Why Stocks, Not Bonds, Assure Less Risk in Retirement

May 20, 2014— -- Sometimes, what everyone thought was right turns out to be flat wrong.

Classic personal finance “wisdom” holds that as you get older, you should have less and less money in stocks and more in bonds to reduce risk of loss from down stock markets as you head into retirement.

But now, two authoritative studies show that this thinking is as wrong as an overcoat in the tropics. It turns out that as you approach retirement, you should have more and more of your total investment portfolio in stocks — as opposed to bonds — because the superior returns they will likely deliver reduce the risk that you will outlive your money during retirement.

A definitive study by Rob Brown, Ph.D., chief investment strategist for United Capital Financial Advisors, demonstrates that if your portfolio is 100 percent in stocks, the chances that you will run out of money during retirement are about half as great as with a portfolio that is 50 percent in stocks and 50 percent in bonds. The study, published in Financial Advisor magazine, found that the faster you withdraw cash from your nest egg to pay expenses during retirement (the withdrawal rate), the more you need to be in stocks.

And a comprehensive study of global stock returns by Morningstar, released this year, found that stocks are actually the safest type of investment. The study looked at 90 years of data from 20 countries.

Unaware of the actual benefits of having more in stocks and less in bonds, individual investors burned by the market meltdown of 2008-09 are now willing to take on what they may mistakenly think is more risk by increasing their retirement investment in stocks to take advantage of the current bull market. Many of these individuals doubtless are deviating from their planned asset allocation by having too large a slice of their total portfolios in stocks. Ironically, they are doing the right thing for the wrong reason.

The reason many of these investors will benefit in the long and the short term is that they’re deviating from decades-old advice that the studies show to be backwards. For decades, asset allocations recommended by the financial services industry have called for a formulaic proportion of assets in stocks — one that decreases significantly as investors go through middle age. It goes like this: Subtract your age from 100, and that number is the percentage of your total portfolio value that you should have in stocks, with the remainder in bonds. If you’re 30, the percentage in stocks should be 70 percent. If you’re 70, it’s 30 percent.

Now that people are living longer, advocates of this formulaic approach recommend subtracting your age from 110 or 120, but this isn’t much better. It still doesn’t result in an allocation to stocks great enough to assure that your nest egg will last through your retirement. Even back in the day when bond yields were good, using this rigid formula was a bad idea because it overlooked market fluctuations. Now that bonds are paying extremely low rates and inflation has begun to creep upward, it makes even less sense.

Many investors have been religiously following this formula under the belief that it reduces risk. Yet, investing more heavily in bonds and less in stocks as you age doesn’t simply pose a risk. Instead, the damage to your ultimate wealth is a certainty. Sure, investment-grade corporate bonds and U.S. Treasuries are virtually certain to return your initial investment and deliver the yield you signed up for. But that’s all you’ll get. When issuing corporations do well, you won’t get a pay raise as stockholders do in the form of increased dividends. Worst of all, the current bond market is paying extremely low rates, and this is expected to continue for years, meaning that inflation will lessen the buying power of your money.

By contrast, stocks have a long history of providing a level of long-term average returns that provides its own cushion against future down markets. The classic advice to reduce stock allocations ignores this. Instead, it illogically fixates on the potential for down stock markets soon before or after people retire to catastrophically reduce resources to rubble — as though all people will spend every dime of their nest eggs in the first few years of retirement. Instead, it’s all about the rate at which you cash in investments over time, known as the withdrawal rate. The superior portfolio returns from having a greater — if not an exclusive — allocation to stocks means not only that retirement nest eggs last longer, but also that retirees can have a higher withdrawal rate.

What about the impact of major market declines like the one in 2008-09? Doesn’t the certainty of occasional similar steep market declines pose a significant risk?

Investors in their 40s and 50s have time for their stock portfolios to recover from big hits. To the extent that investors closer to or in retirement experience a big market hit, they can lessen this damage through rebalancing and buying on the surges that typically follow dips.

Moreover, they can increase their retirement income by maintaining a strong allocation to stocks that pay regular and increasing dividends — primarily, large blue-chip domestic companies. Such companies almost never skip a dividend, and they avoid a decreased dividend payment like the plague because this can damage their share price. Investors can use these stocks to assure a bond-like (yet, so much the better, increasing) income while watching their shares grow in value. This beats the stuffing out of getting a fixed income from bonds while enviously watching shareholders in the same companies enjoy growth. You add this additional risk protection by buying an exchange-traded stock fund like the Vanguard Dividend Appreciation ETF.

It may take you a while to develop a more accurate view of stocks – one that doesn’t see them as being filled with risk – and of bonds, which aren’t the retiree’s friend that most people think they are. But successful investing isn’t about thinking the way most people do. It’s about results.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

Any opinions expressed are solely those of the author and not of ABC News.