You’ve worked hard and saved money your whole life. Now, retirement is approaching, and you want to understand how to build a retirement portfolio best set up for success.
You have goals that need balancing. You want safety and you definitely want to minimize risks. Protecting your assets is important. You value growth and inflation protection on your investments. You also want to take enough income from your portfolio to sustain your lifestyle—without reducing your principal. Then there’s the money you need to leave for your heirs, and paying as little in taxes as possible…
The list goes on.
The Two Steps to Building a Retirement-Worthy Portfolio
There are two steps to building a retirement portfolio:
- Choose your account types
- Choose your investments
I’ll talk about account types first because you need to know where and how to hold your investments. Then, I’ll talk about what types of investments to have in those accounts.
For investments, we’ll look at the three most important decisions you need to make: how much in stocks vs. bonds, what kinds of bonds, and how to diversify your stocks.
The answer to which types of investments to include in your portfolio will vary depending on where you get your information from. If you talk to an insurance company, for example, they might tell you an annuity is the best for retirement. On the other hand, a broker might recommend their latest investments, or whatever happens to be paying the highest commission.
We’re going to answer the question by using academic research on portfolio building. The academic research comes from universities—like Chicago and Dartmouth—rather than from insurance companies or investment companies.
The academics conduct their research simply to find answers. They don’t sell any products—so we should be able to trust their objectivity.
Don’t worry, though, this stuff is easy enough to understand.
It’s also critical for you to understand because you want to make sure you build your portfolio in the best way possible in order to reduce risk and maximize your potential return.
Step One: Choose Your Account Types for Retirement
There are many different types of investment accounts that can hold retirement assets. All of the same options are available to you as when you were working. But some of your needs change in retirement, so the account types you use can change as well.
Account types define the tax treatment of the money as well as the restrictions on when and how much you can put into the account. Different account types do not necessarily mean different investments. For example, you can have a traditional IRA and a Roth 401(k) with the same investments in them. But the tax treatment and restrictions on those accounts are different.
There are three categories of investment accounts:
Within each of those categories are employer plans and non-employer plans. Let’s discuss these first.
Employer vs. Non-employer Plans
Employer plans are—as you may have guessed—retirement plans sponsored by your employer. That means that the investment options available to you are dictated by the provider your employer chooses, not you. You will have some flexibility to choose investments within the plan, but only from the options they make available to you.
On the other hand, you have more control over your investment choices with non-employer plans. There are pros and cons to each, and keep in mind that your needs change from your working years to your retirement years.
The biggest benefit to employer plans is that they have higher contribution limits, allowing you to put more money into them while you’re working and saving for retirement. The limits and restrictions vary by plan, but overall, employer plans have higher contribution limits than non-employer plans. In retirement, however, you’re not putting money into a retirement plan anymore, so higher contribution limits are not as important.
Instead, greater flexibility with your investment choices is more important in retirement. This is because when you take an income from your investments in retirement you’re subject to an additional risk called “sequence of returns risk,” which will be discussed later. Greater diversification can help mitigate this risk.
Since employer-sponsored plans are controlled by your employer, there is less freedom in your investment options, making full diversification more difficult. In fact, many employer-sponsored plans only have a handful of choices and do not offer much diversification at all. Some plans offer a self-directed section where you have many more choices, but even then there are still more restrictions than under a non-employer plan.
So, you’re almost always going to want to move your money into a non-employer-sponsored plan once you retire.
There are, however, two scenarios where you might want to use an employer-sponsored plan for a time before rolling it into a non-employer plan.
First, if you retire early, you might leave your money in an employer plan for a few years before rolling it into a non-employer plan. This is because there is a 10% penalty on withdrawals from non-employer plans before age 59 ½, whereas the age is 55 for employer-sponsored plans. So if you retire before age 59 ½, you may keep the money in the employer plan until you are no longer subject to the 10% penalty.
Second, you may leave your money in an employer plan if you retire late. This is because RMDs are required at age 72 from non-employer plans, while—if you are still working—you are not required to take RMDs from an employer plan. So, if you’re working past 72, then you might leave your money in an employer plan until you fully retire in order to delay RMDs.
Here are the most common employer plans:
- Roth 401(k)
- SIMPLE IRA
- SEP IRA
- Deferred Comp/EDCP
- Traditional IRAs
- Roth IRAs
- Non-qualified accounts
- Personal investment accounts
- Joint investment accounts
Pre-tax Retirement Accounts
This is the most common type of account, and it’s very common for people to have most of their retirement money in pre-tax accounts.
