In last month’s post we ran a little experiment which showed that stock market volatility has not been the main risk retirees’ face. Instead, the biggest risk has been inflation—specifically, the possibility of earning long-run investment returns that fail to keep up with inflation. As we saw, the most dangerous time to retire over the past 88 years was not during the Great Depression, when volatility was at its highest, but during the late 1960s and early 1970s, when inflation was heating up. It was during the long, 16-year secular bear market of 1966-81 that retirees faced the biggest possibility of going broke.
Think for a moment about what this means for investors. We have long been told that as we age, we should reduce our allocation to stocks and increase our allocation to bonds, so as to reduce the risk posed by stock market volatility. A long-standing rule of thumb is that our allocation to bonds should equal our age—a 40-year old should put 40 percent of her portfolio in bonds (with the remaining 60 percent in stocks), while a 60-year old should allocate 60 percent of his savings to bonds (and only 40 percent to stocks). There is no doubt that increasing your allocation to bonds will reduce your exposure to the risk posed by volatility. But what about the bigger risk posed by inflation? During the 1966-81 secular bear market intermediate-term bond returns lagged not only behind inflation, but also behind the returns of the S&P 500. In fact, bond returns have often lagged behind inflation. And with bond yields currently at historic lows, there is a very good chance bond returns will lag inflation over the next ten years.
Don’t get me wrong—I’m not suggesting that your portfolio shouldn’t include bonds. A healthy allocation to bonds will reduce your portfolio’s volatility. What I am saying is that you need to do something to reduce inflation risk, not just volatility risk. Focusing on volatility while ignoring inflation is kind of like taking shelter in a condemned building during a thunderstorm—you may avoid being struck by lightning, only to face a bigger risk of being crushed if the building collapses.
There are a number of traditional inflation hedges, including gold, real estate investment trusts, inflation protected bonds, and commodity futures. But the book I am currently writing focuses on a non-traditional set of inflation hedges: small caps (the stocks of small companies), value stocks (stocks that are inexpensive relative to fundamental measures of value such as earnings), and small cap value stocks, or SCV (which combine the attributes of small caps and value stocks). These stocks are not normally thought of as inflation hedges. But they have in fact done a much better job of consistently outpacing inflation than the S&P 500. And, since inflation has presented the biggest risk of bankruptcy for retirees, small caps, value stocks and SCV have done a much better job of reducing the odds of going broke in retirement than the S&P 500.
We can see that this is the case by continuing the experiment we started last month. In that experiment we considered a retiree, Paul, who’s saved $100,000, and will need to withdraw $4,500 from this nest egg to fund his living expenses in his first year of retirement. This will give him an initial withdrawal rate of 4.5 percent ($4,500 divided by $100,000 is 4.5 percent). We assumed that Paul will increase his $4,500 withdrawal in subsequent years to cover inflation, and that he invests all of his money in a portfolio of U.S. large cap stocks (as represented by the S&P 500 index, including reinvested dividends). Using historical return data for large cap stocks, along with data on the consumer price index (CPI), we tested whether or not Paul’s $100,000 will survive 30-year retirements beginning in January of 1927, 1928, 1929, and so on, all the way through 1986 (for a 30-year retirement that lasts until December 2015). If the portfolio still has money in it at the end of a particular 30-year stretch, then Paul’s nest egg has survived. If his savings drop to zero before the end of the 30 years, then his portfolio failed.
There are a total of sixty rolling 30-year retirements with start years ranging from 1927 through 1986. With his money invested 100 percent in the S&P 500, Paul’s nest egg survived 51 of these 60 retirements, for a success rate of 85 percent. His nest egg went bust in the remaining nine of the sixty retirements. But, if instead of the S&P 500, Paul split his money equally between small caps, value stocks and SCV, his nest egg would have survived all but two of the 60 retirements, for a success rate of 97 percent.
This little experiment gives you a small taste of how small caps, value stocks, and SCV can help retirees reduce the risk of outliving their money. But this example only scratches the surface. Small caps, value stocks and SCV can be used not only to reduce a retiree’s bankruptcy risk, but also to reduce an investor’s retirement number—the amount of money an investor needs to accumulate to be able to afford a financially secure retirement. And these stocks can help you to significantly reduce the amount of money you need to save from your paycheck in order to reach your retirement number—or, for that matter, any financial goal you may have, be it a new house, a child’s college education, a dream vacation—whatever. These reductions in savings rates and retirement numbers can be very significant. In an example included in the introduction to the new book, I show how a young couple is able to reduce the amount of money they need to save out of their paycheck for retirement by 57 percent, without reducing their odds of reaching their retirement number—solely by switching the stock portion of their portfolio from an S&P 500 index fund to funds invested in large cap value stocks and small cap value stocks.
The new book will explain how you can use small caps, value stocks, and SCV to reduce your risk of outliving your money, to reduce your risk of falling short of your retirement number or any other financial goal, to reduce the amount of money you need to save to reach your goals, and/or to increase the amount of money you can safely withdraw from your nest egg once you are retired. The book also explains why small caps, value stocks and SCV reduce the risk posed by inflation, and thus yield all these many benefits to investors who know how to use them. (And, just in case you think the reason why, is that these stocks have out-returned the broader market over the long run—that’s true, but it is only half of the explanation.)