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THERE ARE MANY financial debates that shouldn’t be debates at all. Folks strike strident poses, but often their positions don’t reflect a careful weighing of the arguments. Rather, they either have a vested interest or their ego is invested. Think of commission-hungry insurance agents who pound the table for cash-value life insurance, or retirees who took Social Security early and then insist that early is always best.
In most of these cases, if we marshal the facts and apply some reasoning, we can arrive at a sensible answer. Yes, most retirees should delay claiming Social Security. No, indexing is not distorting the market. Yes, stock-picking is a loser’s game. No, most folks shouldn’t buy cash-value life insurance. Yes, it can make sense to pay off a mortgage early. No, individual bonds aren’t always superior to bond funds.
But there are four questions where reasonable people can disagree—and where it’s all but impossible to settle the debate, in part because we find ourselves peering into an extremely cloudy crystal ball. I have my take on these four questions. But I can’t promise you I’m right.
1. What’s a retiree’s best strategy for drawing down a portfolio?
Even though I consider myself semi-retired, I must confess I’ve grown weary of this debate and rarely read new studies when they appear. Often, they start with the classic 4% withdrawal rate strategy—you spend that percentage of your nest egg’s value in the first year of retirement and thereafter step up the annual sum withdrawn with inflation—and then try to improve upon it. But the solutions seem overly engineered and overly dependent on the investment returns assumed.
In the end, what we need is a strategy that’ll work even if markets are miserable and even if we live an extraordinarily long life. My personal plan: Delay claiming Social Security until age 70, use a portion of my bond-market money to purchase an immediate fixed annuity that pays lifetime income, and each year withdraw 5% of my portfolio’s beginning-of-year value. With this last strategy, I’ll be compelled to spend less if markets perform poorly—and I’ll never run out of money, because I will always be withdrawing a percentage of whatever remains.
2. Is factor investing destined to fail?
You can view factor investing as either an intriguing rethinking of risk—or a dubious attempt to bring renewed respectability to the beat-the-market game. The basic notion: By emphasizing certain types of stocks—value shares, those with upward price momentum, small-cap stocks—investors can raise their portfolio’s risk-adjusted return, if risk is measured by share price volatility.
Academics argue this isn’t a free lunch. Rather, when we overweight these stocks, we’re taking on risk that isn’t reflected in volatility. This risk should be rewarded over the long haul, and hence those who tilt their portfolio toward, say, small-cap value stocks should earn superior long-run returns.
Many investors—professional and amateur—have rushed to take advantage, hoping to goose their portfolio’s performance. But in recent years, factor investing has generated mixed results. That raises two key questions. Did the historical outperformance of these factors really reflect extra risk? And is so much money now seeking to exploit factor investing that prices have been bid up to the point where the return advantage has disappeared?
My hunch is that small-company stocks and value stocks will indeed earn superior returns over the long haul. Small stocks are clearly less financially stable. Value stocks don’t generate the same enthusiasm among investors that growth stocks do, and hence they’re less likely to be overpriced and destined for lackluster returns. But the truth is, I don’t know this for sure—and nor does anybody else.
3. Do U.S. stocks face a great reckoning?
I’ve been wrestling with this question for more than three years—which arguably means I’ve wasted three years, because there’s been no reckoning worth mentioning.
Why all the worry? Corporate profit margins are far above historical averages. Ditto for stock market valuations. Meanwhile, economic growth has been lackluster, in part because of sluggish growth in the labor force, as new entrants barely outpace retiring baby boomers. On top of all this, interest rates and inflation remain notably low—and many wonder how stocks will fare if one or both move significantly higher.
And yet, as if to prove the Wall Street cliché true, stocks have climbed this wall of worry. Indeed, the current bull market just celebrated its ninth birthday.
I have no idea whether stocks are in for a horrific decline. Forecasting short-term returns is a fool’s errand. But I do believe all the worrying is justified—and that we’re highly likely to see modest long-run stock returns. That conviction only grows stronger as shares climb higher.
My five-part plan for investors: Make sure you’re mentally prepared for steep short-term losses, save diligently to compensate for lower expected returns, regularly rebalance back to your target stock-bond mix, consider reducing risk if you’re comfortably on track to meet your goals, and get money out of stocks that you’ll need to spend in the next five years.
