Infinite Time Horizons: An Introduction

One of the standard pieces of advice in the Personal Finance community is that your retirement portfolio should become more heavily weighted with fixed-income instruments as you approach your retirement age. The more that I think about it, the more I'm inclined to challenge that conventional wisdom. In fact, I think it's completely wrong-headed for many people.

You should only sacrifice volatility when liquidity becomes an issue. But your retirement shouldn't be subject to any crisis of liquidity. It should be a steady gradual affair that will span multiple decades. In fact, if you want your retirement portolio to be passed on to your progeny, the time horizon is effectively infinite. So there's no need to sacrifice greater returns in favor of a reduced beta.

Let's look at two different scenarios to illustrate this point. First consider saving for your child's college education. You have an 18 year time frame to save. At the point, all of your principal and gains must be liquidated over a 4-5 year time frame. Because there's a very real possibility that the markets might tank during little Timmy's senior year in high school--and remain depressed for the following 4-5 years--it makes sense to tilt your portfolio towards safer (lower-return) investments as he approaches college-age. Because you must demand liquidity at a fixed point in time and over a short time-frame, investing conservatively is the correct behavior.

Now contrast this with saving for retirement. Unlike college, you don't need to liquidate your entire portfolio on your 60th birthday. Instead, you want to gradually liquidate it over the next 20 years. In any given year, you'll probably only need to draw down a small portion of the portfolio. This situation is vastly different than the first example.

If you're an average healthy male, you're going to live to be about 81. You've got a 20 year time frame with which to work. Furthermore, if you want to leave your children with a sizable inheritance, then there is no foreseeable time horizon for your retirement portfolio because it will continue to exist in perpetuity even if you don't.

So why would you ever switch to a lower-yielding fixed income portfolio if you can afford to ride out a substantial stock-market corrections during your retirement years?

Here's where I could trot out some statistics about historic market performance over decade-scale time frames. If you're willing to assume that long-term historic trends are an accurate indicator of long-term future trends, you can see the advantage of a 100% equity portfolio even during retirement. This is Siegel's "Stocks for the Long Run" thesis taken to it's logical extreme.

What follows is four more installments of a five part series where I'll use my own retirement numbers to illustrate this point.