If you're nearing or in retirement, holding two to four years' worth of living expenses in cash or short-term bonds is a good rule of thumb.
Stable, short-term securities can provide a cushion in case of market volatility and allow you to invest the rest of retirement portfolio in stocks, as well as intermediate-term and higher-yielding bonds.
The combination can provide you with the best of both worlds: the ability to comfortably weather market gyrations, and the potential for inflation-beating growth and income.
I know a retired client who owns a particular blue-chip stock that has been paying steady dividends for more than 25 years now. She loves it. But the markets have been volatile lately, and the stock is down more than 15% since late July. Why isn’t she more worried about how this may affect her retirement income?
Because she owns bonds. To be exact, she holds enough in cash and short-term bonds to cover two to four years' worth of living expenses, in conjunction with her other sources of income, such as Social Security payments. She's not in a position where she is likely to be forced to sell stocks in a down market just to make ends meet—and you shouldn't be, either.
This two-to-four-year reserve is a core part of our advice for your retirement plan. That cushion can allow you to invest the rest of your retirement portfolio in stocks, as well as intermediate-term and higher-yielding bonds. The combination of the relatively stable short-term reserve and the higher-yielding assets can give you the best of both worlds: stability to help weather market volatility, and the potential for growth to beat inflation and keep income growing.1
Investing during retirement is different
I often hear retirees complain that bonds don't generate high enough returns. They say dividend-paying stocks are a great substitute that can earn them more money.
However, when the market takes a tumble, these retirees often find their retirement plans are far more exposed than they realized. That's because, even though dividend-paying stocks may seem more stable, they're still stocks, not bonds. While they may offer higher potential returns, that potential has a cost. Even a diverse portfolio of stocks, represented by the S&P 500® Dividends Aristocrats Index in the chart below, has been far more volatile than bonds.
Stocks—even blue-chip dividend payers—are more volatile than bonds
Source: Bloomberg, S&P 500 Dividends Aristocrats Index, total return from dividends and change in price, shown on a monthly basis, from 1/1990 to 9/2015.
Past performance is no guarantee of future results.
Bonds, on the other hand, have been a lot more stable. Even as yields remain low and the Federal Reserve is expected to soon raise interest rates for the first time in almost a decade, volatility in bonds has remained subdued. The chart below shows how little bonds tend to move up or down.
Bonds have low volatility
Source: Bloomberg, Barclays U.S. Aggregate Bond Index, total return from interest and change in price, shown on a monthly basis, from 1/1990 to 9/2015.
Why is this important? Modern portfolio theory says that diversification matters. You should have an appropriate allocation across stocks, bonds, and cash—and potentially other asset classes, too—to help ensure that when one type of investment is declining, another has the ability to rise.
But another school of thought, one that's especially relevant when you're at or near retirement, argues that investing is less about diversification by asset class than diversification based on time. Using this framework, you make your asset allocation decisions based on when you expect to need the money.
If you're nearing or in retirement, it's important to make sure a healthy chunk of your portfolio is invested in relatively stable assets that can withstand wild price swings, because when your time horizon is short, behavioral finance research shows that you may be more likely to overreact and sell volatile investments at the wrong time. The idea behind time-based diversification is to structure your portfolio so that it counterbalances this tendency, by providing you with stable assets that can fund your spending while the market fluctuates.
What to do now
If you're in or near retirement take a look at your portfolio and consider having a two- to four-year short-term allocation to cash and short-term bonds or bond funds. Then, shop for stock—dividend payers or not—to round out your longer-term allocation, using the stock screeners at Schwab.
1If you are older and in retirement, inflation and income growth may be less important to you, depending on your situation and legacy goals.
Talk to Us
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.