Building a Successful Modern Retirement Portfolio
In the good old days, retirees were advised to take their savings and lump-sum payouts and invest everything in "ultra-safe" bonds, CDs, and the occasional blue-chip stock. Over the last few decades, as people began enjoying longer and more active retirements, the conventional wisdom was to increase one’s exposure to stocks to generate higher returns and serve as a hedge against inflation. Not surprisingly, conventional wisdom is wrong. Here’s an alternative approach to generating consistent returns while managing risk.
The basic premise that retirees will need to generate higher returns to support longer lives is absolutely correct. It is also true that stocks tend to outperform fixed income investments and can provide an effective inflationary hedge. The problem, however, is that simply adding stocks to a portfolio creates an overly high concentration of highly correlating assets (i.e., assets that tend to move up or down in the same pattern).
The solution is to benefit from diversification—often called "the free lunch of investing"—by adding a variety of non-correlating assets that can also outperform fixed income, hedge against inflation, and zig when the stock market zags. The asset classes that can help accomplish that goal include international bonds, emerging market bonds, and emerging market equities. But the two most important assets that should each represent at least 5% of every retiree’s portfolio are real estate and commodities.
Like pretty much every other asset class, real estate took a beating in the 2007-2008 meltdown. Nonetheless, it remains a smart choice for capital appreciation and income generation, and its inflation-fighting power is second to none. Rather than direct ownership of investment property, most investors would be better served by the more diversified and liquid approach offered by REIT (real estate investment trust) mutual funds and ETFs.
From a pure performance standpoint, in the 14 years from 1995 through 2008 real estate outperformed U.S. large-cap stocks 8 times and outperformed foreign stocks 10 times. Real estate is also valuable to retirees because of its high dividend stream. By law, U.S. REITs must pay out at least 90% of their taxable income to shareholders. From 1986 to 2008, REIT dividends averaged 7.4% annually.
On top of it all, real estate provides two key inflationary benefits. REITs can offset inflation by charging higher rents and, because REITs represent “real assets,” they tend to increase in value along with inflation.
Like everything other aspect of investing, REITs do have their downside. Unlike corporate dividends, the income generated by REITs is taxable at ordinary income rates rather than the 15% dividend tax rate. In addition, REITs are just as volatile as stocks and experienced a 37% decline in value during 2008. Notwithstanding that volatility, REITs have a very low correlation to U.S. stocks, U.S. bonds, and foreign stocks and are a good diversifying choice for most retirement portfolios.Continued on the next page