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The Pitfalls of Traditional Stock and Bond Investment Allocations
Understanding Investment Risk/Reward 1970-2006The bear markets in U.S. stocks in the early 1970s and 2000s showed investors the importance of protecting their nest egg from large losses from which it may take years to recover. To illustrate, assume you plan to retire on your 65th birthday, which happens to fall on December 31, 2010. As of January 1, 2008, you have amassed $1,000,000 in your investment portfolio, which you plan to use as a source of income during retirement. Your projections assume 10% pre-retirement growth in 2008, 2009, and 2010, which means you hope to have $1,331,000 heading into retirement in 2011. During retirement, you plan to cut back on your exposure to risk reducing your expected return to 8% per year. The results of your retirement projections are shown in Table 1.
The Real World Can Throw You a Curve BallIn a possible real world scenario, you head into 2008 with your retirement plan neatly filed away. Unfortunately in 2008, 2009, and 2010 we get the same gut-wrenching S&P 500 returns we had in 2000, 2001, and 2002, which were loses of 10.14%, 13.04%, and 23.37% respectively. Under this scenario, it would take annual returns of 10% in 2011, 2012, 2013, 2014, 2015, and 2016 just for you to get back to break even. The results of the hypothetical real world retirement scenario are shown in Table 2.
Your planning process projected you would have $1,331,000 heading into retirement on January 1, 2011 (Table 1). The real world scenario resulted in you having only $598,804 heading into retirement (Table 2). Your planning process projected you would have $2,112,130 at the end of 2016. The real world scenario resulted in you having only $1,060,818 at the end of 2016. These examples show the importance on focusing on your potential gains and losses in both good and bad times for investors. Most people cannot afford to sustain large principal losses so close to retirement. Regardless of your age, Table 1 and Table 2 demonstrate the difficulty in recovering your original principal after sustaining large losses.
Same Scenario with 65% Stocks / 35% BondsThe standard industry response to reduce volatility in a stock portfolio is to add bonds. In this case, assume you plan to retire on your 65th birthday, which happens to fall on December 31, 2010. We will use the same assumptions as above with the following exceptions:
Table 3 below shows the actual returns for the Vanguard 500 Index Fund and the Vanguard Total Bond Market Index Fund. The Vanguard 500 Index Fund holds the 500 stocks that make up the S&P 500 Index. The Vanguard Total Bond Market Index holds a diversified portfolio of bonds. In this scenario, the 65% stock / 35% bond investor still experienced losses of 1.90%, 4.86%, and 11.51% in 2000, 2001, and 2002 respectively.
Table 4 shows the results with a 65% stock / 35% bond portfolio. Even with some bonds in the portfolio, it takes almost six years to get back to the original $1,000,000 in principal.
High Inflation – Case One 65% Stocks / 35% BondsAs a retiree or someone who is approaching retirement, a return to 1970s style inflation may represent the greatest threat to your standard of living. Assume you plan to retire on your 65th birthday, which falls on December 31, 2010. As of January 1, 2008, you have amassed $1,000,000 in your 65% stock / 35% bond portfolio, which you plan to use as a source of income during retirement. Your retirement projections assume 8% growth and 4% inflation from 2008-2019. Assuming no portfolio withdrawals for simplicity, you hoped to have $2,518,170 in nominal dollars and $1,601,032 in inflation-adjusted dollars (purchasing power) at the end of 2019. These retirement projections are shown in Table 5.
Unfortunately 2008-2019 produces the same results as 1970-1981 for stock returns, bond returns, and inflation (see Table 6). Under these real world conditions and using a 65% stock / 35% bond blend, your nominal portfolio value at the end of 1981 would have been $2,100,278 with an inflation-adjusted purchasing power of only $798,932 (Table 7). This means the actual purchasing power produced after being invested in 65% stocks and 35% bonds from 1970-1981 (Table 7) would have been 50% lower than a projection using an average annual return of 8.0% and average annual inflation rate of 4.0% (Table 5). Said another way, this means your standard of living would be 50% lower than you projected. Tables 6 and 7 use large company stock returns, long-term government bond returns, and annual inflation rates (1970-1981) (SOURCE: Ibbotson Associates).
High Inflation – Case Two 100% Stocks The typical Wall Street response to high inflation is to reduce your bond exposure and increase your stock exposure. Table 8 assumes a portfolio of 100% stocks from 1970-1981. During this period of high inflation, the results would have been almost identical to the investor with 65% stocks and 35% bonds. The 100% stock investor would have had $838,334 in purchasing power after investing $1,000,0000 from 1970-1981. The 65% stock / 35% bond investor would have had $798,932. The point of the exercise is to illustrate in the 1970s, a period with high inflation, both stock and bond investors struggled to protect and grow their purchasing power.
The next segment covers CCM's approach to investing, which uses multiple asset classes in an effort to protect principal and purchasing power.
All material presented herein is believed to be reliable but we cannot attest to its accuracy. The information contained herein (including historical prices or values) has been obtained from sources that Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes any representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
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