case for using an aggressive investment portfolio with a high stock allocation
to fund retirement expenses rests on the idea that it will probably work. Stocks are expected to outperform bonds, and if and
when that happens, a retiree will be able to spend more from their asset base
example, in a February 2016 New York
Times column on retiring, David Levine suggested that people treat an
all-stock allocation very seriously, saying, “And, so, what I actually say to
people who ask my advice is this: Put as much money into the stock market as
you can stand. One hundred percent is best, but even if you are very
risk-averse, allocate at least 75 percent to stocks.”
Exhibit 2.1 shows similar details as a previous example (Exhibit 1.1 Summary Statistics for US Financial Market Annual Returns and Inflation, 1926–2018) about returns and volatilities for historical US data. But it also highlights more about the differences in returns as one moves up the exhibit to better highlight the idea of a risk premium. These are the historical excess returns that more volatile asset classes provided. Starting from the bottom, historical inflation averaged 3 percent. Short-term Treasury bills provided a historical average return of 3.4 percent, which is 0.4 percent higher than inflation. That represents the short-term real rate of return.
investing in intermediate-term government bonds, historically one could earn an
average 5.2 percent return, which is 1.8 percent more than Treasury bills and
2.2 percent more than inflation. Long-term US government bonds offered another
0.7 percent higher historical return, and long-term corporate bonds offered an
additional 0.4 percent on top of the government bonds for a 6.3 percent total
return. Moving into stocks, large-capitalization stocks averaged 11.9 percent
returns. This was 5.6 percent more than long-term corporate bonds, 6 percent
more than long-term Treasury bonds, and 6.7 percent more than intermediate-term
treasuries. These are the types of numbers that are often identified as the risk
premium, or the expected additional return of stocks over bonds, at least as
based on the historical data. As expected, that risk premium is even higher
with small-capitalization stocks, which averaged an additional 4.3 percent more
than large-capitalization stocks, or, for instance, 11 percent more than
intermediate-term government bonds. These risk premia have been identified in
terms of their arithmetic averages.
is also the case that the compounded equity premium would be less than its
arithmetic value. For instance, though not shown in the exhibit,
large-capitalization stocks outperformed long-term government bonds by 4.5 percent
in terms of compounded growth, as compared to the 6 percent difference in
Exhibit 2.1 The Components of US Financial Market Annual Returns, Stocks, Bonds, Bills, and Inflation Data, 1926–2018
Source: Own calculations from SBBI Yearbook data provided
by Morningstar and Ibbotson Associates.
types of comparisons can be made between any of the asset classes in the
exhibit, and what these comparisons make clear is that over the entire
historical period, stocks have outperformed bonds by a dramatic degree. Those
seeking to grow assets in retirement by investing in stocks are relying on
these historical relationships to continue in the future.
Advocates for using aggressive investment portfolios as the primary way
to fund a retirement plan often will allude to the concept of “stocks for the
long run.” There is a degree of comfort that an aggressive portfolio will
provide sufficient returns in time to maintain retirement sustainability.
According to advocates, the long-run growth potential for stocks can be expected to materialize so
that the aggressive portfolio can support a higher spending level than bonds
To better understand this probability-based
point of view, Exhibit 2.2 plots the historical worst-case annualized nominal
returns for large-capitalization US stocks and intermediate-term US government
bonds since 1926.
Over shorter holding periods, bonds were less
exposed to downside risks. Over one year, for instance, the worst case for
bonds was a 5.1 percent drop, while stocks fell by 43.3 percent in their worst
year. Over any historical three-year period, bonds provided a positive
annualized return. It took fifteen years before stocks historically were always
able to provide a positive return. But for holding periods of at least
seventeen years, the historical worst-case annualized performance for stocks
exceeds that for bonds. Over twenty-year periods, for instance, stocks
experienced a worst-case 3.1 percent annualized return, compared to 1.6 percent
for bonds. For thirty-year periods, the worst case for stocks was 8.5 percent,
compared to 2.2 percent for bonds. And for forty-year periods, stocks’ worst
performance was an 8.9 percent annualized return, compared to 2.8 percent as
the worst for bonds. For historical forty-year periods, even the best case for
bonds (8.1 percent) could not beat the worst case for stocks.
Because probability-based advocates have
confidence that the historical record provides precedence for what can be
expected in the future, this is the basic logic for understanding the view that
stocks should be the primary asset to support retirement expenses.
Exhibit 2.2 Worst-Case Annualized Nominal Returns for Different Holding Periods S&P 500 and Intermediate-Term Government Bonds, 1926–2018
calculations from SBBI Yearbook data provided by Morningstar and Ibbotson
As well, Bill
Bengen’s work that led to the 4 percent rule-of-thumb for retirement spending
is also a historical exploration which shows that higher stock allocations have
tended to support more spending with little in the way of additional downside
risk. Though not framed this way, Bill Bengen’s research is a type of efficient
frontier analysis that includes a spending constraint seeking to maximize the
amount that could be spent in the worst-case thirty-year period from the
historical data. He found that the highest worst-case spending level could be
found for any stock allocation between 35 and 80 percent, and he argued that
retirees should attempt to stick with stock allocations in the higher end of
the range because this would support additional upside when not in a worst-case
For historical data, I have confirmed this point in international data as well, showing in my book How Much Can I Spend in Retirement? that across the twenty countries in the Global Returns dataset, the highest worst-case spending rate occurred with at least 50 percent stocks in eighteen of the twenty countries. Only in Sweden and Switzerland did the peak worst-case spending level occur with a lower stock allocation.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.
Originally posted at https://retirementresearcher.com/the-case-for-stocks/