Recently I wanted to teach my children about the concept of saving money and earning interest. My parents taught me by opening a bank account. The problem is that banks pay almost nothing to hold your money. Savings bonds yielding 1% or 2% are no better. My children are simply not very excited about the prospect of investing $100 and waiting patiently for an entire year (a lifetime for them), only to receive an extra $1 or $2 for their trouble! They have a point; there is a lesson here for all of us. In the end, I used their money to purchase a few stocks as a learning exercise. Thanks to Apple’s stock, their portfolio has done better than mine over the past year!
There is an old rule of thumb about the right mix of stocks and bonds: The amount in stocks should be 100 minus your age. So, following this rule, a 55-year-old would have a portfolio with 45% stocks and 55% bonds. This may have been good advice 25 years ago when interest rates were much higher. Someone fortunate enough to retire with a million dollars back then could invest entirely in high-quality bonds and have an income of more than $90,000 [annually]. That same million-dollar bond portfolio today would only generate less than $20,000 of income [annually]. This is not a viable retirement plan!
Determining the right asset allocation is a complicated task and specific to one’s circumstances. For this article, I’m going to simplify things and assume that stocks and bonds are the only choices, but in reality there are many other asset classes worth considering such as real estate and commodities. I’m also going to assume you have a 10-year time horizon. Given these assumptions, there are some strong arguments that most — if not all — of your portfolio should be stocks:
- Better investment yield: Stock investors are effectively buying partial ownership of a company’s profits. There is no guarantee that these profits will remain constant. There is also no guarantee that the price one pays for each dollar of profit (the P/E ratio) will remain constant. But in the long run it is helpful to think about stock ownership as ownership in a stream of profits. Buyers of mutual funds or exchange-traded funds (ETFs) that track the S&P 500 (such as the S&P ETF “SPY”) enjoy an implied profit stream of almost 7% on their investment. This is the “earnings yield” calculated as the inverse of the P/E multiple (Earnings / Price). Some of these profits are paid out as dividends, some are reinvested in the companies. As profits grow this 7% earnings yield also grows. Meanwhile bonds yield only about 2 to 3% with no possibility of an increase during the lifetime of the bond.
- Superior cash flow: There are many stocks where the dividend on the stock is actually higher than the yield on a bond issued by the same company. Even better, these dividends tend to go up over time, represent only a portion of the total profits of the company and are taxed more favorably than bond interest. The stock of GE, for example, currently has a 3.4% dividend yield. Meanwhile GE’s 6 year bond only yields about 3%.
- Better track record: The average annual returns for stocks over the past 87 years is 10.2% compared to 5.5% for bonds. Given current interest rates, it is mathematically certain that bonds will be worse than their historical average going forward if held to maturity.
So, do I really believe a 55-year-old planning to retire in 10 years should put 100% of their life savings in stocks? In theory, yes, but in reality I have very few client portfolios at or close to 100% stocks due to the short-term risk involved. Most cannot stomach this volatility. I maybe right about my 10 year view, but if the market crashes next year my clients would likely fire me well before I had a chance to be proven correct! Still, I suggest a much higher stock allocation than normal, especially for retirement and other long-term investment portfolios.
Learn more about Keith on NerdWallet’s Ask an Advisor.