You're not a finance professional. You're a new assistant professor. And whether you are already in the position or preparing to start in the fall, one of the important decisions you face is how to invest your retirement savings.
If you've studied investment planning at all, you may have run into the standard line that how your investments do over the long haul depends almost entirely on how your assets are allocated. What is asset allocation? In simplest terms, it's how you invest among the various asset classes available. Although there is no real limit to the number of categories you could create to slice up the investment universe, the most basic are stocks, bonds, and cash. Broadly, each asset class has its own risk and reward characteristics, so you can moderate the risks of any one asset class by owning a mix of classes. Let's run through the options.
Cash, normally invested in money-market funds, is generally described as the safest of investments, because its market value rarely changes. All the investment return from cash comes via regular dividends. (Cash dividends may vary greatly over time.) The greatest attraction of cash is to the part of the psyche that hates to see market values fluctuate, especially downward. But cash is very risky if daily fluctuations aren't your primary concern, because the yield on cash may well lag behind that of inflation, and will almost certainly lag far behind the return on bonds and stocks over the long term.
Bonds encompass a huge range of investments. Even though they are sometimes described as "fixed income" investments, some bonds have fixed terms and fixed income, and some come with variable terms and variable rates. A company can stop paying dividends at any time, but if it stops paying the interest on its bonds it faces bankruptcy. The attraction of most bonds is that they pay most of their return in current, steady income for a preset period of time. The risks of bonds as a class include their tendency to lag in performance behind stocks over the long term and their always-surprising vulnerability to changes in interest rates and inflationary expectations.
Stocks also include an enormous range of investments, but the most typical characteristic is that they provide some income in the form of current dividends and some in appreciation. They are ownership in a small piece of a business. The total return (dividends plus appreciation) on stocks as an asset class over many years has been greater than bonds or cash by a wide margin. Bonds tend to rise in price during periods of declining interest rates, while stocks have tended to perform best during periods of rising expectations for corporate profit. Since they perform differently under certain economic scenarios, a portfolio of both stocks and bonds may be less volatile in price than either stocks or bonds alone, although the long-term expectation would be for a lower total return than an all-stock portfolio.
Now that we've reviewed some basic characteristics of these asset classes, let's consider some history. Over the past 10 years, stocks in the United States have averaged an annual return of 12.6 percent, corporate bonds about 8.7 percent, and U.S. Treasury bills (a proxy for cash) about 4.8 percent. (Depending on how you place your ruler, other 10-year periods have been much less favorable, especially after inflation, but this is not too far from the long-term historical averages.)
How much could asset allocation affect your accumulation over a career? Assume you're just beginning a 40-year career, starting with an annual contribution of $4,500 toward your retirement. If we estimate the performance of bonds at 7 percent annually, and assume inflation of 2.5 percent a year, and expect that your salary and retirement contributions increase at the rate of inflation, a retirement account allocated totally to bonds would grow to $1.3-million in 40 years. If you add enough stock so that the average growth rate is 8 percent instead of 7 percent, the final total rises to $1.6-million. With an annual growth rate of 10 percent -- a conservative estimate for long-term growth of stocks -- the total soars to $2.7-million. On the other hand, if you put everything in cash, at 4.8 percent, you could end your working life with a relatively miserable $700,000.
For every 30-year span between 1925 and 1997, stocks beat bonds. Compared with all you could put away over the next 40 years, any move in the averages in the first few years is relatively minor, anyway. So not only does the historical record urge it, the present stage in your career suggests you have little to lose. If you've got 40 years of working life ahead, why not just put 100 percent in stock and think about other things? Why not go for it?
There are two main reasons to reflect. The first is that history is not a map of the future in investing. There is no guarantee that any relationship or trend will continue to hold just because it held in the past. The second is that within the historical pattern itself there were times when you would almost certainly have bailed out of stocks rather than stay the course. The long stretch from 1970 through about 1982 was characterized by high inflation and down markets, both for stocks and bonds. It took two decades after 1929 for the Dow Jones Industrial Average to go higher than it was before the crash. In recent years, stocks have had some brutal times, losing 30 percent of their value in 1974, and 23 percent in 2000-1. Trustees and money managers often lose their jobs for such performance, so you'd probably conclude that history was a false friend and give up on an all-equity strategy at some time before retiring. It's likely that you would have thrown in the towel at some point in the past 30 years, perhaps selling at just the worst time and not getting back into the market until the recovery was half behind you.
Many mutual-fund companies offer asset-allocation calculators on their Web sites, with fairly simple questionnaires to determine what your risk profile might be. It's OK to trifle with these, provided that you also take the time to do some basic self-education about investments and seek out the guidance of a live, experienced adviser. The asset-allocation calculators are a wonderful example of the kind of spurious precision that statistics can produce. Such work is well-suited for consultants trying to develop methodologies complicated enough to justify their high fees to boards of trustees, but for individuals who are just starting their careers and who have less sophistication in such things, modern portfolio theory has limited value.
What's clear is that the asset-allocation decision is one of the most important choices you will make at any stage of your investing career. Personally I come down on the side of putting 100 percent of your allocation into equities for the first years of your career, and I suggest you use a few market index funds to get there, since they outperform most active managers and get you instant diversification at low cost. Since academic institutions are more stable than the general workplace, and tenure makes things doubly stable, all that potential salary you have coming in over the next 40 years is like owning an enormous bond worth several million dollars. The few thousand you begin to salt away now might as well go into equities.
Even if you accept my advice, things will get more complicated over time. That's why financial advisers often provide the one-size-fits-all type of advice for clients to invest heavily in equities early in their careers and move toward bonds steadily over time. But my point is that you need whatever amount of diversification will help you avoid some of those bad-timing decisions. If that means having 10 percent of your retirement investments in cash and 20 percent in bonds from the beginning, that may provide a better long-term return than trying to aim for an all-equity strategy and then not having the courage to follow it.
Eventually you will reach a point where over half of your lifetime earnings are behind you. That multimillion-dollar "bond" will have shrunk drastically, and you'll have a large, growing equity portfolio. It may then make sense to contribute less to stocks. Finally, at retirement, you may face some widely conflicting choices. If you have just enough to retire on, you'll be forced to adopt a fairly cautious investment allocation. If you've done well and have more than enough to be comfortable, you'll have the choice of deciding whether to allocate defensively, or if you like excitement, to maintain a riskier profile on the basis that you can afford to weather the ups and downs of equities.