But can I let you in on a secret? I’d probably offer the same five-part plan, even if I didn’t expect long-run returns to be lackluster.
4. How much should we invest abroad?
This is another topic that has consumed me in recent years—and readers have noticed that both my recommended international allocation and my own portfolio’s investment in foreign stocks have been drifting higher.
This reflects a change in how I think about portfolio construction. For years, I started with U.S. stocks and then pondered what I should add to reduce risk, without doing too much damage to my long-run returns. That led me to allocate maybe 30% of my stock portfolio to foreign shares, while also holding increasing amounts in bonds as I’ve grown older.
But these days, instead of pondering what to add to a core holding in U.S. stocks, I start with the global market portfolio—the worldwide investable universe—and then decide what to subtract. The global market portfolio consists of four major sectors, all roughly equal in size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. In other words, if you want a portfolio that reflects what everybody else owns, you should allocate a quarter of your money to each of these four sectors.
From this mix, I subtract foreign bonds, because I don’t want the extra currency exposure, given that most of my future spending will be on U.S. goods and services. But I’m happy to hold a full helping of foreign stocks, even though it means allocating half my stock portfolio to international markets. There are three reasons.
First, I fear for my portfolio’s performance if U.S. stocks generate truly terrible long-run returns. I can’t imagine that the U.S. would suffer the fate of Japanese stocks over the past 28 years—but then again, three decades ago, nobody could imagine that fate for highflying Japanese shares.
Second, foreign stocks, and especially emerging markets, are much better value than U.S. shares. This makes my increasing foreign exposure seem suspiciously like a short-term market bet—and I’ll concede that valuations have made increasing my international allocation a far easier decision.
Third, and most important, I can’t think of a good reason not to have a market weighting in foreign stocks. The currency exposure doesn’t bother me, given that I have no foreign bonds, and the arguments in favor seem compelling.
Think of it this way: The global market portfolio is the investment mix that reflects the combined judgment of all investors, with their votes cast with every trade they make. I can imagine straying from that mix for reasons for risk. What if I have no worries about risk? In that case, I should stray only if I think I’m wiser than the collective wisdom of all investors. Long experience has taught me never to be that arrogant.
Follow Jonathan on Twitter @ClementsMoney and on Facebook.
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Jonathan, with regard to issue #1, retiree drawdown … For many American Baby Boomers (and generations to come), they live payday to payday with a couple of large exceptions – building home equity, contributing to Social Security, and increasingly, as a result of widespread adoption of automatic features, save in an employer-sponsored retirement savings plan. As a result, more and more retirees wealth, where in the form of cash equivalent investments, are in the form of account balances in IRAs or tax-qualified plans.
Studies show many Baby Boomers, who have reached their Required Beginning Date under IRC 401(a)(9) and who must commence distributions to avoid a 50% penalty tax, are taking only the required distribution. Some spend it, others save the net proceeds. So, the first question I have is whether there is anyone in the financial services industry targeting, with a specific product or service (such as a Roth IRA conversion strategy, or perhaps linking IRA/qualified plan accounts with taxable investment accounts) for those retirees subject to MRD.
I noticed that your strategy would draw down 5% of your invested assets – perhaps starting at age 70 or so. At age 78 today, the MRD reaches 5% for the first time, and continues to increase thereafter. At age 80, it is 5.3%, at age 85, it is 6.8%, at age 90, it is 8.8%, and at age 95 it is 11.6%. President Trump signed an Executive Order that could push that age out to 79 or 80 – also affecting distributions at older ages.
So, the second question I have is whether you (or someone in the financial services industry) have a strategy that targets retirees with regard to periods after reaching age 78, when more than 5% must be distributed from IRAs.taxable accounts.
There are plenty of folks who will help retirees figure out how much they can safely spend each year, including financial planners and mutual fund companies. There is no lack of advice available and no shortage of studies on the topic.
The amount you can safely spend isn’t necessarily the same as your RMD. That said, one comprehensive study suggests that conflating those two may be one of the best and simplest strategies for retirees:
http://longevity.stanford.edu/wp-content/uploads/2017/11/Optimizing-Retirement-Income-Solutions-November-2017-SCL-Version.pdf