Can you save less for retirement by putting more into stocks?

September 17th, 2012 by

Vanguard recently published a report called, “Penny Saved, Penny Earned.”  While the content of Vanguard reports is always interesting, the language is difficult to follow and overly wordy.  

Thankfully, this report was summarized by My Money Blog, in a post titled, “Retirement: Saving More Versus Higher Investment Returns”.
 

To see a list of high yielding CDs go here.

 
 
The conclusions are as follows:

  1. You should start saving as early as possible. (Duh.)
  2. You should put more into savings. (Duh.)
  3. You can cheat on step one or two, if you simply put 80% of your portfolio into stocks. (What?)

They actually don’t say that you should skip steps one or two.  However, their hypothetical analysis suggests that a 25 year old saving 6% of their earnings, with an 80% stock / 20% bond asset allocation, would be financially better-off than a 25 year old saving 9% of their earnings with a 50% stock / 50% bond asset allocation at the age of 65.

You can save 50% less and end-up ahead?  That sounds like magic – sign me up.

 

Hold On A Minute? What’s The Catch!

Well, the projections are based on assumptions about how stocks perform over the long-term.

There is a belief that stocks outperform bonds by several percentage points, when held over long-periods of time.  In other words, the only reason why a rational investor holds bonds is to try and soften the impact of big stock market drops.

The idea of the Vanguard piece is that If you can hold stocks long enough, you will come out ahead with the 80% stock portfolio even if there is a large market drop right before you retire.  The additional gains from allocating a larger percentage of your portfolio to stocks, should be enough over the long term to offset even a large loss.

 

There are a few problems with this thinking

  1. It hasn’t been true for the last 30 years.  Long maturity bonds would have beaten the S&P 500 for the last 30 years.  There are several reasons to believe that bonds outperformance will not continue over the next 10 or 15 years.  However, if the US and/or world economy continues in a prolonged slump, the extra return of a stock heavy portfolio will probably not compensate for the extra volatility.
  2. Its based on a false perception about how and why people save. The basic idea is that this “25 year old” is saving for retirement and will not touch their money before the age of 65.  However, a 25 year old that is wise enough to start saving at an early age, will probably be buying a house in their mid thirties.  According to American Housing Survey, the average age of first time home buyers is 33.  The median price of that house was $150,000.  In other words, this research does not take into account that a good portion of savings will be diverted for a downpayment and to pay down the mortgage.

The Bottom Line

As the projections calculated by Vanguard are based on uninterrupted savings starting at 25 with no withdrawals, I think they have little to do with reality.  If you shortened the savings time by 12 years, short-term market performance has a far greater impact on returns. At Learn Bonds, we believe a portfolio with 60% stock and 40% bonds creates a nice balance between returns and risk.

While I am critical of Vanguard for this specific research piece, I want to compliment them on exploring these fundamental investing topics which most asset management firms don’t touch.

Learn More

Is the 60/40 Rule all investors need to know?
101 Free Resources for Bond Investors
Buying Bonds – A How to Guide
Bond Basics – Interest and Maturity

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