The stock market regularly makes a mockery of reasonable strategies and smashes them to pieces like a deranged bull rampaging through a china shop. Its latest victim is the idea that investors should invest heavily in stocks when they're young and then gradually move into bonds as they prepare for retirement.
It sounds like a sensible idea. After all, young investors have time to make up for losses without suffering too much. On the other hand, older investors can hide out in bonds and remain safe at a time when losses really hurt.
Problem is, most young investors start with very small portfolios. Early gains, or losses, from stocks don't matter too much. On the other hand, opting for bonds later in life when the stakes are far higher can significantly depress returns and reduce the amount of money available for retirement. The return reduction is often big enough to throw the whole idea of moving to bonds over time into doubt.
It's a point made by money manager Robert D. Arnott, who recently examined several different scenarios in the U.S. context. He calculated that investors were better off opting for a half-bond and half-stock portfolio instead of starting mostly in stocks and then moving mostly into bonds before retirement. Investors would have done even better by flipping the rule on its head. Those who invested mostly in bonds when they were young and moved into stocks as they grew older fared the best.
However, it's risky to generalize the U.S. experience, which has been exceptionally good to stock investors for more than a century. Similar results might not occur in less successful nations.
In this case, the U.S. isn't the exception, according to Professor Javier Estrada of the IESE Business School. He studied the issue in a recent paper called The Glidepath Illusion: An International Perspective, which examines how different asset allocation methods fared in 19 countries over 110 years.
Prof. Estrada specifically considered the case of an index investor who spends 40 years accumulating assets before hitting retirement. Each year they add $1,000 to their savings, adjusted for inflation, and rebalance back to their desired stock-bond mix. (Fees and taxes were not considered.)
As a result, each country provided 71 overlapping 40-year trial periods representing the working lifetimes of different investors. Their overall experience was revealed by the average real returns for investors in each country and the extremes highlighted by the results for the best and worst 40-year periods.
It turns out Canada was a pretty good place for stocks from 1900 through 2009. The equity markets climbed by an average of 5.8 per cent a year, adjusted for inflation, and bonds provided annual real returns of 2 per cent.
Canadians who invested in a simple half-stock and half-bond portfolio entered retirement with $120,100 on average. The best 40-year period provided $193,000 and the worst yielded only $61,400.
Those who started with an all-stock portfolio and steadily moved into bonds accumulated an average of $107,300. The luckiest got $196,100 and the most unfortunate was left with a mere $51,500.
Flip the usual advice around, and investors who started entirely in bonds and moved steadily into stocks accumulated a nest egg of $135,800 on average. The best period provided $298,100 and the worst $61,100.
In other words, moving from bonds into stocks over time proved to be the best of the three options. In addition, the simple half-bond and half-stock approach generally fared better than moving from stocks to bonds.
The same trend persists when you consider data from all 19 countries.
Those who started with all stock portfolios and moved to bonds were able to begin retirement with $96,100 on average. The best result was $239,700 and the worst $30,800. The contrarians who went from all bonds to all stocks over 40 years walked away with $123,00 on average. The luckiest got $360,800 and the unluckiest $33,600.
Once again, investors who flipped the regular rule on its head fared the best.
While it's true that stock-heavy portfolios tend to be more volatile, they've vastly outperformed the more conservative options. As Prof. Estrada says, "the higher variability is merely upside risk; that is, uncertainty about how much more, not how much less, capital investors are expected to have at retirement."
If history is a guide, then investors are better off avoiding the urge to move into bonds in a big way as they prepare for retirement. But those who can't handle the ups and downs of the stock market can still do reasonably well with more conservative low-fee balanced funds and strategies that stick to the same asset mix over time.