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Retirement Roll of the Dice: How to Make Portfolio Decisions In Today’s Market


  • Stock have historically outperformed bonds in the long term but valuations have never been so high as today.
  • The only time in history that the S&P 500 had a higher valuation and the economy was in the growth part of a cycle was in 2000.
  • Analysts and pension funds usually buy high and sell low.

Introduction

One of the most discussed financial topics is the best ratio between stocks and bonds or other investments a person should have in order to retire at a certain age with enough funds to last through a long and cozy retirement. As there are many topics related to retirement this article is going to focus on the relation between stocks and retirement.

Historical Long-Term Performance of Stocks

Stocks are considered the best long term investment as they have historically outperformed all other assets. Since 1871, the most reliable stock market data available shows stocks have outperformed bonds 99.3% of the time in a 30-year period, 78.2% in a 10-year period and 61.3% in a period of a year.

1 figure stock outperformance
Figure 1: Percentage of times that stocks outperformed bonds and bills over various holding periods. Source: Jeremy J. Siegel – Stocks for the Long Run.

This brings us to the first factor influencing one’s retirement exposure to stocks, age.

Bonds have much lower volatility in relation to stocks and are therefore more suitable for investors with a shorter than 30-year investment horizon. This can be clearly understood by looking at the chart representing US and international stock returns versus bond returns since the beginning of this century.

2 figure stock vs bods 21 century
Figure 2: Total returns this century – Stocks vs. bonds. Source: Wall Street Journal.

An investment at the beginning of the century in stocks would have provided lower returns than bonds due to the overvaluation stocks had at the peak of the dotcom bubble (the S&P 500 peaked at 1,527.46 points on March 20, 2000). As long term stock returns are correlated to underlying earnings, a look at the PE ratio for stocks will give good indications of whether to go long stocks or to stick to bonds for a while.

3 figure PE ratio sandp 500
Figure 3: S&P 500 PE ratio from 1880. Source: Multipl.

The S&P 500 current PE ratio is 23.67 which is 61.7% higher than the historical median. Such a high current PE ratio makes historical data unreliable as through history, from where the conclusion that stocks always outperform bonds in the long term was extrapolated, the PE ratio was much lower. It was higher than the current one only in a few occasions: in 1895 at 25 in a depressed economy and deflation, in 1992 at 25.93 with peak unemployment at 7.8%, in the tech bubble peak period above 30 and bust period above 40, and in the midst of the great recession at 70 due to low corporate earnings. This means that the only time in history the S&P 500 had a higher PE ratio than it currently does—that was not related to difficult economic times—was in the year 2000 due to the tech bubble which resulted in bonds outperforming stocks with much less risk (volatility) as can be seen in figure 2.

What To Do Now? 

It is impossible to give a straight answer to this question as it mostly relates to one’s personal risk appetite. Figure 2 shows not only that bonds outperformed in the last 15 years but also shows how bonds are far less volatile than stocks. In the last 15 years the S&P 500 index fell more than 45% twice in very short periods of time (from 2000 to 2002 and from 2007 to 2009).

4 figure s&P 500
Figure 4: S&P 500 in last 15 years. Source: Yahoo Finance.

The question is not really what to do, but whether you can sleep well and invest in stocks for the long term even with the above mentioned volatility and risks. If you are close to retirement and the last bull market has created a nice retirement nest for you, it might not be the time to be greedy and want more as, according to history, you might need to wait for about 30 years to outperform bonds.

At this point, while the S&P 500 is still relatively high it is a good time to sit down and assess one’s individual future financial needs and relate them to the risk and reward the stock market offers at this point. We already mentioned the risks while the rewards are related to corporate earnings that have been falling since 2014 and give a current yield from stocks of 4.22% derived from the PE ratio of 23.67. The current 10-year US government yield is 1.83%, which is much lower than stocks but also much less risky at this point.

What Do Analysts Say and Do?

More often than not, investment decisions are left to financial advisors as non-specialists often find it better to let others invest their funds. But do not think that it is always the best option. A simple example of how professionals often get it wrong is the fact that in 2007 corporate pension funds had 69% of their assets in stocks and lowered that to 45% in the 2009 crisis. Advisers that use TD Ameritrade had 26% of assets in bonds in 2007 and 51% of assets in bonds in 2009.

Do not be fooled by someone who does not see the complete picture and just follows the crowd because it often results in buying high and selling low.

Conclusion

The best way to make retirement decisions is to base them on facts. The facts are that stocks currently yield 4.22% with declining earnings and there is always the risk of a 50% decline. Short term bonds yield far less but the volatility is also lower which enables a steady source of investment potential as the imminent interest rate increases arrive and bond yields also increase.

With the S&P 500 at historical highs and extreme historical valuations the good old thesis that stocks always outperform bonds might be in jeopardy. Look at your goals, the risks you can handle and make investment decisions that allow you to sleep well.

 

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