to let fear force you into making bad decisions or doing nothing at all. Take a closer look at how your investments are allocated, what kind of returns you’ve been earning and variables such as your savings rate and how many years you have left until retirement. Doing so can help you develop a comprehensive plan for getting the best returns possible.