Some surprises are good, like birthday parties, an unannounced visit from the grandkids and winning free tickets to your favorite show. Some surprises are bad, like stepping on gum, flight delays and sipping scalding hot coffee—all annoying and inconvenient, but probably not catastrophic. In retirement investing, however, bad surprises are serious. It’s no fun to discover your investments don’t deliver the returns you planned for, volatility is wilder than anticipated or you suddenly need more cash to support growing living expenses. A good retirement investment strategy should forestall these distressing discoveries by setting appropriate expectations for portfolio performance. Let’s take a look at a few surprises investors often encounter and how to avoid them.
This is a common lament for those invested in fixed income, which historically returns much less than stocks. Now, there is nothing inherently wrong with bonds. If your time horizon—how long you need your money to work for you—is short, if you simply must reduce volatility or if you have relatively high cash flow needs, bonds’ reduced price swings can be useful. But that relative stability comes with a cost—lower returns. Since 1926, US Treasurys have returned 5.3% annualized—a far cry from stocks’ 9.9% average gains.i Too many underestimate the growth they need and are taken aback when they find themselves struggling just to keep up with inflation. Your retirement plan should focus on the asset allocation—the mix of bonds, stocks, cash and other securities—that fits your long-term financial goals and needs. Ask yourself:
Answer either one “no,” and you may have to reconsider your asset allocation, your goals … or both.
There are two sides to this coin: First, this can again relate to asset allocation. A suboptimal mix of stocks, bonds, cash and other securities could either generate insufficient returns or have too much volatility to sustain your portfolio in the long run. But most often, it’s the other side of the ledger: Expenditures are too high. New expenses pop up: Some retirees help out with grandkids’ tuition, others decide frequent vacations are a must-have and nearly all shell out for medical care at some point. Inflation also rears its ugly head, particularly as health care costs—which affect retirees most—have risen much faster than overall prices. Now, we aren’t telling you to steer clear of expensive treatments, avoid vacations and turn into Scrooge. Just be thoughtful about your spending and how it might change over time. In general, withdrawing more than 5% from your portfolio yearly risks early depletion. Now, perhaps you’re too thrifty and find yourself with surplus cash late in life. That’s ok! The idea that you’ll bounce your last check sounds romantic but isn’t realistic, given that you don’t know which check is your last. Facing drastic cuts in quality of life due to miscalculating expenses and/or underestimating how long you’ll be on this rock is the worst possible outcome in retirement investing. Lifespans continue rising, which is great! But they’re just one more reason to plan for a long time horizon, think carefully about expenditures and make sure your asset allocation is in tune with your expectations.
This unrealistic expectation is very common because it seems to make sense: Why indeed would stocks diverge from their long-term average? If my portfolio isn’t achieving stocks’ average, doesn’t that mean I’m missing out? This perception misses a crucial point: Averages are often made up of extremes. Stocks rarely return their long-term average: Since 1926, negative or 20%-plus-gains account for nearly two-thirds of yearly returnsii. Investors expecting consistently positive returns will experience something very different. Sadly, many respond unwisely, concentrating holdings in a narrow category with eye-popping recent performance, or handing their money to hucksters offering too-good-to-be-true guarantees of stable, strong returns. Perpetually high returns on any investment—no volatility, no tough months—does not happen, and anyone promising that is likely either preying on what you don’t know or showing what they don’t know. Remember, your time horizon isn’t just one year. It’s a long journey, and how stocks fare over long periods is much more meaningful than any single year or two. Set your expectations for “volatile, but up most often,” not “predictable, stable, always-hit-the-average.” Your portfolio—and your future, more financially secure self—will thank you.
We hope you’re never blindsided by bad surprises like these: They’re emotionally jarring, often stem from a poorly crafted investment plan and can lead to yet more unwise decisions. Knowing what to expect from your portfolio’s asset allocation—its range of probable returns, how a sustainable withdrawal rate squares with your planned expenses and how its value could fluctuate over time—can help keep your financial future on track, so you can focus on the good surprises in life. Don’t let incorrect expectations ruin the party.
i Source: FactSet, Global Financial Data, as of 2/11/2016. S&P 500, from January 1926 – December 2015.
ii Source: Global Financial Data, Inc., as of 1/5/2016. S&P 500 Annual Total Return, 1926 – 2015.