Saturday, August 18, 2012

The power of "a penny saved"

Modern portfolio theory—the concepts that underlie most financial thinking today—would argue that an aggressive allocation to stocks should generate higher returns over time than a comparable holding of lower-risk assets such as bonds. The flip side, of course, is greater risk of loss.

During "the lost decade" of 2000–2009, which left the broad U.S. stock market under water, that risk came home to roost. The lesson was especially hard on investors closer to retirement who had a significant allocation to equities and were counting on "average" returns from stocks to reach their goals.
A recent Vanguard study points out that some of the most reliable and powerful levers in your retirement toolkit have less to do with modern portfolio theory than with Benjamin Franklin. The study, Penny saved, penny earned, illustrates that investors who increase risk with the objective of gaining higher returns might actually be less likely to meet their retirement goals than those who simply save more, whether by starting earlier or by saving at a higher rate.
Maria Bruno, a Vanguard investment analyst who coauthored the study, noted, "The markets over the past few years have been a reality check for investors. In saving for retirement, it's better to focus on the things you can control—when you start to save and how much you save—because that's going to be the most reliable way to succeed in meeting your goals."
Save sooner, save more
As the study shows, saving earlier and saving more are things you can control. Independently or together, they are more likely to help you reach your retirement goals than adding riskier assets in the hope of getting higher returns.
While investors nearing retirement and facing a shortfall might be tempted to move more aggressively into stocks to try to catch up, a less risky option would be to keep working and keep saving. If you delay retirement by even a few years, the extra savings coupled with not spending from the portfolio can make a material difference in helping to fill the gap.
Looking at what you can control
The study used the Vanguard Capital Markets Model® (VCMM) to simulate investment returns using various assumptions about salaries, asset allocations, and contributions. One data set from the study shows a hypothetical 35-year-old investor planning to retire at age 65 who puts 12% of an annual salary into a retirement portfolio with a moderate asset allocation (50% stocks and 50% bonds). After 10,000 simulations based on different potential market scenarios, the investor's median inflation-adjusted balance at retirement was $475,000.
The study then examined the impact that each of three investment levers—portfolio risk, savings time horizon, and savings rate—could have on the investor's portfolio balance at retirement.
Behind door number 1—a 22% increase
Asset allocation—the portfolio's balance of riskier and safer assets—has been proven by a number of studies to be a powerful driver of portfolio performance over time. Choosing a more aggressive asset allocation (80% stocks and 20% bonds) would increase the investor's median balance at retirement by 22%. It's worth noting, however, that with this allocation the "worst-case" outcome is a much lower balance at retirement than the 50%/50% portfolio produced in its own worst case.
Door number 2—a 25% increase
Adding more savings to the portfolio—in this case, contributing 15% of an annual salary rather than 12%—would result in a median balance 25% higher than the initial one, according to the VCMM simulations.
And door number 3—a 51% increase
As Ben Franklin would have guessed, the power of compounding has the potential to be the most effective strategy. By starting to save ten years sooner, even with the 50%/50% allocation and the 12% saving rate, our investor would have garnered 51% more, with a median balance of almost $720,000 at retirement.

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