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After those three wrenching
years, the 1926-2002 annualized return of the index was 10.2 percent
– exactly the same as from 1926 through 1994. In case you’re
wondering, the 1995-2002 annualized return was 10.3 percent.
This is called regression
to the mean, the tendency of statistics to return to long-term averages.
It doesn’t always happen. But it’s highly likely.
In planning your retirement,
you’ll always be better off to use conservative assumptions
rather than optimistic ones.
I hope you’ll trust
me on this point: If you do better than you plan for, you’ll
be able to cope with your unexpected higher returns. But if you
plan optimistically and the future fails to measure up to your plans,
you could find yourself facing some mighty unpleasant choices.
Step
5: Determine what
assets have the highest probability of giving you the returns you
need. This means you should own much more than just large-cap U.S.
stocks, which are represented by the Standard & Poor's 500 Index.
Here’s a simple
example. Remember that from 1926 through 1994, the S&P 500 Index
had an annualized return of 10.2 percent. During that same period,
U.S. micro-cap stocks returned 12.6 percent, small-cap value stocks
returned 14.6 percent and large-cap value stocks returned 12.4 percent.
An average of those four asset classes could have gained 12.5 percent,
much higher than the S&P 500 Index alone.
From 1995 through 1999,
the S&P 500 Index led the pack with its gains of 28.6 percent.
The average of all four was 21.5 percent –a terrific gain for
any five-year period. In 2000 through 2002, when the S&P 500
Index lost 14.4 percent a year, the four-way combination lost only
1.7 percent a year.
If you diversify among
asset classes that have performed well over very long periods, you
won’t get snookered into putting all your trust in whatever
has been performing well lately.
Step
6: Determine what
combination of assets will produce the return you need within your
risk tolerance. You may want the expected returns that come with
an all-equity portfolio. But such a mix of assets is too risky for
most retired people. Remember the general rule that the higher the
return you seek, the more risk goes with it.
There
are three steps in this process.
First, find the best
combination of equity assets. For information on exactly how to
do that, see an article that’s easily accessible on our Web
site called “The Ultimate Buy and Hold Strategy.” That
article will also help you take the second step, which is to identify
the best fixed-income assets to stabilize your portfolio.
Third, find the right
percentage combination of equity assets and fixed-income assets
to give you the best balance of return and risk.
Here’s a case where
you can make the best decision when you have the best information.
In our workshops, we
use a table that shows several historical risk measures for portfolios
split between stocks and bonds in various percentages. There’s
an example of this table on our Web site in an article called “Fine
Tuning Your Asset Allocation.”
The most important numbers
in those tables are in the rows at the bottom. They show the annual
returns as well as six measures of risk for every combination. This
is the kind of information that investors should focus on when they
ask themselves how much risk they can (or how much they want to)
take on.
One interesting way
to use this table is to fold it so that only the bottom six rows
are visible. Then scan across whatever line seems most relevant
to your concern (for instance the worst 12-month period) and find
the closest column to the right (indicating higher risks and higher
returns) that would be acceptable to you.
Then make sure the other
risk measures in that column would be acceptable to you. If not,
keep going to the left until you find the first column in which
every one of those measurements of risk would be acceptable.
Assuming you are a buy-and-hold
investor, that tells you the percentages of your portfolio that
you should have in bond funds and equity funds. That will tell you
the past return that such a combination would have produced. But
the return figures are less reliable in the future than the risk
measures.
Our
advice: Give priority to the risk measurements, not past returns.
Step
7: Keep your expenses
as low as possible. If you think of an investment portfolio as a
sailboat trying to move forward, then think of expenses as an anchor
being dragged behind. They slow you down. You may have a wonderful
sail and a great crew. But you won’t get where you want to
go very efficiently if you are dragging a heavy anchor behind you.
There are two kinds
of expenses: ongoing and one-time-only. Almost all investments involve
some type of recurring expenses. Savvy investors always want to
know what the expense ratio is. Naïve investors ignore this,
focusing instead on marketing hype and recent returns.
Investors should expect
to pay for investment management and the administration that goes
with it. But they don’t have to overpay. One of the least expensive
ways to invest is in index funds. Vanguard’s 500 Index Fund
(VFINX), which follows the Standard & Poor's 500 Index, is a
bargain, charging its shareholders just 0.18 percent per year in
expenses. But some funds charge more than 1 percent a year to invest
in essentially the same group of stocks. That’s counterproductive
and unnecessary.
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