You’d like to have an idea of when you can retire, right?
You’ve told everyone you’ll be so ready. Sometimes you close your eyes and smile, imagining your retirement bliss.
There’s just one problem. You’re afraid you won’t have enough money to retire without risking your standard of living.
Either Bonds Or Stocks On Their Own Won’t Be Enough
In a recent article we explored a number of ways to replace your paycheck once you retire and stop working.
But what we found was that neither a bond portfolio or stock portfolio alone could do the job.
Bonds alone will not work because although they are less volatile and risky than stocks, they do not provide the growth you will need so that your income can keep up with inflation.
Investing in bonds-or bond mutual funds-alone, is likely to land you with a fixed income that does not keep up with inflation. And this will create a situation where your standard of living will decline as you age. Not a good position to be in!
By comparison, a portfolio of stocks will likely keep up with inflation. In fact there are few investments readily available to the general public with a tremendous a track record for outpacing inflation as stock do.
But stocks have a different problem. Selling stocks to create an income stream, especially in a down market, can seriously erode the value of your portfolio. When this happens, you once again wind up being unable to increase your purchasing power as the years pass. In fact, you could wind up in a situation where a few years into retirement you have a significantly smaller retirement nest egg than when you started.
You don’t have to be afraid to retire. But you do have to be smart to make sure you have enough money to successfully retire.
One solution is to use what I call the Two-Portfolio Approach.
The Two-Portfolio Approach To Retirement Income Planning
Two-Portfolio Approach is a method of managing risk by dividing your investment portfolio into two distinct parts. One part will be a diversified stock mutual fund portfolio and the other will be a diversified bond mutual fund portfolio.
Your goal is to get enough money outside the stock market – in other words, into bond mutual funds – so that you can generate the income you need by selling shares of your bond funds. You want to be able to keep selling shares of your bond mutual funds until the stock market has recovered.
After the stock market has recovered and gone on to new highs, you can sell shares of your stock mutual funds to replenish the bonds you sold when the market was down. This resets the process so you can be protected from the next market downturn.
Managing your investments with this approach is an excellent way to provide the income you need to have enough money to retire in good markets and bad.
One note about this approach: don't plan to get the income you need from the dividends that the bond mutual funds pay. For most of you this won't work because you can't generate enough dividend income from your bond portfolio to meet your needs. You probably don't have enough money to put into bonds to achieve this goal.
How To Implement The Two-Portfolio Approach
To implement the Two-Portfolio Approach, the first question you need to answer is how many years of income do you want to have outside the stock market?
In other words, how many months or years do you think it will take for the stock market to recover from a decline?
If you do a little research, you will find that the average bear market lasts about 14 months. So, you might decide that putting enough money in bonds to cover 14 months of income will be enough. But is this true? Probably not.
Even if the next bear market lasted only 14 months like the average, that is only counting the time it took for the market to decline from its high to its bottom. It doesn’t take into account the time the market takes to recover and reach a new high.
When you use the Two-Portfolio Approach to get the income you need, you’ll make sure to put enough money into bond mutual funds so you can sell them every month (or quarter) to provide sufficient income until the stock market rebounds and gets to its new high.
How long does this take? Let's use history as our guide.
In our lifetime, the longest it has ever taken the market to recover was also a fairly recent event; it was the bear market which began in 2000. This market took seven years to move from high to low to new high.
If you decide that you'd like to have seven years of income protected from stock market volatility, calculate the total income you will need from your investments over the next seven years.
You can do this by calculating how much money you will take from your investments in years 1, 2, and so on. Add them all up and that is your number.
For example, if you need $50,000 every year, you will need to put $350,000 in your bond mutual fund portfolio ($50,000 per year X seven years).
If you know how to calculate the present value of money, you could do that calculation and use a lesser amount, but that is a topic goes beyond the scope of this article.
How This Approach Works For You Have Enough Money To Retire
See how this works? When creating your retirement income plan, you need to decide just how much risk you are willing to take.
In other words, how many years of income do you want to protect from stock market volatility by investing in bond mutual funds?
Some of you may be tempted to invest solely in bond mutual funds. But you need stocks or stock mutual funds in your portfolio because they protect you from inflation.
Just imagine if, when you were working, your boss never gave you a raise. How would you pay your bills if you were still earning the same amount of money as you did back in 1990? It would be impossible.
The same principal will apply once you retire and stop working. Prices will increase as time goes by and you will need a way to give yourself a periodic raise in income. Stocks are one of the few investments that have been able to outpace inflation over time.
Not only do you need to have stock mutual funds in your investment portfolio, you need to make sure you put enough in them so your investment portfolio can continue grow over your retirement.
Use This Smart Investment Strategy
The Two-Portfolio Approach is an effective investment strategy that will not only help you have enough money after you retire, but also make it more straightforward for you calculate when you can successfully retire.
You’re getting closer to the time when you want to stop working.
You’ve got big plans for your retirement.
Isn’t it time you were able to confidently put a date on the calendar?