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How a Young Investor Should Invest Retirement Funds Today

I recently had lunch with a former co-worker who asked me straight up how I thought she should be investing for retirement in the current investment environment. She is only in her early 30s but has been saving diligently for retirement and seems genuinely concerned about the current economic climate. So, I thought I would write a post on the investment approach I would take today if I were in my 30s. This will also allow me to re-emphasize some important points I have discussed in previous posts.

My former co-worker has much reason to be concerned about today’s economic climate. Equity markets are moving sharply up and down, housing prices continue to fall, endless government budget deficits, fixed income assets pay near zero interest, and inflation is starting to rear its ugly head. There are entire countries in Europe that are bankrupt and being propped up by central banks. Indeed, there is much to be concerned about in today’s economic climate.

Unless you have been hibernating under a rock for the last 3 or 4 years, you know by now, this is not your father’s economy. The 1980s and the 1990s, I think, will prove to be the “golden age” of investing in America. Those of us who are now in our 50s and 60s were very fortunate to have been able to invest in that period while we were young. The United States dominated the world in almost every economic area. Interest rates were in the teens in the early 1980s, but trended down for 25 years. Inflation was very low for most of this period; real estate prices generally rose and unemployment was low. I do not want to say that the golden age of investing that America experienced in the 1980s and 1990s is gone forever, but, I think, it is not likely to return in the lifetime of anyone currently 30 years.

From about 1982 to 1999 the average annual return of the S&P 500 Index was over 19%. When you have 19% annual returns on your equity investments and inflation is averaging about 3%, with every dollar you save, you are gaining much more than that dollar in purchasing power. Of course we now know that much of this incredible growth was due to the slow increase in the availability of all types of credit. The beginning of the end of this debt super cycle began with the sub-prime mortgage crisis in 2007-2008 which is still being dealt with.

The unwinding of the debt super cycle will take much longer than many people realize, perhaps as long as another decade. This is why, in my opinion, investing over the next decade will be much different than in the past. The debt overhang currently being experienced by consumers, banks, and all levels of government in the western countries will cause their economies to experience much slower than historical economic growth. As a result I can see the next decade having average equity returns closer to 6%-7%. And, although inflation will be muted during the early stages of the debt unwinding phase, I believe all the monetary stimulus currently being injected into the western economies will eventually cause higher than normal inflation. This means that, over the next decade, average “real returns” will be much lower, and in some years negative, than the average returns of past decades.

But lower equity returns is not the only retirement area where things will be different for people currently in their 30s. The federal government provides retirement benefits for most Americans in the form of social security and Medicare. These programs are going to change in the future. So today’s younger people who are decades from retirement need to allow for the inevitable changes coming to these federal programs.

What all this means for people in their 30s, just starting their retirement investing plan, is they must save more money out of each paycheck than their parents did to maintain their standard of living in retirement. In this earlier post I provide a guide as to what percent of your current earnings you should be saving today based on what you have saved to date and your current age. If you have not started saving for retirement, and need some motivation about getting your savings plan started, this previous post will illustrate how costly it is to wait. So my first advice to younger people today, if they want to ensure a secure retirement, is to stay employed, live modestly, and save as much money as you can as early as you can, and be consistent in your savings during your entire working life.

Back to my friend’s specific question: how she should invest her retirement assets in the current economic environment? I cannot give specific advice about how someone else should invest their money. I can only say what I would do if I were in their situation today.

Before investing another penny in a retirement account, I would first do the obvious things any young family should do:

• Obtain the proper amount of life insurance,
• Set aside at least 3 to 6 months of living expenses in an emergency savings account.

After these things have been done, I would read Post #11, Post #12, and Post #13 and spend some time thinking about what equity allocation I feel comfortable with. Being a very conservative investor, I would use the simple formula outlined in Post #13 to guide my equity allocation. This simple formula is:

Your Equity Allocation = 100 Minus Your Age.

So if my wife and I were currently 35 years old, my total equity allocation would be about 65% of our retirement assets. All retirement assets should be included whether employer 401(k)s, former employer 401(k)s, Individual Retirement Accounts (IRAs), and any taxable accounts dedicated for retirement. Within this 65% allocation, I would allocate a large share of this amount to global large-cap stocks. When it comes to large cap stocks, it is no longer necessary to differentiate between US, Canadian, Australian, UK, or European large cap stocks because global markets have made them highly correlated. I would allocate a small part of this 65% to US mid-cap or small-cap stocks and another small part to emerging market stocks. I would also allocate, as part of the equity allocation, a significant percentage to precious metals (i.e., gold and silver).