When you contribute to pre-tax accounts, you receive a tax deduction. Then, the earnings grow tax-free until you take the money out. This offers a great tax benefit for investing while you are working.
But, in retirement, any withdrawals you make from pre-tax accounts are taxed as ordinary income. So, these are actually the least advantageous accounts to own in retirement.
That doesn’t mean you shouldn’t contribute to them when working, though, because your taxes are usually higher while working—so the tax break while working often is greater than the disadvantage of paying taxes in retirement. Whether or not to contribute to a pre-tax or a post-tax plan depends on your specific tax situation.
Types of pre-tax accounts:
- Profit-sharing plans
You want to consolidate your accounts as much as possible for simplicity. If you have several different types of pre-tax accounts, you can combine them together into one—without causing a taxable event—with a rollover.
It also usually makes sense to combine them all into one IRA, because that’s the only non-employer pre-tax account.
The only time you might keep several different IRAs is if you have a different purpose for each. For example, one might be for retirement income, while another might be for a specific purchase in the future.
With post-tax accounts, you receive no tax deduction on the money you put in, but they still grow tax-free until you take the money out.
Then, withdrawals in retirement are tax-free, making these accounts the best to own when you hit retirement.
Types of post-tax accounts:
- Roth IRA
- Roth 401(k)
- Anything with “Roth” in it
Again, it usually makes sense to combine all your Roth accounts into a single Roth IRA—unless you have different purposes for different parts of your money. Combining Roth accounts with a direct rollover is a non-taxable event, and is recommended for simplicity and keeping track of all your assets.
This is the broadest category of investment account. Taxable accounts go by several names: non-retirement accounts, non-qualified accounts, or personal accounts.
Taxable accounts do not qualify for tax-deferred growth on earnings. Instead, they are taxed a little each year. This “tax-as-you-go” feature limits their growth potential.
In retirement, taxable accounts are subject to capital gains tax. The money you put into them can be taken out tax-free, while growth in the account—called earnings—is taxed at capital gains rates.
As far as taxation in retirement goes, these accounts are a middle ground between pre-tax and post-tax. Your entire withdrawal isn’t taxed like it would be from a pre-tax account, but the entire amount isn’t tax-free like it would be from a post-tax account.
Taxable accounts are the most flexible, as they do not have limits on contributions or withdrawals. Unlike pre-tax and post-tax accounts, you can access the money at any time. They trade that flexibility, however, for a lack of tax breaks.
Again, it makes sense to consolidate these into a single account unless there are different purposes for the money. These are also the most common types of accounts to have different purposes for because of their flexibility. For example, you might use them for a sinking fund to invest for car purchases.
Step Two: Choose the Investments for Your Retirement Portfolio
Now that you know which accounts to use—and you’ve consolidated them into as few accounts as you need—you’re ready to set up the investments within those accounts.
There are three steps to choosing your investments in your retirement portfolio:
- Choose your stock to bond ratio
- Choose the type of bonds
- Diversify your stocks
Where Does the Research Come From?
While there is a long history of academic research on markets, I want to point out two of the most important developments over the last thirty years on structuring a portfolio. These two pieces lay the groundwork.
Academics use databases with historic stock pricing and then run statistical analysis on them. The conclusions they reach have to be rigorously tested and proven to hold true over different time periods and in different countries.
The following two individuals both won Nobel prizes for their research on putting portfolios together, and these are particularly important for retirement portfolios.
In 1989, Harry Markowitz won the Nobel prize in economics for research showing how to put stocks and bonds together in a portfolio. His work is often referred to as Modern Portfolio Theory, or MPT. Markowitz said you can increase the expected return of your portfolio while decreasing your risk when you put different types of assets together. He showed this concept with something called the “efficient frontier,” which looks kind of like an upside-down nike symbol:
Then, in 2013, Eugene Fama won the Nobel for furthering Markowitz’s research and coming up with “The Three-Factor Model” and the “Efficient Market Hypothesis.” Fama was able to break down stocks and find three factors that are the most responsible for returns in a portfolio.
These two—and many other academics—lay the foundation for building a retirement portfolio. The following will be a non-technical discussion on how you can practically follow their research.
Choose Your Stock to Bond Ratio
Your stock to bond ratio is the first decision you must make when choosing investments for your portfolio. This is the most important decision when it comes to the risk and return of your investments.
