Source: 401kcalculator.org via flickr
When you are retired, or are planning for your retirement, what type of investments should you have in your portfolio? If your answer didn't include stocks, you might be doing yourself a big disservice.
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Stocks should make up a substantial part of your portfolio, if not the majority of it, before and during your retirement. Here's why you need stocks and what could happen if you don't have them.
Before you retire: it'll be tougher to meet your goalsHow much do you need to retire comfortably? Many investors have a certain number in mind that they would like to reach before retiring. And too little exposure to stocks in your portfolio could make it much tougher to achieve that number.
Let's say that you are 35 and plan to retire at 65. You have $50,000 saved for retirement and plan to save another $5,000 per year. We'll also assume that the bonds you invest in will return about 4% per year, and that the stocks in your portfolio will produce average annual returns of about 9.5% -- the average historical return of the S&P 500.
By investing 50% of your portfolio in stocks and 50% in bonds, you'll end up with a $976,000 nest egg at the age of 65. Not too bad, right? However, by using a 75% stock, 25% bond allocation, this increases significantly to more than $1.2 million. Of course, this is a simplified example, and past performance of the stock market doesn't guarantee future results, but the point is that sacrificing too much growth in order to achieve safe, predictable income can make it more difficult to accumulate enough money to retire.
Beware of fixed-income when rates are lowBonds have a reputation as a low-risk investment, and many investors mistakenly believe bonds are totally risk-free. While it's true that bonds are safer than stocks in the sense that the income they produce doesn't depend too much on a company's earnings or the overall economy, bonds have one major risk that many investors don't realize -- interest rates.
This is especially true with the long-dated bonds that many retirement investors buy. As an example, let's say that you invest $1,000 in a 30-year U.S. Treasury bond, which currently pays about 2.7% annual interest. If rates rise, and the 30-year Treasury rate shoots up to say, 4%, the face value of your bond will be (roughly) based on that amount.
In other words, if you were to decide to sell your Treasury bond, the investor who buys it will expect about the same 4% yield as they could get from buying a newly issued bond. In order to yield 4%, the face value of your Treasury bond would drop to about $675, since it only pays 2.7% of the original $1,000. There are a few other factors that affect the price of bonds, so it wouldn't be exactly this amount, but pretty close.
In a rising rate environment, many stocks can actually perform well. However, the value of an all-bond portfolio is almost certain to take a significant hit.
Fixed income is good for now, but what about in 20 years? 30 years?So, we've seen that when interest rates rise, your bonds and other fixed-income investments can lose value. However, if you are already retired, you might say that doesn't matter because you never plan to sell -- you simply rely on your bonds for income.
And this is definitely true for the time being. Let's say that you anticipate needing $50,000 per year from your investments once you retire, so you take your $1 million nest egg and create a bond portfolio that pays 5% per year. That should meet your needs, right?
The problem with this type of strategy is that it assumes you'll need $50,000 per year forever. Unfortunately, inflation will erode the purchasing power of that money over time. Even if we assume the long-term inflation rate is just 2% per year, your $50,000 will only be worth about $33,400 in 20 years. So your "sure thing" bond portfolio will actually produce less income as time goes on, when adjusting for the increasing cost of living over time.
On the other hand, the growth opportunity you get when buying stocks can help you keep up with inflation and then some. And as long as you invest in high-quality dividend stocks, you can still create a nice income stream. However, with stocks your income stream can grow over time. Just look at how some of the biggest and most rock-solid companies in the market have increased their dividends over the past decade.
Note: Yields current as of 3/13/2015
Stocks don't have to add much riskMany people mistakenly equate the word "stocks" with "risk", but that doesn't necessarily have to be the case. Sure, some stocks are risky and speculative, but many (like the ones in the table above) are hardly riskier than bonds, and with a whole lot more upside potential.
The article 1 Retirement Mistake You Cant Afford To Make originally appeared on Fool.com.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Johnson & Johnson, McDonald's, and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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