Christine Benz, the author of Morningstar’s 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and senior columnist for Morningstar returns to talk withDoug about how investors can use the “bucket strategy” to manage their fear of risk.
She shares how investors can manage risk in this “war on savers” market. In today’s current market, risk is becoming more of a necessity. Christine explains how to balance the old methods of retirement planning with being more open to risk and how to make dividends work for you.
Getting married? Consider Doug’s advice about merging your finances.
When people get married, there are financial discussion to be had, aside from how the wedding will be paid for. Doug has 6 steps a couple should follow before they get married and combine their finances. He discusses how well you should know your partner’s spending habits, and why a good money manager is worth the investment. Make sure to share these points with any young couple you know.
You can find Christine Benz on Morningstar.com and check out her book Morningstar’s 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances too!
Listen to Doug and Christine’s first discussion here.
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What should a retiree’s investment portfolio look like? Should it consist of dividends alone? And how should retirees deal with the fact that bond yields and interest rates have gone so far down?
Douglas Goldstein: I'm very excited to be talking once again with Christine Benz. She was recently on the show and spoke to us about ETFs, mutual funds, and index funds. You can find a lot of her work at Morningstar.
She's also the author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.
Let’s move beyond that last interview, and discover what people who want to build wealth should be doing.
Christine, one of the things that a lot of people say is that in the stock market, it's not just about buying stocks that grow in value. It's also about collecting dividends over time. Is this true or is this a myth?
Should You Build Your Portfolio With Dividends?
Christine Benz: When you look at market history, dividends are certainly a really big component of market returns, and estimates vary about how much dividends have contributed to market returns. But it's high.
It's as much as half of the market's long-term total return. Investors should squarely have dividends in their sights when they think about building their portfolios.
Whether that should be their focus to the exclusion of all else, I don't really think so. But I think dividends are a big component of what investors should be looking for, when they're building equity portfolios.
Douglas Goldstein: What about when you are in a low interest rate environment? How does that affect what's going on with dividends of stocks and should people be worried about them?
Christine Benz: That has created a problem for people who wanted to subsist off of whatever income that their portfolios kicked off.
So, whether it’s interest income from bonds or dividend income from stocks, the fact that interest rates have gone down so low has created a problem, especially for bond investors or investors who are trying to eke out a living with cash investments.
It's sent every bond investor out on the risk spectrum.
My thoughts on dealing with a low interest environment is to take a step back and just think about building a portfolio with the best combination of risk and return characteristics, given the investor’s time horizon.
If an investor is retired and actively drawing upon that portfolio, let's not get too hung up on whether we pull the cash flow from that portfolio: from bond income, or from dividend income, or from periodically scaling back appreciated parts of that portfolio.
Let's not worry too much about the specifics of where we go for the income. Rather, let's build a portfolio with the best risk-return characteristics that we can identify.
Douglas Goldstein: How do you explain that to a client? In my day job as a financial advisor, I talk to people about long-term financial plans and help them to develop investment portfolios. I try to do exactly what you're saying.
The problem is, they'll often quote their grandmother who said, "Earn enough money, put it in the bank, and just live off the interest. Never touch the principal." What do you say to someone like that?
The Bucket Strategy For Retirement Planning
Christine Benz: Our grandparents were able to do just that. Unfortunately, the fact is that bond yields and interest rates have gone so far down and that has changed the calculus of retirement planning.
One framework that I often talk about, and I think very intuitively illustrates a sensible way to create cash flow in retirement, is to think about the bucket strategy for retirement planning. The basic idea is that you are segmenting your portfolio by your expected spending horizon.
If you're retired and you have money that you expect to spend within the next couple of years, you really can't afford to take much, if any risk, with that portion of the portfolio.
You've got two years’ worth of portfolio living expenses in cash instruments, so you should consider a type of safe account that has very limited chance of losing money.
Then you just step out a little bit on the risk spectrum from there. When I think about your first three to ten years of retirement, you might have high quality bonds, and probably have a little bit of high-quality, dividend-paying stock exposure.
For the next eleven years and beyond, that's where you can go on for some growth. You can own stocks - growth stocks - and you can globalize your equity portfolio a little bit.
That's where you're taking risks because you have a long enough time horizon to put up with some of the volatility that will inevitably accompany the equity investments.
When people think about equity returns, they might say, "Equity returns are always better than bonds and cash." The fact is, that's not necessarily the case if you have a short time horizon. You want to make sure that you have at least a 10-year time horizon for the equity piece of your portfolio.
