Yesterday Mel Lindauer, Forbes columnist, book co-author, Boglehead extraordinaire, offered some advice for younger investors. Rocky markets like the one we’ve been bobbing along in are great for the young, Lindauer argued, because investments are essentially “on sale” at the moment.
But the perfect market for someone in their 20s is a tough one for someone in their 60s. The last few years have been extremely tough for those close to retirement. In today’s post, drawn from the same interview with Lindauer, he addresses the challenges older investors face and the downside of a down market.Getting ready for retirement is the subject of one of his two books, The Bogleheads’ Guide To Retirement Planning.
The sharp slides and high volatility of the US stock market have caused many people to reexamine just how comfortable they are with risk. And many of us are not the investing daredevils we thought we were. “When the market’s going up everyone’s brave, they’re bold,” says Lindauer. “A lot of times people overestimate their risk tolerance. Until you have gone through a bear market, it’s hard to know. We’ve had a couple in the recent past and that should help a lot of younger investors understand risk. But it’s hurt a lot of people close to retirement. They were overextended and some lost 40% or 50% of their portfolio. [Risk tolerance] is a personal thing. You can’t apply rules of thumb to that.”
A Challenging Market for Those Close to Retirement
Those who don’t have enough to retire and are gun shy about investment risk are in the toughest spot of all, Lindauer says. “It’s really a problem to have the need to take risk but not the tolerance. [Those people] have to change things. They have to save more or work longer or downsize.”Surprisingly, Lindauer’s more worried about investors in their 50s or 60s taking on too much investment risk these days than too little. With deposit and short term rates so low, he sees people who are naturally conservative reaching for better return.
”You’ve got two things happening,” says Lindauer, “the people who are scared to death are running to cash. Then you have all the other people who were already in conservative investments, but now there’s no income (from those investments). A lot of those people are searching for higher returns and this is when you really run into problems, when people are grasping at straws.”
He is especially nervous about high yield bonds, also known as junk bonds. Lindauer worries that many people look at the higher yields but don’t understand the risk in these bonds and assume they’re not too much riskier than Treasuries or investment-grade bonds. They need to understand that the higher the yield, the riskier the bond is. You might have some defaults.”
Smart Income Investing
Lindauer suggests that investors looking for income match their bond holdings to their cash needs. An intermediate term bond fund usually has a duration of four to six years. If interest rates go up during that time, the fund will lose some of its net asset value, but its holdings will start to yield higher interest rates. If an investor stays the course with that fund – leaving his money in there for the length of the funds “duration”, in 4 to 6 years, he’ll likely be made whole.
“Your time horizon should always be equal to or longer than your bond fund’s duration,” Lindauer says. “As long as you don’t sell, you don’t need to worry about it.” (A fund’s duration is available in its prospectus and marketing materials.)
“You can get burned if you only focus on the yield and not the risk. There’s no free lunch. You can’t find a bank FDIC- insured account that’s paying you 10% interest.”
Investors are Getting Burned
Even high quality bonds have risks. The risk in an all-bond portfolio, Lindauer notes, is that you might not beat inflation. “When people are working they’re normally getting increases in their wages to compensate for inflation. Once you’re retired, though, you no longer have those wage increases to help offset inflation, so you have to protect against that yourself.” Lindauer recommends people use iBonds or TIPS which adjust for inflation in order to insulate their portfolio and protect against inflation eroding the future spending power of their savings. Short term bonds are also less susceptible to inflation because they’re constantly turning over and new issues are being purchased at current higher interest rates. “You can take risk if you want to,” Lindauer says, “but you need to understand and be willing to accept that risk.”
It’s not just junk bonds that have Lindauer worried. He’s also seeing a lot of insurance companies pushing annuities, which are not insured by the FDIC and carry the risk that the insurance company might go under. He’s also seeing high teaser rates on fixed annuities that fall after the first year, often locking the investor in to a bad lower rate for a long term. “Investors are reaching for returns, and this is when people get burned,” Lindauer says. “But it’s hard to fool an educated consumer.”
A note on yesterday’s post:
Mr. Lindauer thought it worth noting that while the model diversified portfolio shows how asset allocation can pay off, it’s unlikely that a young investor would in reality have had a lump sum of $20,000 to invest. It’s more typical that people invest over time, and if they have been doing that over the past few years they’ve had the benefit not just of investing when the market was high, but also when it was low. “The fact is, most investors were contributing on a regular basis to their 401k and 403b plans, thus buying when the market was low. So those investors have done very nicely when the market recovered,” he writes.