NEWSWEEK: The market has done well as baby boomers bulk up their 401(k)s. What happens when they belkin to cash out and retire?
JACOBS: It’s not a concern in this decade. Baby boomers are just beginning to invest – they’ve barely crossed the starting line. You’re also seeing people keep more of their money in stocks later in their lives, so you can’t assume that baby boomers will pull much money out of stocks when they hit retirement age.
Is that because we’ll have to hold stocks longer?
There is a rule of thumb that you should take 100 and subtract your age, and that’s the percentage of your portfolio that should be in stocks. So if you’re 65, you’d want 85 percent in stocks and 65 percent in bonds. But I don’t believe that rule of thumb is meaningful. Today when you’re 65, you might have 20 years left to live, so you need to keep more money in stocks. And what’s more important than your age is your wealth. If you’re wealthy and can afford risk, you can keep your equity exposure high throughout your life. If you retire with $5 million, keep it in stocks and it declines by 20 percent in a bear market, you’ve still got $4 million–you’re going to be all right. If you retire with $150,000, you can’t afford that risk. Everybody accepts the notion that as you get older you have to get more conservative, but it’s not true–it depends how much more you have than you need to live on.
OK, baby boomers are just starting. But will they and others ball out when the market really heads into a tallspin?
I don’t expect fund investors to nm and hide. This long bull market has conditioned people to buy on dips, and that will probably be most investors’ immediate reaction. The market had a couple of bad days in early January, yet the funds were selling strong. There were some people–myself included–who bought on those days. There will be selling in a bear market, but I don’t think it’s going to be quite the catastrophe that the worst Cassandras are projecting.
The Cassandras are also worried that so many people are investing in index funds.
You have to understand the pluses and minuses of index funds. The pluses are the low expenses, the continuity of performance, tax efficiency and that you don’t have to worry about a manager quitting. But there are downsides. Since index funds are always fully invested, they’re going to be more volatile in a bear market. For that reason, you need a longer time horizon. If your time horizon is long enough-say 10 years or more –you ought to index about 50 percent of your stock portfolio. We typically recommend a package of five index funds. To use Vanguard’s Index funds as an example, we’d recommend putting 50 percent in the Total Stock Market fund, 80 percent into the Small Cap Stock Market, and divide the other gO percent between the European, Pacific and Emerging Market international funds.
What about the other half of the portfolio?
You should invest the other 50 percent to overweight areas that you think will do well, or to just reduce your risk level. Maybe you want to increase your technology holdings, or you think that small-cap value funds will be hot right now. You’d use this half to overweight these areas. Or you’d invest in equity-income funds, which are lower risk and would counterbalance some of the risk of having half of your money fully invested in index funds.
What are you overweighting now?
Picking funds is like predicting the future-there’s a limit to how right you can be. Your asset allocation-the mix of stocks and bonds in your portfolio- is much more important than the funds you pick, because the allocation determines your risk level and how diversified you are. That said, ordinarily I recommend funds based on momentum. I’ve done a study that shows that the top-performing diversified fund for one year usually does well the next year, too. Last year’s top performer was Wasatch Mid-Cap, so we like that one. But sometimes I buy on weakness, and last year small-cap value funds lagged, so we’re recommending funds like Mutual Discovery and Babson Enterprise II. The emerging markets are also looking good this year, and if people have less than 5 percent of their portfolio in emerging markets, they should take another look. Funds like Lexington Worldwide Emerging Markets, T. Rowe Price New Asia and Vanguard’s Emerging Market Index are all coming back. We’ve come through a two-year bear market in the emerging markets, and the long-term potential is there.
