Relax, You‘ve Got Plenty of Time

Relax, You‘ve Got Plenty of Time
November 7, 2004

Take your time.

Before you plunk down money for any investment, you should think carefully about when you will need your money back. And if you do that, you will likely come to a surprising conclusion: Often, your time horizon is a whole lot longer than you imagined -- and you don‘t need to be quite so cautious with your portfolio.

To understand why, consider the four big financial goals: funding retirement, paying for college, preparing for financial emergencies and buying a house.

Keeping It Working

People often have a target amount they want to amass by retirement. That drives them not only to save like crazy as they approach their 60s, but also to load up on bonds, money-market funds and certificates of deposit, so they have a heap of cash available on the day they call it quits.

But, of course, these folks won‘t spend their entire nest egg on a single day. Instead, once retired, they might draw down their portfolio over 20 or 30 years.

So how much cash do you need on the day you retire? I often suggest that each year retirees look to withdraw 5% of their portfolio‘s beginning-of-year value. For instance, if your nest egg is worth $400,000 at the start of the year, you would withdraw 5% of that amount, or $20,000, over the next 12 months.

You can garner your 5% through dividends, interest and occasionally selling investments. Part of this money will be owed in taxes, so don‘t bank on spending the entire 5%.

Even though you are withdrawing just 5% each year, I would keep more than 5% of your portfolio in cash. My advice: Stash 25% of your portfolio in money-market funds and short-term bond funds, so you have enough set aside to cover the next five years of retirement withdrawals.

Meanwhile, invest the other 75% for long-term growth, by sticking maybe 25% in a mix of high-quality intermediate-term bonds, inflation-indexed Treasury bonds and high-yield junk bonds and the remaining 50% in a collection of blue-chip, small-company and foreign stock mutual funds.

The growth from these riskier investments will likely come in handy. After all, during the course of a 20- or 30-year retirement, consumer prices could easily double, so you will want your income to keep pace. Indeed, because of the threat from inflation, keeping everything in low-risk investments is -- ironically -- probably the riskiest thing you can do.

Getting Educated

As with your retirement savings, you won‘t spend your daughter‘s entire college account on a single day. Rather, you will likely draw down her savings over four years.

This brings me to a popular rule of thumb: Once you are within five years of a financial goal, any money you plan to spend should be completely out of stocks. There‘s a good reason for this rule. Over some five-year stretches, stocks have lost money.

In fact, we have just had a couple of these rough spells. According to Chicago‘s Ibbotson Associates, the Standard & Poor‘s 500-stock index lost a cumulative 3% over both the five years ended in December 2002 and the five years ended in December 2003. If you wait too long to unload your stocks, you could get caught up in one of these rotten patches and find yourself selling shares at fire-sale prices.

How should you use the five-year rule when handling your daughter‘s college account? Suppose you plan to put a quarter of her money toward each of her four college years.

With that goal in mind, you might move a quarter of her college account out of stocks when she‘s five years from her freshmen year, another quarter when she‘s five years from her sophomore year, and so on.

Don‘t, however, be too mechanical about this. If your daughter is five years from college and stocks are deeply underwater, I wouldn‘t sell a quarter of her stocks. Instead, postpone all selling until shares bounce back. With five years until you need the money, you should get ample opportunity to sell at better prices.

Looking Down

When it comes to emergency money, the conventional wisdom is that you should keep six months of living expenses in conservative investments. But this advice has always struck me as absurd.

Think about it: You are leaving a huge wad of cash languishing in low-returning investments in preparation for events that probably won‘t occur. Yes, you may need the money tomorrow. But there‘s a good chance you won‘t need it for years and years.

As an alternative to the six-month rule, I often suggest that folks keep maybe two months of living expenses in a money-market fund or a short-term bond fund. That should be enough to cover small-scale disasters, like the boiler going into a meltdown or the roof suddenly needing to be replaced.

Meanwhile, I would take the rest of your emergency money and invest for long-term growth, by buying a diverse mix of stocks and riskier bonds. To be sure, your next major financial emergency might coincide with a nasty bear market and it will be a bad time to sell these investments. But you could always borrow temporarily by, say, tapping your home-equity line of credit. You can then repay this money once your stocks and bonds bounce back.

Heading Home

While we don‘t have a strict deadline with retirement, college and financial emergencies, that isn‘t the case with home purchases. To make that house down payment, you really do need a sizable chunk of money on a single day.

Because there‘s no wiggle room, I would be more cautious with your house money than with your retirement, college and emergency money. Hoping to buy a house in the next few years? As you save for your future down payment, I would funnel every dollar into a money-market fund or a short-term bond fund.

Write to Jonathan Clements at [e-mail]¹