In retirement this is especially important because you want both as much safety as possible while still growing the portfolio.
Bonds provide safety—which will be discussed more below—but they don’t provide much for return. Stocks are where the return comes from, but they are much more volatile than bonds.
Have too much in stocks and you run the risk of a prolonged down market cutting too heavily into your retirement assets; have too little in stocks and you don’t have enough growth. Have too much in bonds and you run the risk of inflation outpacing your assets; have too little in bonds and you don’t have enough stability for down years in the market.
It’s kind of like balancing water and sunlight when growing a plant. I’ve had countless house plants die on me by not maintaining the right balance. Too much water and you drown the plant, too little and you dry it up. Too much sun can damage the plant, but not enough sun and it will wither and die.
Not only that, but every plant is different and needs a different balance for optimal growth. In the same way, every person entering retirement is different and needs to balance their stock to bond ratio according to their specific needs.
The exact stock to bond ratio for someone in retirement can vary based on their specific financial and life situation, and their investment income strategy, but the optimal range should be anywhere from 50:50 (50% stocks and 50% bonds) to 75:25 (75% stocks and 25% bonds).
Within that range, you have both growth and inflation protection from stocks while still maintaining important safety from the bonds.
50:50 is on the conservative end and would be for someone who needs more protection on their principal, and isn’t as concerned with greater growth. There are still enough stocks to protect from inflation, but with 50% in bonds, half of your portfolio won’t be subject to the volatility of the stock market.
75:25 is on the more aggressive side of a retirement portfolio. This is for people who have more flexibility and are in a position to withstand market fluctuations. For example, if pension and Social Security income provide a large portion of your living expenses so that you are not entirely dependent on investment income to live on, then this mix could make sense.
However, having the right type of bonds in your portfolio is essential because the wrong kinds of bonds do not diversify well from stocks—they can often go down when stocks go down—and so they don’t provide the needed safety for retirement.
Choose the Right Types of Bonds in Your Portfolio
It’s critical to have the right types of bonds in your portfolio, especially in retirement.
The 2008 downturn saw many bond portfolios go down 20–30%, there was even a bond fund that went down 78%! But the right types of bonds actually went up in value at the most crucial time.
If you remember anything I say about bonds, remember that bonds are there for one thing only: safety.
You run into problems when you start looking for high returns from your bonds. Investors try to increase the returns of their bonds by either looking for certain types of corporate bonds or long-term bonds, but here’s a quick overview of why that’s problematic.
Some corporate bonds tend to go down with the stock market during bad economic conditions. That happens because companies can struggle to repay debt when the economy is weak. This defeats the purpose of bonds because they lack safety.
These “high-yield” bonds lend money to riskier companies. While they might be able to keep up on their interest payments while the economy is good, once the economy goes into a recession their risk of default on their debt skyrockets. Basically, right when you need them they can collapse.
Long-term bonds (bonds with maturities of over five years) may provide higher yields, but their problem is that they are affected more adversely by a rise in interest rates.
Bonds and interest rates have an inverse relationship. When interest rates rise, the price of bonds falls, and when interest rates fall, the price of bonds rises.
So, the longer your bond has until maturity, the more it will be affected by a change in interest rates. If my bond has six months until maturity and interest rates rise, I only have to wait six months before I can reinvest in the higher-paying bonds. But if my bond has 30 years left, I’m stuck in the lower-paying bond for a long time.
This increased risk from interest rate fluctuations takes away the safety I need from bonds in my portfolio.
Government bonds come in many forms, anywhere from 3-month Treasury Bills to 30-year Treasury Bonds; with several different varieties.
The important thing about Government bonds is that they are backed by the government. The government has an incredibly low risk of default because they are so big, but also because they can print more money if they need to. No one else has that ability—legally
For that reason, government bonds are the safest you can invest in, and the rate on Treasury Bills is often called the “risk-free rate.” It’s usually the lowest rate out there because it’s the least risky.
What Type of Bonds Should You Include?
We want high-quality bonds in our portfolio. These types of bonds provide the safety we need to balance the volatility of stocks.
There are several different types of bonds that categorize as high-quality, and it’s good to own all of them for diversification purposes.
