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Last week, Michel, a regular reader and commenter, asked in my post about Volatility Vs Risk, how to manage his portfolio at retirement. As a financial planner myself (note; this post is no different than others, I’m not giving financial advice on this blog), I see this situation almost on a weekly basis: Retired or about to retire couples with a considerable nest egg that want to know what to do with it. They are curious about the effects of withdrawals on their portfolio vs market fluctuations. Sometimes, they can’t sleep at night because they are worried about the volatility of their portfolio.
So this got me thinking: Why do we take volatility in our portfolio?
You probably noted that I just used the word “volatility” instead of “risk” as my title suggested. The point is that you will incur “volatility” in your portfolio if you invest in the stock markets (through stocks, ETFs or mutual funds). However, if you are well diversified, you won’t have much “risk”. So why do we have to suffer from volatility in our portfolio?
Truth: we have to take volatility in our portfolio because we don’t save enough
To prove my point, I invite you to read how to build a 6 figure dividend payout portfolio. You’ll notice in this post that it is feasible to earn over $100,000 in dividends annually from your investments. But you have to start very young and save a lot of money. Because when we are young, we are more interested in starting a family, buying a house, car, traveling and all these things, chances are that you won’t be able to build such a portfolio.
The math gets even worse when you have to calculate your portfolio growth at 3% (what a long term bond or certificate of deposit would yield at the moment). The math is more interesting if you make projections with a 5-6% yield. But in order to get there, you’ll need to invest in stocks in one way or another. This actually implies at least 50% of your portfolio invested in the stock market.
But is it the same story when you are about to retire? Do you still need to invest in the stock market?
Truth: It is more profitable for any advisor, broker, financial institution to have clients invested in “managed products” (read mutual funds or ETFs) than in bonds and CDs
Why? Let’s be honest for a second: Bonds and CDs don’t pay much commission to the seller and they don’t pay much interest to the investor, either. Therefore, for those who only want to invest in bonds and CDs, the only thing that matters is the rate (in most cases) and this leads to an “interest rate war”. So most advisors will be tempted to offer you a managed solution where they are better paid, avoid any “price war” and you get to invest in the market at the same time.
But there are honest people out there as well ;-). Financial advisors are not all crooks, believe me. There are investment solutions with less volatility that will both succeed in providing security and a bit of growth to the investor.
So how do you invest without taking much volatility?
Truth: Volatility is controlled via your asset allocation (yup, it’s that simple!)
If we go back to Michel’s situation; he has a good pension plan, no debt, he’s 60 and has money to invest. Does he have to take on volatility? Absolutely not. But the real question is
“Is he willing to leave growth on the table for the sake of less fluctuations?”
If the answer is yes, then he should not invest more than 25 to 30% of his portfolio in stocks. Technically, he could invest 100% of his money in bonds as he really doesn’t need much yield. But this would incur other problems:
– Lack of liquidity (if he creates in a bond ladder for example)
– Highly dependent on interest rates (and he will still see the value of his portfolio decrease upon interest rate increases)
– Investments being eroded by inflation (considering the low interest environment combined with taxation in some investment accounts, investing in bonds right now puts your capital at stake)
– Being bored. Let’s be honest, it is VERY boring to manage a 5 year bond ladder 😉 hahaha!
This is why a bit of stocks in his portfolio wouldn’t hurt.
A quick example on how to invest 100K with almost no volatility but still providing moderate growth
So I want to leave you with a scenario where you invest 30% of your portfolio in dividend stocks and another 70% in a bond ladder (including Govt bonds, CDs and maybe one corporate bond).
You can easily be able to build a 30K portfolio giving you a 3% dividend yield (especially right now!) and you should manage your to earn about the same thing in interest from your bond ladder (depending on the moment you invest, you may make slightly under 3% right now but this will change over time).
So you would be making $3,000 in dividend/interest per year. Let’s take a look at the worst case scenario that could happen in a span of 12 months: a drop of 20% of the value of your stocks.
So you start the year at $100,000.
You Lose money from your stock portion ($30,000 * 20%): – $6,000
You still make your $3,000 in dividends/interest: + $3,000
Your portfolio value at the end of the year: $97,000
So if you don’t need the money right away, you can reinvest your $3,000 in your stock portion and you would barely feel a 20% bear market… how cool is that?
But how can you pick up stocks that will survive market turmoil?
If you are about to retire, it’s not the time to invest in the next Apple or Google. You need to find proven stocks with solid balance sheets, financial track records and (obviously) a great dividend payout history as well.
Here are a few suggestions where you can start your research:
– Download my free Dividend Investing eBook to learn which ratios to look at for before buying a stock
– Look at the Dividend Growth Index (there are some solid stocks out there)
– Look at the Best Canadian Dividend Stocks (this list has been made with very strict criteria)
Michel, and the others, if you have any other questions, please let me know!