I've earned a 16% annual return the last seven years by investing my entire 401(k) in stocks. Any reason I shouldn't just keep my retirement savings in equities? --Ron R.
I have no problem with you staying in stocks. The question is, how much of your retirement stash should you keep in stocks?
Given the annual return you say you've earned, I can understand why a pedal-to-the-metal all-stocks approach might seem appealing. After all, if you continue to earn that return year in and year out, you would double your money every five years or so, allowing you to build a nice nest egg while devoting less of your income to saving.
But is such outsize performance likely? Your impressive gains came largely during a period when the stock market was rebounding from the carnage of the 2008 financial crisis. For example, from its trough in early 2009 to late May, the Standard & Poor's 500 index more than tripled. But there are two reasons I think it's dangerous to base your investing strategy on that spectacular rise.
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The first is that those sorts of gains are unsustainable. While there have been multi-year stretches when stocks have generated comparable-or-better returns in the past the long-term annual average return for stocks is much lower, about 10% annualized from 1926 through the end of 2014. And given today's low yields, many economists and investment pros believe even that average is far more than what investors will likely earn in stocks going forward. In his recent long-term investment forecast, for example, investment adviser and ETF guru Rick Ferri estimates that large-company stocks will return about 7% or so a year, assuming 2% inflation.
The second reason I think it's unwise to invest your 401(k) stash on the basis of recent spectacular returns is that you may be operating with a false sense of the risks you're taking with an all-stocks portfolio. Investment pros are divided when it comes to individual investors' appetite for risk. Some say investors are willing to take on more risk during bull markets, which might suggest its okay to hold more stocks when the market is rising. But others say that, aside from becoming less risk tolerant when we're older, our appetite for risk remains largely the same in up and down markets. Adherents to this view say that people aren't more willing to load up on stocks during market surges because their risk tolerance is higher. Rather, investors simply underestimate the risks they're taking when the market's on a roll.
I think the second camp probably gets closer to the truth, but for the purposes of creating a suitable investment strategy it almost doesn't matter. What you want to avoid is freaking out when this market hits a wall, which, even though we can't predict when, it inevitably will. Or, to put it another way, it would be a huge mistake to stay 100% in stocks on the theory that "you can handle it" only to find that the reality of owning an all-equity portfolio during a market meltdown like the 50%-plus downturn from late 2007 to early 2009 is more financially and emotionally unsettling than it seemed when stock prices were at or near a peak.
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So how should you invest your 401(k) to take advantage of stocks' long-term growth potential and blockbuster gains during big market upswings without leaving yourself too vulnerable to the market's periodic meltdowns?
Start by getting a handle on your true appetite for risk. You can do that by going to Vanguard's online Investor Questionnaire. This tool will recommend a mix of stocks and bonds, and show you how that mix as well as others have performed in markets good and bad.
You can then go to a good retirement income calculator to see whether that blend of stocks and bonds makes sense given what you're trying to achieve, whether it's building an adequate nest egg for a retirement that's decades away or, if you're retired or nearing retirement, making sure your nest egg will be able to sustain you for the remainder of your days. Generally, you want to see a success rate of 80% or so. If the calculator puts your chances of success lower than that, you may need to fine-tune your stocks-bonds mix, although you don't want to get too aggressive or conservative.
Better tweaks are saving more if you're still accumulating savings, spending less if you're in the drawdown phase and focusing on low-cost index funds and ETFs whatever stage of retirement planning you're in. And don't forget to periodically rebalance so the market's ups and downs don't throw your portfolio's proportions too far out of whack.
In short, don't just look at what the market has done lately when deciding how to invest your 401(k) stash, or any other money for that matter. You also need to think about what might happen tomorrow, and realize that when things get ugly (and they definitely will at some point) a 100% stocks portfolio will lose a lot of its charm.
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