Here’s a list of all the bonds you want in your portfolio:
- Short-term government
- Intermediate government (3-5 years)
- High rated (A or better), short-term corporate
- High rated, short and intermediate global bonds
Bonds to avoid:
- High-yield bonds
- Low-grade bonds (Anything below BBB)
- Long-term bonds, anything beyond 5-years
Many people can get antsy with their high-quality bonds when they go for years with only 2% returns. It can be tempting to opt for the 6% or 7% returns of junk bonds. But those who remained disciplined were rewarded in years like 2002 and 2008, when everything in the market was going down. Some safer AA and AAA rated bonds went up with high double-digit returns during those market declines.
Don’t fall for the allure of higher returns when it comes to bonds. Stay disciplined and remember that bonds are there for safety.
What Is True Diversification?
I know what you’re thinking, Diversification? Really? Everyone knows that. Give me something deeper.
The problem is, very few portfolios have true diversification. And true diversification helps a retirement portfolio last longer, while false diversification doesn’t help at all.
A portfolio may have over a thousand stocks. It may have a list three pages long of mutual funds. It may have different types of investments, mutual fund companies, or investment managers, but you can have all of those things without having true diversification.
Let me explain.
Remember playing sports in school and having team captains take turns picking people for their team? Think of diversification like choosing players for your team—except you don’t know which sport you’re going to be playing. You could choose basketball players, soccer players, hockey players, and swimmers, among others.
If you pick a team of all soccer players, you’ll win if the sport ends up being soccer, but they’ll be slipping and sliding if they have to put on skates against the hockey players. The swimmers will be great if you end up in a pool, but they’ll be fish out of water on a basketball court. Each type of player will do best at their specific sport, but the problem is there’s no way to know what sport is coming up.
Investing is the same way. There are different types of companies and there are different types of market conditions; certain companies perform better than others in certain types of market conditions and vice versa.
True diversification is owning each different type of company. That way, you almost always have something that is doing well, no matter the market conditions. If you pick one player from each sport, you always have someone that can help you, no matter what sport.
Academics call these types of companies “asset classes,” and they use statistics and correlation coefficients to come up with them. I won’t get into all of that here. You don’t need to know how they work, but it is crucial that you know what they are, and a little bit about why they work.
Applying Diversification to Your Portfolio
Everyone knows they should diversify their portfolio, but how is it actually done? Many people think that they are diversified when they really aren’t. This happens when a portfolio is made out of all the same types of companies. In the analogy above, if you were able to choose ten teams of hockey players, it still doesn’t help your chances of winning if the game being played is soccer.
Diversification comes down to owning statistically distinct asset classes. Academics have defined eight distinct asset classes: Large US Growth, Large US Value, Small US Growth, Small US Value, Large International Growth, Large International Value, Small International Growth, and Small International Value.
That’s a mouthful.
Here’s a chart to make it easier to see:
Proper diversification means owning investments from all eight categories. If you own fifty different mutual funds and other investments, but you don’t own from all eight categories, you’re not fully diversified.
Academics have shown that, historically, you can increase return while decreasing risk when you own all eight categories. In other words, if you just own one or two, you’re subject to more risk without adding any more expected return.
The final thing I’ll say here is that these categories aren’t arbitrary. They are based on correlation coefficients, which is just a way of measuring how similar they are to each other.
These are the asset categories that are the most different from each other, which means that oftentimes when one is doing poorly, another is doing well. Sometimes they all move together but many times they don’t.
Most other ways to separate out investments are statistically insignificant and don’t provide true diversification..
Let’s walk through the different asset classes to understand more about why they are different from each other, and then we’ll end by talking about bonds.
Small vs. Large
The first category of stocks is small companies versus large companies.
Their size difference causes them to react to market conditions in varying ways. For example, small companies are more agile, allowing them to respond to new information more quickly and to adapt faster to market changes.
Large companies, on the other hand, have more resources and brand influence at their disposal. Think of Walmart moving into a small town and putting the local stores out of business. Walmart buys in bulk and has more leverage when dealing with suppliers thus helping to reduce their costs.
We expect more return from small companies because they have more room to grow than their larger counterparts. They can often make changes in strategy more quickly than a large firm—like the difference between turning a battleship and turning a motorboat.
But as you might expect, small companies also have more volatility. For that reason, some people worry about adding small companies to their retirement portfolio. But when you own both—because they don’t always move exactly together—you decrease the overall risk.
And it’s not like large companies are without risk. For example, the S&P 500 (the most common index for large US companies) went 16 years from 1966 to 1982 with no return above inflation. You wouldn’t want to be in retirement with only large companies for that period.