Below is an example portfolio using passively managed Exchange Traded Funds (ETFs) from the low cost Vanguard family of funds. However, any similar funds from another fund family will do. I would break down my 65% equity allocation as follows:

• 40% in a large-cap stock index; I would favor dividend paying companies such as contained in Vanguard’s ETF VIG, or if you prefer a broader large-cap fund you could choose Vanguard’s ETF VV.
• 7.5% in US mid-cap or small-cap stocks fund(s); a good choice for mid-cap would be VO or VB if you prefer a small-cap fund. Another option is you could select a fund that combines both mid-cap and small-cap stocks in one fund such as an “Extended Market” fund like Vanguard’s ETF VXF. This fund provides a convenient way to model the performance of regularly traded U.S. stocks except those in the S&P 500 Index.
• 7.5% in an emerging market fund such as Vanguard’s emerging market fund VWO; this fund does not include any Middle East or African companies, only companies from Russia, Asia and South America.
• 10% in a precious metal fund such as CEF which is a Canadian-run fund that holds both gold and silver bullion; alternately, you could buy gold and silver bullion separately using the ETFs GLD and SLV operated by State Street Global Advisors.

The reason I chose a large allocation to large-cap dividend-paying stocks is because we could have a lot of market volatility over the next few years with market indexes moving sideways and ending up right where they are today. This is what has happened to US equity indexes in the last decade. Dividend stocks assure you of some return in this environment. Additionally, if we continue to experience difficult credit markets, large established companies have more cash on hand and cash flow available and are not as dependent on the credit markets.

Historically, US small-cap stocks have higher average annual returns than large-cap stocks. I am not confident that this will continue in the future. The reason for the smaller allocation to US small-cap and mid-cap companies is the debt crisis has been especially hard for these companies because they are still growing and are more dependent on borrowing which has been difficult. Also I cannot help but think, with the US’s current monetary and fiscal policy, that we headed for some kind of dollar crisis. If this happens, many US small-cap stocks who only serve the US domestic market will be crushed. Conversely, today most US large-cap companies have significant overseas operations which will help them survive any dollar crisis. There is no doubt we are in a new world where only the strong will survive. However, you never know what is going to happen, so a small allocation should be made to US small-cap and mid-cap companies.

Many people may think that a 7.5% allocation to emerging market stocks is too small as the emerging markets will be the big growth area of the future. This is true but, despite what you may hear, the emerging markets are still mostly export economies that have not “de-coupled” from the developed markets. I believe this will be true for some time. This means that emerging market companies are still largely dependent on the health of the developed economies. You can choose to increase your allocation to emerging market stocks if you prefer a bumpier ride in return for possible higher returns.

If you do not already have a small allocation to precious metals, I think you should consider it. If you want to know why I would own precious metals, you can read my thoughts in this post on gold ownership. You should accumulate precious metal shares by dollar cost averaging over several months as metal prices can change significantly in a short period of time. Most employer 401(k) plans do not offer precious metal funds. You will have to purchase these funds in your IRA account. Another piece of advice is, when you change jobs, do not roll over your former employer’s 401(k) assets to your new employer’s 401(k). 401(k) plans are high cost vehicles. Roll over all previous employer 401(k) funds into your IRA. If you do not have an IRA, I would recommend opening an account with Vanguard as their funds have the lowest costs.

As for your 35% allocation to fixed income assets many financial advisors tell you to have an allocation to corporate bonds, treasury bonds, municipal bonds of short, intermediate, and long term duration. Frankly, in this low interest rate environment, I don’t think you really benefit from buying intermediate term or long term bond funds where you have no control over the maturity date. Long dated bonds will experience a big drop in price if (or rather when) we leave our current low interest rate environment. I think the yield on longer term bonds is just not worth the risk at this point. For now, I would just keep all my fixed income assets in a “stable value” fund, a money market, or a “short term” bond fund.

The most important portfolio management task you should do is to periodically “re-balance” your portfolio. In this low return environment your fixed income allocation’s main role in your portfolio is to provide stability and enable re-balancing. If the market goes sideways for another decade, re-balancing will provide some return in addition to interest and dividend income. Re-balancing is very important. If you are not familiar with the concept of re-balancing you should read this post.

The above general portfolio guidelines is what I would do if I were 35 years old today. In fact, the above portfolio is very similar to my current portfolio, I just have a lower equity allocation. It is not very exciting, but retirement investing should not be exciting, only enriching.

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