Douglas Goldstein: There certainly is a lot of risk. Christine, you said a moment ago, that based on the low interest rate environment, we're seeing a change in the calculus of retirement planning.
What that sounds like to me is that people who once thought they would just live on clipping coupons, literally living on the interest from their investments, now have to take more risk. Is that just a euphemism for, "Okay guys, sorry things don't look like they used to and now you've got to put more money in the market if you want to be able to live the lifestyle that you expected you'd live"?
The Pros and Cons of Low Yields
Christine Benz: Yes. That's a true assessment and it's sometimes called “the war on savers.” The fact is we've seen yields drop globally, and that has affected people who are attempting to construct retirement portfolios.
Unless someone can subsist on a one percent yield on some sort of very safe guaranteed security, they've had no choice but to venture out on the risk spectrum.
It's a fact of life of the low-yield environment. On the other hand, low yields aren't all bad. If you have a bond investor or if you have bond investments in your portfolio, you have actually benefited.
When yields go down, that means that bond prices go up. That trend may be reversing before our very eyes, at least here in the U.S., but it's certainly been a phenomenon that even though it's taken with one hand as yields have dropped, bond investors have benefited as bond prices have gone up.
Douglas Goldstein: But, as we say, past performance is no guarantee of future returns.
Christine Benz: Right.
Douglas Goldstein: That's something that might be happening because, presuming that rates are so low, now it looks like the only way they can go is up, although I'm not predicting that.
Certainly, some European countries have had negative interest rates. Assuming that interest rates go up, what can people who own bond funds expect?
What Should Bond Fund Investors Expect If Interest Rates Go Up?
Christine Benz: You can expect to see a little bit of price volatility with your fund. Even though your yield goes up, which is generally a good thing, you may see some price declines in the value of the bonds in that portfolio.
The reason is that when higher yields come on line, other investors say, "Well, I don't want your old bonds with low yields attached to them."
Those might be some of the bonds in the bond portfolio. They say, "I want some of these new higher-yielding bonds."
That has a depressive effect on already-existing bonds, with lower yields attached to them. I would say, though, that investors should bear in mind that even if we have, say a fairly significant jump up in interest rates, not just in the U.S. but perhaps in other parts of the world as well, investors may not suffer the sorts of declines that they might be envisioning.
I think investors think that if we have this interest rate uptick, that it's going to translate into some sort of market shock like we sometimes have with the equity market.
I don't think it will be anything nearly as extreme. When I look at a lot of some of the core type bond funds that investors own in their portfolios, I would say they have durations. That is a measure of interest rates at sensitivity of roughly five years, yields of maybe 2.5 percent.
The losses that an investor might experience in such a product might be like 2.5 percent in a one-year period, in which rates jumped up by one percentage point. So don’t run for the hills yet and assume that just because rates are going up, that will translate into catastrophic losses for your bond portfolio.
Douglas Goldstein: Just to go over that math once again: you're saying that a bond with a duration of five years, if interest rates go up one percent, would be expected to drop by about 2.5 percent over the one-year period, if the bond increased?
Christine Benz: Right. Assuming the product had a 2.5 percent yield currently. You're subtracting that yield from the duration, and the amount that you're left over with is roughly the amount that you would expect to see the product lose in a one-year period in which rates jumped up by one percentage point.
Douglas Goldstein: Based on that, it sounds to me like you would feel it's okay for retirees to own bond funds. If they don't want to pick individual bonds, or if they don't have enough money to diversify, or if they own enough money to diversify a bond portfolio, they still might be better off using a bond fund because of the professional management and at the end, a diversification.
So, you're saying that they shouldn't panic if they think interest rates are going to move up at a reasonable pace? Obviously, if rates were to go up by 3, 4, or 5 percent, I assume that's a different story.
Christine Benz: Yes, that's exactly my viewpoint. I think a professionally managed product can make a lot of sense for exactly the reasons you cite. I think that smaller investors might struggle with, A, picking bonds, and B, adequately diversifying, not just their issue or specific risks, but also the interest rate risks.
I think the wise thing to do for small investors is to think about a professional fund management.
Douglas Goldstein: Okay. All right, Christine, tell me in the last few seconds, how can people follow you and follow your work.
Christine Benz: I write a lot about retirement planning on our website, morningstar.com. I also do a lot of videos with my colleagues as well as people outside of Morningstar.
Douglas Goldstein: Okay. We will put links to that at the show notes of today's show, at goldsteinongelt.com. Christine Benz, thanks so much for your time.