A properly diversified portfolio has both large and small companies in it, but we have found that most portfolios hyper-focus on large companies. People become enamored with the big companies they recognize and forget that it was probably best to own those companies when they were first starting out.
Growth vs. Value
The next category of companies is growth versus value. Now, this one is a little less intuitive because the names growth and value don’t quite give away the difference.
Growth companies are strong and stable, and they tend to be in a phase where they are dumping their earnings back into the company for future growth.
Value companies are the opposite—they tend to be less stable and often pay a higher dividend in comparison to their price. I like to joke that value companies have one foot on a banana peel and the other in bankruptcy court. Maybe a bit of an overstatement, but you get the point.
A good analogy to think about growth and value companies is to think about the house-flipping shows. When people go to flip a house for profit, they usually buy one of the worst-looking houses on the street because it has the potential to be spruced up and sold for a profit. They don’t buy the nicest house on the street because there’s less potential to fix it up and increase its value.
So, value companies have a higher expected return because they have more room to grow, just like with small companies—and as with small companies, value companies have more volatility.
The technical way to measure value companies is with the price to book ratio (P/B), which is the book value—or assets of the company minus its liabilities—divided by the price per share of the stock.
P/B = (Assets + Liabilities) / Price
Companies are worth more than their assets. They have the ability to make a profit, and they have future growth potential. So, they usually sell for more than their book value. The higher the P/B ratio the more growth a company is, and the lower the P/B ratio the more value a company is.
Morningstar and other investment research companies will also categorize companies as value or growth, making it easier to pick them out. But you have to be careful, sometimes the P/B ratio can creep up before Morningstar recategorizes it.
A properly built retirement portfolio has both growth and value. Sometimes growth companies perform better and other times value companies perform better. Having both increases the chance that something is performing well which is important for retirement income.
International vs. US
The final major category of companies that we will discuss here are US and international.
Again, market conditions can affect international companies differently than they can US companies. For example, the dollar fluctuates in value, and international companies thrive during periods when the dollar is weakening. The returns of US and international companies tend to go back and forth—sometimes market conditions favor international companies and sometimes they favor the US.
In the 70s, it was all international, then US companies started to take over in the early 80s, but by the end of the decade international companies had trounced US companies. By that time, everyone was saying, “Forget the US, invest everything in international companies.” But then the 90s came and US companies completely dominated.
It’s a cycle that goes back and forth, and there’s no predicting the changes, which is why it’s essential to stay diversified and own both.
You also want to make sure to own growth, value, small, and large in both international and US. For example, it’s not enough to have those four categories in the US, but only large International companies. Small and value international companies provide the greatest diversification from US companies.
Why Most Portfolios Aren’t Diversified
You might think: But isn’t every financial advisor aware of these principles? Can’t I just give my money to them and trust that they’ll do what’s in my best interest?
Are they aware of the principles? Maybe, but using them is an entirely different story. Studies show that advisors routinely don’t follow the academic principles of investing.
But if this research is out there, why don’t they follow it? Unfortunately, it comes down to sales and marketing. I like to give advisors the benefit of the doubt. Most are not aware of the academic principles, they’re only aware of what their investment company has taught them, and company training is more about how to sell than it is about how investing works.
It’s much easier to sell investment products that go against the academic principles than it is to sell a client on a portfolio that follows the principles. Not only is it easier to make a sale when going against the principles, but investment companies are often set up in a way to incentivize the sales of certain products—their advisors make more commissions selling some products than they do others.
The easier sale and the more profitable sale usually move a truly diversified portfolio to the sidelines.
True diversification is hard to sell because it means you’re never the best-performing portfolio. One of the eight categories is always going to be the best; therefore, a portfolio built completely of that one category will be a top performer—and it’s always easier to sell a top performer than it is a middle-of-the-pack performer.
But if you’re focusing on only the best performer, then you’re focusing on only one category, and the problem there is that no category will be the best forever. Any one category can go long periods of time with no return. Large US stocks, for example, went sixteen years with no return above inflation from 1966–1982.
Not only that, but if you’re buying what has just done well recently, then you’re consistently buying high, breaking a fundamental rule of investing. So, don’t fall for an advisors sales pitch to buy their best-performing funds.
Stick to true diversification instead and you’ll set yourself up for better success in the long-run.
By Michael Sharpnack.
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