How much of your money should be conservative?
In times like these where interest rates are low, one of the biggest challenges facing investors today is how to keep money safe and still earn a decent rate of return.
Unfortunately, there is no magic solution. The investment world has forever preached the relationship between risk and return. If you want higher returns, you need to take more risk. If you prefer to be more conservative, then don’t expect high returns. Anyone preaching high returns with low risk might flag some caution.
Age rule of thumb
One rule of thumb is to take your age and that should be the percentage of safe guaranteed investments in your portfolio. For example, if you are 60, then the rule of thumb would suggest you have 60% of your portfolio in safe guaranteed investments.
The problem of course is this rule of thumb was developed a long time ago when interest rates were much higher and the financial industry was not as complex. When interest rates are 6% to 8%, it’s much easier to keep a higher percentage of asset in safe guaranteed investments. Many investors today, especially the baby boomers can’t afford to keep 50% to 65% of their assets in safe GICs or bonds producing a mere 3% return.
What is your withdrawal rate?
Instead of using the age rule of thumb, another approach is to look at how much income you might need from your portfolio and multiply that by 5. Here’s an example of how that works. Let’s say you need $50,000 of annual income. Let’s say that pension plus Canada Pension Plan (CPP) plus Old Age Security (OAS) makes up $40,000 per year. That means you need to draw $10,000 per year from your investments like RRSPs. If that’s the case, my suggestion is to keep a minimum of $50,000 ($10,000 times 5) in safe guaranteed investments. The rationale is that no matter what happens to the markets over a 5-year period, there will be enough money to create 5 years of income. Keep in mind that 5 years is simply based on the fact that on average market cycles move in 5 years. That being said, if you are pessimistic or bearish on the markets, you might want to use 7 or 8. If you are more optimistic or bullish, then 3 to 4 might work. Regardless of the number, the idea is to keep some money safe in relationship to your income needs.
Allocation based on need as opposed to age
The two big advantages of safe guaranteed investments like GICs are they provide security and create predictability. When saving for retirement, this is critically important the closer you get to retirement. We’ve heard before that the older you are, the more conservative you need to be but the challenge as I see it is that this is not being practiced. How many times have you seen or heard about people nearing retirement with too much money in the stock market or mutual funds? How many times have you seen people delay retirement because of the stock market or mutual funds? Or worst of all, how many times have you seen people retire only to have to go back to work because of the stock market?
You see, the more money you have in the stock market or mutual funds, the less control and predictability you have over your retirement. Ask yourself the question, how much money do I NEED to have in safe guaranteed investments so that I can live a comfortable life? In the worst case scenario, how much money would I NEED to draw from my investments to prevent me from having to go back to work? I call this understanding risk capacity.
Are lifecycle funds the solution?
Lifecycle funds or target date funds are fairly trendy these days. Basically these funds reduce the amount of exposure to equities and increase the exposure to fixed income the closer you get to a target date. While lifecycle funds may address the need to be more conservative, the closer you get to retirement, I’m not sure they are the end all be all to investing. They are really geared to the person who has no interest, skill or knowledge to manage their retirement savings. My hope is that people care enough to get a little involved.
If you are already retired and drawing income from your investments, you probably know by now that market fluctuations work against you. The old philosophy of buy and hold does not work well when you are creating income from a stock or mutual fund portfolio because the math works against you.
My suggestion is to keep at least 5 years of income in safe guaranteed investments. For example, let’s say you were taking out $1000 per month from your portfolio (or $12,000 per year). My suggestion is to keep $60,000 in something safe and guaranteed.