Here’s the first part of a three-part post to answer the nitty-gritty details of the following question:
If you’re receiving a military pension, then how should you invest the rest of your portfolio?
Frankly, to the majority of you readers, this will be a boring technical essay. The big picture of this week’s posts is that emotions will influence our investing no matter how logical we attempt to be, and a military pension lets us feel a lot better about stock-market volatility.
But if you plan to invest your savings in more than just Vanguard’s total stock market & total bond market index funds, then here we go:
There are two aspects to every financial decision– the logical and the emotional. Both aspects are equally important, and investors who make their decisions from just one aspect will find it very difficult to stick with their commitments. Investor psychology research into “loss aversion“ has shown that losing money causes far more pain than gaining it. Even if an asset-allocation plan is chosen with the most rigorous criteria and extensive analysis, the inevitable high volatility or unexpected losses will cause far more pain than the benefit of any gains. That emotion can overcome rational thinking. Investors eventually decide that the most logical and well-researched asset-allocation plan is useless if they’re not also emotionally comfortable with the results. When the markets do badly, even for a short period, distress can cause investors to sell out (and lock in their losses) at the worst possible time. This path to retirement is long and painful.
One distress-free option would be to invest in assets that have no volatility and never lose money. Treasuries, TIPS, and I bonds all attempt to offer this solution. One drawback is that these “risk-free” investments pay a very low rate of return (sometimes no return at all) and Treasuries can actually lose value to inflation. Their low yield means that it also takes longer to save enough to support even a frugal lifestyle. When this type of a portfolio is big enough to for its returns to support retirement, it will only keep up with the Consumer Price Index (CPI). If a retiree’s rise in personal spending exceeds the CPI then they risk outliving their assets as their personal inflation erodes their value.
A high-stress option would be to embrace volatility. Many investors spend months researching the mathematics and histories of asset allocations. They become experts on the correlated performance among different classes of stocks, bonds, real estate, commodities, and cash. The idea is that when one asset class is performing poorly, another asset class will be rising at least as quickly to offset the overall portfolio. Nobel-winning researchers have been able to “prove” that a diversified portfolio built from uncorrelated asset classes is actually less volatile than the individual assets in that portfolio.
Regrettably, the diversification “proof” only works most of the time– not all the time. As the recession of 2008-09 showed, the markets are still not efficient. Low-correlated asset classes can still drop together for days or even weeks before investors stop their panicked selling and are tempted to buy. “Portfolio insurance” methods can reduce the impact of these rare episodes, but their expense reduces the portfolio’s overall return. Spending hundreds or even thousands of dollars a year on hedging (for stock options that expire worthless) seems like wasted money during a hot bull market.
Another option, dividend investing, is a variation on a diversified portfolio of volatile assets. Investors own shares of diversified yet high-yielding stocks. They plan to receive enough dividends to live off the portfolio’s yield without ever selling any shares. This plan works well in a bull market because companies generally strive to please their shareholders by raising dividends even when their shares are growing in value. In bear markets, a company will avoid cutting its dividend when possible to keep shareholder faith (and its share price). Long-term investors can look forward to years of dividends that hopefully meet or exceed inflation while never having to worry about volatility or selling shares in a bear market.
A minor drawback to dividend stocks is that their share price tends to grow more slowly than the rest of the market because their yield is a larger part of their total return. Another issue is that it takes a larger portfolio of dividend stocks to support retirement expenses. Instead of spending principal, a dividend portfolio can only support a withdrawal rate of its total dividends– usually 2-3.5%. The portfolio never runs out of money since principal is never consumed, but it takes longer to save enough to support retirement.
Unfortunately the last recession also showed that companies will cut their dividends to avoid bankruptcy. The stocks of banks and investment firms were hit particularly hard, with some even cutting their dividends to a token penny a share. Dividend-paying stocks are an important part of a diversified portfolio, but dividend stocks should not be the only asset of a portfolio.
A final option would be to sidestep volatility and render it irrelevant. It requires having enough in cash (money markets and CDs) to support living expenses during a bear market. Retirees live off their pension and their cash while they wait for the bear market to end and their assets to recover. A two-year cash buffer (as much as 10% of a portfolio) works well for all but the longest bear markets. Although investors can ignore downward volatility for months or even years while they’re spending the cash, the emotional impact can still be severe enough to make them question the wisdom of this asset allocation.
Most investors choose a middle ground among the various investing options. They invest in assets paying dividends as well as those whose returns are expected to beat inflation. Diversified portfolios assume risk with volatile assets, but the assets are split among several classes to (hopefully) reduce overall volatility. Part of the portfolio is also kept in cash to support living expenses during bear markets. The asset allocation allows investors (and their spouses!) to enjoy a good night’s sleep.
Even with this accumulated wisdom, investors are still trying to put stock-market meltdowns in perspective. It’s painful to watch equity portfolios go into free fall and temporarily lose 50% of their value, even if diversification minimizes the paper losses. It’s a great opportunity to rebalance by buying more shares at a discount. The portfolio’s cash allocation provides the spending money to ride out a bear market while waiting for the rest of the assets to recover. But the emotional depths of a bear market can still make even the most dedicated investors question their logic and their discipline.
Next post: “human capital” and the asset-allocation value of a military pension.
“Present value” estimate of a military pension
Saving base pay and promotion raises
Military pension inflation protection
Tailor your investments to your military pay and your pension
Where to put your savings while you’re in the military
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