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Buy and Hold: Why it Doesn’t Work During Retirement

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Many retirement income planning “experts” suggest investing a portion of your portfolio in some form of diversified stock portfolio. The rationale often provided is that retirements can last as long as 60 years, which means that you both have a need to grow your investments to meet needs in the later years of retirement, as well as having a long enough period to ride out market volatility.  So, make the investment and hold on to it for the later years, when you will need it.

While these observations are partially correct, the average time period over which stocks can beheld is considerably shorter.  In other words, 60 years of life during the payout phase is quite different than 60 years during the accumulation phase as it relates to the average lifetime of your investments.  More specifically, the average lifetime of the stock portfolio holding will be considerably shorter than 60 years due to several factors.

The Rebalancing Effect

Asset allocations should become increasingly conservative as you move into the later years of retirement because the time horizon for future income shortens; the portfolio of a 90 year old should be more conservatively invested then that of a 60 year old.  At older ages, investors have less time to ride out market volatility and a greater need for liquidity and principal protection.  Because stocks are more volatile than other investments, they become less appropriate in the later years of retirement.  Therefore, you cannot simply “buy and hold” a stock portfolio into the later years of retirement – you need to periodically rebalance, moving money out of stocks and into bonds and cash to achieve this more proper allocation.  Therefore, stocks should be a smaller piece of the overall portfolio “pie” in the later part of retirement.

The Portfolio Shrinkage Effect

Second, the holding horizon for stocks will be shorter because you will be spending down your assets, meaning that the overall size of your portfolio will shrink due to withdrawals taken to generate income. Because stocks are going to be a proportional amount of a shrinking pool of investments, the amount of stock held will decrease along with the size of the portfolio.  In other words, not only should stocks be a smaller piece of the overall “pie”, as mentioned earlier, but the entire pie will be much smaller as well.

The Redemption Effect

Now, let’s think about both of these points together.  We have a portfolio that is shrinking each year due to withdrawals, and we need to move the portfolio toward a more conservative asset allocation.  These conditions mean that the assets that we are drawing into income are essentially the stock holdings (because we will not need as much of them at the end of each year), while the more conservative part of the portfolio will be “bought and held” into the later years of retirement.  This totally conflicts with conventional wisdom!

We have been raised to believe that stock investments should be held for many years while the more conservative investments should be drawn down to create income.  However, if we did this we can quickly figure out that the portfolio will become increasingly risky from one year to the next, which is neither a desirable nor prudent practice for any retiree.

The Compounded Growth Effect

Another factor that renders a “buy and hold” strategy impractical for stocks during retirement is that, over a reasonably long time horizon, they will likely grow at a faster rate than the rest of your portfolio (heck, this is why we are investing in them to begin with).  Holding on to these investments over long periods will naturally cause the portfolio to become more risky, even if we did not draw down assets into income, because the risky stock portion of the portfolio is growing at a faster rate than the rest of the portfolio.  This is another reason why periodic rebalancing is needed to maintain a reasonable asset allocation each year during retirement.

Implications

So, what does this mean?  First, the proportion allocated to stocks should reflect the expected average holding period.  Take a 65 year old who has a portfolio of $1M, and is considering investing 25% of her portfolio in stocks.  She plans on spending $40,000 in the first year and increasing 3% thereafter, and wants a portfolio that is 100% invested in bonds at age 95.  The average holding period for stocks will only be about 10 years, which is not a very long period of time to benefit form significant growth.  As a result, the proportion of the portfolio invested in stocks should be somewhat lower than they would for a comparable time horizon during the accumulation stage.

Check the Plan: Is the Long Term Asset Allocation Assumption Appropriate?

Second, be sure any financial analysis that you use to assess your retirement income strategy has explicitly taken this aspect about stocks into consideration and uses an appropriate asset allocations in the later years of retirement.  If the analysis shows very large concentrations of stocks at older ages, be skeptical.  It may well be that the advisor did this in order to get the assets to grow to a targeted level (using the higher expected returns associated with stocks) or to support higher levels of income. Such a practice places you in a high-risk situation – a good advisor would never (barring a highly unusual situation) tell someone at such an age that they should keep a large percentage of their savings in stocks, so why build a plan that does exactly that?  Make sure that the portfolio allocation in the later years matches up with one that you feel would be appropriate for your needs at that time, not what justifies a level of income today.

Remedies

  • If you do want to buy and hold a set of stocks, then you should solve for an amount so that its expected future size will be a reasonable proportion of the anticipated portfolio in the future. This requires making estimates of the rate of growth on the stocks and the amount of money you anticipate having from other sources at that time.  It will require some number crunching, but it is doable.
  • Alternatively, if you feel that holding on to stock is important consider using put options, or a collar strategy, on your stock portfolio to protect against market losses.  These instruments act as a form of insurance, placing a floor on the value of these holdings.  You will have to pay a price for them, but the downside protection may be well worth it.
  • Finally, you can also invest in a fixed immediate annuity or longevity insurance – these products can allow you to be more aggressively invested with your remaining portfolio in the later years because this income-oriented insurance products is quite conservative.

 

 

 

 

Posted by

John Bevacqua on October 29, 2011

Filed Under

Investing, Risk & Protection

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We have been raised to believe that stock investments should be held for many years while the more conservative investments should be drawn down to create income. However, if we did this we can quickly figure out that the portfolio will become increasingly risky from one year to the next, which is neither a desirable nor prudent practice for a retiree.


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