4 Pitfalls to Avoid in a Lofty Market

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The year is not quite over yet, but 2017 looks set to be another buoyant year for the stock markets, and that's reflected in valuations. I'm here with Christine Benz, she is our director of personal finance, to look at some pitfalls for retirees in such a lofty market.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: The first pitfall here really doesn't just impact retirees, but when the market is so high, there can be a bit of a wealth effect--it makes you feel like you want to spend more, you feel wealthier. This is something that you think investors really should guard against though.

Benz: Absolutely. I think it's particularly important for retirees, but as you say, it's important at every life stage to make sure that you are not letting your inflated portfolio balances go to your head. When we think of the key things that make or break a retiree's plan, the baseline number that will be the most impactful is that spending rate from the portfolio. I think it's natural to maybe feel a little more comfortable with spending more from your portfolio when your balances enlarge than you otherwise would.

I think that accentuates the virtue of making sure that you are operating with some sort of a withdrawal rate system that makes sense given your portfolio's asset allocation, given your time horizon, and make sure that it's something that you are revisiting on an ongoing basis. I sometimes talk to retirees who say that they are using fixed percentage withdrawals from their portfolios because it tethers them to whatever is going on in their portfolios. I would point out that those fixed percentage withdrawals are really nice to employ when the market is going up, just bear in mind the repercussions when the market goes down. If that's your strategy and say, you are pulling 4% annually from a $1 million portfolio, think about how that would feel pulling $28,000 from a $700,000 portfolio. Just be careful. Make sure that you are using a system.

I really like the idea of committing your withdrawal rate system to some sort of a document. We've got a retirement policy statement template available on Morningstar.com. I think people should use a template like that, use a retirement policy statement like that to make sure that they are on track and they are not getting buffeted around by what's going on in their portfolios and with their portfolio balances.

Glaser: When the market is on the way up, it's easy to feel like a genius, because everything you select goes up. But that could lead to overconfidence and then that's your second pitfall?

Benz: Absolutely. I have to say, anecdotally, I'm hearing signs of overconfidence in terms of talking to investors and hearing abut some of the choices they are making. It's not uncommon for me these days to run into people who are approaching retirement who say, you know what, I'm going to take Social Security right when I turn full retirement age because I can easily out-earn that 8% that you tell me I can earn on my Social Security benefit if I delay. The fact is that there is no way you can out earn a guaranteed rate of interest that's equal to delaying Social Security. I see signs of overconfidence in things like that.

I think investors are confident in their security selection. As you said, Jeremy, that is another potential pitfall. There is a tendency to feel like you are maybe a better fund-picker or a stock-picker than you actually are because it's been very hard to go wrong in the equity market, especially so far in 2017.

I do think that there are also signals that investors are sometimes overconfident in certain fund managers. I have been paying attention to what seems to be a little bit of a cult of personality around the Primecap team. They run terrific funds. They are among the best active managers I can think of, and I own one of their funds myself. But I think you do have to think as an investor that these things don't grow to the sky, and there will be periods when the strategy as much as I like it will not perform well. You have to check your expectations, and also perhaps send some money to other parts of your portfolio that haven't performed as well.

Glaser: Let's talk about portfolios. We often advocate a pretty hands-off approach. But when you are in this kind of bull run, you can be too hands-off.

Benz: I think so. That's a big risk for retirees today in my view. If they have been very hands-off for many years now, they have ended up with portfolios that have gotten progressively more equity heavy and in turn they have higher volatility potential in their portfolios. I do think that retirees who have not done so recently should take a look at their asset allocation.

The key things that they want to look at is, just whether they have enough in safe assets to tide them through a difficult period for the equity market. I usually urge retirees to kind of back into an appropriate asset allocation mix using their planned portfolio withdrawals. In my model portfolios, for example, I have talked about thinking about using two years' worth of portfolio withdrawals, steering that to cash; another eight years' worth of portfolio withdrawals in bonds; and then the remainder of the portfolio, I think, could reasonably go into more aggressive, high-returning assets like stocks. But make sure that you have those near and intermediate-term reserves set aside. If you haven't done that sort of portfolio maintenance recently, you are probably overdue to do it.

Glaser: Zooming in on that equity portion, you could be too hands-off there as well. There could be some misalignment just within that portion.

Benz: Absolutely. We have had a period, especially in 2017, where growth has looked unassailable. Growth stocks have been performing tremendously well. And there again, if you have done nothing, if you have been hands-off with portfolio, it's a good bet that that portfolio might be listing toward the growth side of the style box. Many investors though have actually been actively adding to the growth components of their portfolios. That would tend to give their portfolios an even more growth-heavy look.

My thought would be to not overlook the value side of the style box. Don't overlook high-quality stocks, which haven't performed particularly well. I think of Vanguard Dividend Growth, for example, which is a fund that I own in my model bucket portfolios. It has had a year to forget so far in 2017, but I still think it's a stellar core holding. Those are the kinds of things that investors shouldn't give up on even though they haven't performed especially well relative to growthier names in their portfolios.

Glaser: Christine, thanks for the tips in a lofty market.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.