Dec 19, 2013

    Should retirees invest life savings in stocks?

    MOST statements in life, when repeated often enough, will be taken as the indisputable truth, especially so if our general, everyday observations sort of suggest that the statements are right.

    In the field of finance, one tenet which is often purveyed is that of life-cycle investing.

    The theory goes that young people should be more aggressive in their investments, namely that they should allocate a higher proportion of their portfolios to equities, for the long-term compounding effect to take place.

    But when they approach retirement age, they should cut their exposure to equities and hold more of their portfolios in bonds and cash.

    What if a retiree had her entire life savings in equities, and saw her portfolio diminish to less than half during the global financial crisis in 2008? That would be a nightmare scenario, wouldn't it?

    But here's the thing: The image of this scenario is likely to be most vivid when the stock-market crash is at its worst.

    But, you know what? Markets recover, even from the worst of crises.

    As long as retirees don't panic and cash out their entire portfolios at the bottom of the market, there is a good chance that they will see their portfolios recover.

    We did a stress test on an all-equities portfolio at each of the previous market peaks in the Singapore market, going as far back as 1973.

    Let's assume that there were seven retirees.

    Each retired with $1 million and decided to put the entire sum into the stock market.

    The bull markets at the time of their retirement gave them confidence that the stock market was a good place to keep their savings.

    So each of them plonked their $1 million into the market at the beginning of 1973, 1982, 1984, 1990, 1997, 2000 and 2008.

    And each wanted to withdraw 5 per cent from that $1 million, or $50,000 a year, to pay for their living expenses.

    As it turned out, the years that the seven retirees put their money into the market were the years of market peaks. Soon after, major crashes or market corrections took place.

    Could the $1 million equities portfolio have lasted them until today?

    Well, six out of the seven portfolios did.

    The initial $1-million portfolios were worth between $824,000 and $3.4 million as of the end of last year, with one exception.

    For the person who retired in 1982 with $1 million invested entirely in the Singapore stock market, her portfolio as of the end of last year was worth $3.4 million.

    This was after she withdrew $50,000 a year from the portfolio for the last 31 years. The withdrawal amounted to $1.55 million in all.

    For the person who retired on the eve of the Asian financial crisis, her portfolio as of the end of last year was worth $1.6 million. And in the intervening years, she had taken out $800,000 from her portfolio as spending money.

    At a 5 per cent withdrawal rate, the lowest the six retirees' portfolios ever fell to was $429,000. That was for the person who retired at the peak of the dotcom bubble.

    The only retiree whose portfolio didn't survive was the one who put her money into the market during the massive 1973 bubble in the local market.

    At that time, according to Thomson Datastream, the Singapore index was trading at a price-earnings ratio of 35 times. In other words, there was a massive bubble in the Singapore market.

    Admittedly, the ride can be quite rough at times. The portfolio can plunge by half in a year. The key is to hang on tight.

    But there is one very important caveat here. The equities portfolio must be made up of a diversified basket of stocks of real businesses and purchased at a price which is unlikely to result in a significant permanent loss of capital to the investor.

    Buying into stocks such as Blumont, Asiasons or LionGold, whose business prospects are uncertain, and at overvalued prices, is a sure-fire way for you to outlive that $1 million in the shortest possible time.

    The writer, a CFA charterholder, is head of research at Aggregate Asset Management, manager of a no-management-fee value fund. This article first appeared in The Sunday Times.