- Common retirement investing advice worked ok in the past, but could have been much better.
- Why would you sell stocks that you bought a long time ago, and that are still growing and paying dividend, to buy bonds that yield less than inflation?
- Over the long term, little differences amount to a huge difference. Take responsibility for your retirement.
The common advice on retirement investing is to be overweight stocks when you are far from retirement and then overweight bonds when you are closer to retirement. Some funds offer target date retirement funds that have such a portfolio allocation.
Vanguard’s target retirement funds invest up to 90% in stocks when you are more than 25 years from retirement, and then lower that exposure to about 50% when you retire. 7 years into retirement, you have 70% of your portfolio in bonds.
Now as soon as I see a fixed investing strategy, I suddenly have allergies. Many don’t understand that investing and business isn’t like physics. In physics, when you find out how something works, you can expect it to work like that forever. Just think of the law of action-reaction, Newton’s third law.
However, in business and investing, you might do the same but the result will most likely be different. Vanguard’s portfolio allocation is based on how the stock market worked over the past 30 years. Stocks went up while bonds were safe and provided a decent income. This might not be the case in the future.
So by applying just a bit of common sense, I firmly believe investors’ returns could be much higher than those achieved by following the above strategy. There are two fallacies that I want to discuss.
Issue 1 – Mindless Investing: Buying High, Selling Low
The first issue that I have with the portfolio allocation described above comes from the fact that valuations, which are the main factor driving long term returns, are totally disregarded.
In the past, when valuations were at the levels they are today where the current Cyclically Adjusted Price Earnings (CAPE) is at 29.66 for the S&P 500, shorter term returns have been negative while longer term returns have been miserable.
On the other hand, when the CAPE ratio has been below 10, 15 year returns have always been above 10% for the S&P 500.
So by following common retirement investment advice, a younger person would have to be heavily invested in stocks now even though in the past, valuations that are as high as they are now have led to poor returns. By following such advice, you are looking at potentially negative returns in the next decade or longer. Thus what common retirement investment advice suggests is buying high and selling low because, after a while, you should sell your stocks and buy bonds.
Issue 2 – Selling Stocks & Buying Bonds
The best way to invest in stocks is to invest for the long term, or as Buffett would say: “My preferred time period for holding a stock is forever.”
This is because stocks are growth investments that grow as the economy grows, increase their prices alongside inflation, and grow thanks to their investments and reinvestments. If you invest in good companies with stable long-term outlooks, you can expect that their dividend will be higher in the future and thus provide you with very satisfying income when you are retired.
The same can’t be said for bonds, but according to common retirement investing advice, retirees should switch to bonds as they grow older. Let me show you how switching from stocks to bonds would effect an investor by comparing the S&P 500 and U.S. Treasuries.
The current S&P 500 dividend yield is 2% while the current 10-year U.S. Treasury yield is 2.3%. It’s also important to mention that inflation is around 2% and is expected to be in the range of 2% to 4% for the foreseeable future.
So if you invest in treasuries now, you can expect to lose money as inflation will eat up your yield. However, if you invest in the S&P 500, you can expect that your dividend will increase over time. In the last 10 years, the S&P 500 dividend has increased by 44% while in the last 20, it has doubled. Now I’m not a fan of the S&P 500, but there are many investments that have much higher yields and will grow even faster than the S&P 500. You can find an example in yesterday’s article about Buffett’s last purchase.
Now if you invest in a company that has a good business, a relatively good yield, and good growth prospects, you’d be crazy to sell such a stock just because someone is saying that you should own bonds.
For example, Southern Company (NSYE: SO) has consistently increased its dividend for the past 15 years.
The current dividend is 4.72% from a $2.32 dividend. As earnings growth of 5% per year is expected, you can expect a continuation of this dividend growth pattern. If the dividend grows by 5% per year, your yearly yield would be 10% after 14 years and 20% on your initial investment after 28 years.
If you reinvest that money back into SO’s stock and valuations stay the same, you’re looking at an amazing return of over 7% per year. That’s much better than what the S&P 500 and other indexes offer at this point, and it’s perhaps less risky as well. Given all this, why would you sell a stock with growing dividends for a bond that has lower yields?
My message today is that everyone should take responsibility for their personal finances and retirement plans. There are so many strategies out there that have worked well in the past, but that’s mainly due to the fact that interest rates have been declining for the last 35 years. The environment is different now and different approaches will work much better.
If you don’t take responsibility for your retirement, 20 years or more will pass and then you might find yourself in a situation with miserable returns and where you have lost the most valuable asset in investing, time! Long term investing can lead to wonderful results if only a bit of common sense and thinking are applied.