Post #20 – The 2 Biggest Investment Mistakes Made by People over 50
This will be a short post on the 2 biggest investment mistakes that people over 50 make. I have touched on these areas briefly in previous blogs, but I felt they are important enough that I wanted to address them more directly.
In my opinion, the 2 most common mistakes made by people over 50 are:
1. Taking on too much equity risk,
2. Assuming an unrealistically high return on assets.
I am sure that the 2008-2009 financial crisis has reduced both these investment mistakes somewhat, but they are worth pointing out again.
I discussed in some detail the importance of selecting the appropriate equity allocation in Post #11 to Post #13. These posts focus on the appropriate equity allocation as a way to maintain stability in one’s portfolio by including a good quantity of fixed income assets. This, in turn, allows you to maintain your investment discipline in down markets.
But I read and hear about many people over 50 increasing their equity allocation because they have a savings shortfall in their retirement accounts. Sometimes this is done based on the recommendation of a financial advisor. Some people are being advised to invest more aggressively to make up for a savings shortfall. Let me repeat a theme from earlier posts. One of the most important investment principles I have learned over time is that controlling investment risk is as important as (or perhaps more important than) maximizing investment gains.
Increasing your equity allocation because you have a savings shortfall is a bad idea. As I have stated before, if your equity allocation is outside of your comfort zone when it comes to market volatility, you will not be able to maintain your investment discipline in a down market. If you do not maintain your investment discipline, then the higher equity allocation will not have done you any good. And it conceivably could hurt you more than if you had maintained a more comfortable equity allocation. Do you remember the panic selling by retail investors during the financial crisis. Many of these people are still largely out of the market and have missed out on the huge bear market rally from 2009 to today.
It is best to keep your equity allocation at an appropriate percentage based on your risk tolerance, age, and years from retirement. As I write this in spring of 2011, we are in an economic climate that is very unsettled and the markets, in my opinion, are fraught with peril. If you learn nothing else from this blog site, it is to maintain your “age appropriate” equity allocation and stick with it regardless of what the markets do (with periodic re-balancing, of course, as discussed in Post #15).
The second big investment mistake is actually one that can affect investors of all ages but the mistake is more harmful to older investors. It is assuming an unrealistically high return on assets. To some extent, the mistake is understandable as it is about statistics. It is a fact that the average return of the S&P 500 stock index from 1990 through 2009 is 10.1% including dividends. Many people use this figure in their retirement asset accumulation calculations. These calculations help people to determine their required savings rate to reach their retirement nest egg target. But what if the average equity asset return turns out to be 8.5% instead of 10%? Your calculations will be off and your retirement savings goal will not be met (i.e., not in the expected timeframe).
Let me break down this 10.1% S&P 500 20-year average annual return into two parts:
-1990 through 1999 = 19.0% average annual return
-2000 through 2009 = 1.2% average annual return
The average annual return for the two 10-year periods is very different.
The reason the mistake of assuming too high an asset return is not as harmful to younger investors (i.e., under age 45) is, over the next 20 years, the average annual stock market return may start to approach the 10% 20-year return of 1990 to 2009. Also if this group is wrong, they still have time to make some adjustments if they are made early enough.
However, for investors over 50, assuming a rate of return that turns out to be too high can be more damaging. We are currently in a secular bear market that started in the year 2000. Although I do not think the average annual return of equities over the next decade will be as low as 1.2% (especially if you include foreign market equities in your portfolio), I do believe the average annual return will be less than 10%. And remember, as discussed above, you will not have 100% of your assets in equities so this fact must also be taken into account. Since people over 50 only have about 10 to15 years before retirement and we are in the midst of a bear market, assuming the 10% average annual return for equities, I think, is a big mistake.
Let’s assume a 55 year old couple, with only 10 years before retirement, has a 50% equity allocation. If equities return 8% per year over the next decade and fixed income assets return 4% per year, this is a blended annual return of 6%. An investor would have to save a lot more money assuming this average rate of return versus an average 10% return or even an 8% return. My advice is to assume something similar to this lower return and save more money to allow for it. If the equity returns turn out to be higher, you will have a much better retirement than your plan allowed for.
One last point, this entire discussion assumes that inflation rates in the US will remain subdued. Based on the monetary policy the Federal Reserve has adopted as of late (i.e., quantitative easing), this may not be a good assumption. Regardless, the prospect of higher inflation is just one more reason to keep your savings rate higher than historical asset returns would suggest is needed.
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