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Young Investors:Playing It Safe Can Be Costly to Your Wealth

Despite skittish sentiment, younger investors can take full advantage of more aggressive, more risky asset classes, because they won't need their money anytime soon, says Morningstar's Christine Benz.

Young Investors:Playing It Safe Can Be Costly to Your Wealth

Adam Zoll: For Morningstar, I'm Adam Zoll.

Investors in their 20s, 30s, and 40s are often told how important it is to save for retirement, but many are also skittish about investing in stocks.

Here to talk about retirement savings strategies for younger investors is Christine Benz, Morningstar's director of personal finance.

Christine, thanks for being here.

Christine Benz: Adam, it's great to be here.

Zoll: Christine, many younger investors understand the importance of saving early to allow their money more time to grow, but how important is allocation within their retirement savings account?

Benz: It's really important. In fact, young investors can take full advantage of more aggressive, more risky asset classes, because they won't need their money anytime soon. So, they can ride out those inevitable ups and downs that come along with those asset classes, especially stocks, because they won't need be tapping their capital in the near future.

Zoll: So, what would be some allocation guidelines that you would recommend for a younger investor who does have that longer time horizon to invest?

Benz: I often look to the Morningstar Lifetime Allocation Indexes, which are powered by some Ibbotson research, and for people who are in very early accumulation mode, so people in their 20s maybe with their first jobs, those allocations call for portfolios that are almost entirely equities, so upwards of 90%.

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Now you would want to sort of gradually reduce the equity exposure as you get into your 30s and certainly your 40s, you'd want to back off from that full equity exposure and maybe think about being in the neighborhood of anywhere from 75% equities to two-thirds equities. But you probably wouldn't want to be a lot lower than 50% at that point in your life, because you still have several years of accumulation ahead of you.

Zoll: What about the allocation within asset classes? So, within stocks do you want to try to invest across the market cap spectrum, for example, for maybe a broad part of your allocation?

Benz: That's a really interesting question. People with longer time horizons have more time to benefit from some of these long-term effects that we tend to see persist in the market. So, there's been a lot of academic research that points to the long-term outperformance of small-cap value stocks. If you have a long time horizon, you could reasonably skew your equity portfolio more heavily to small value because you can fully benefit from that small-value effect over time.

Ibbotson's allocations also call for younger folks' portfolios being more heavily global than would be the case for people who are in their 50s, 60s, and 70s. The reason you would want to back off on that global exposure as you get older, is because you don't have as much time to make up for big currency fluctuations that may break the wrong way on you. When you're young and you have a lot of time, what you'll find is that those currency fluctuations will kind of come out in the wash--that you won't be caught leaning the wrong way.

So you should have a fully globalized portfolio, and you might want to think about the composition of the total global market capitalization as a starting point for determining your allocations between U.S. and foreign stocks. So, right now the U.S. constitutes something like 45% of the global market cap. Not many investors have that much in foreign stocks. So they don't have 55% in foreign stocks, but I think that's a reasonable starting point, if you are a young accumulator.

Zoll: Let's talk for a moment about risk. For many younger investors, when you say the words "stock market," they immediately think of the financial crisis, the dotcom bubble bursting, and basically the pain associated with those sharp market downturns. And there is a chance that some of them may be … sort of pulling back on their equity allocation because of that aversion to risk. Is there a danger with playing it too safe with the market?

Benz: Absolutely, and I think you're right, Adam. We've seen varying studies about how younger people are allocating their portfolios, but there have been some studies that point to 20- and 30-somethings being excessively risk-averse, and there is a problem with that, in that if you are hunkering down in say, cash, stable value, bonds, your upside potential over the long haul just isn't that great. Because current yields are a pretty good predictor of what you can expect from bonds, you are lucky to be earning 2%, 3%, 4% in terms of current yield from bond portfolios right now. Money markets are yielding even less, and so there is a big opportunity cost in playing it safe when you're young. You're not harnessing your long time horizon, and you are also increasing your vulnerability to inflation. So, if you are barely outpacing inflation with your portfolio, or not outpacing inflation, you are not growing at all.

So, I think that the higher returns that are made possible by having an equity-heavy portfolio are something to anchor on, when you think about how to position your portfolio.

I brought some statistics about how various asset classes have performed over the past two decades. And even though the past 20 years have been pockmarked by these two really difficult market environments, if you had a total stock market index fund and bought and held it for that 20-year period, you would have a $50,000, if you would have invested $10,000 initially.

If you had a balanced portfolio, you would have $43,000, not much worse, but definitely worse. And if you had stuck with bonds, you'd have $32,000 at the end of that 20-year period. And this has been a relatively good period for bonds. If returns from bonds are more meager in the decades ahead, that could mean that younger investors who are playing it too safe could face an even bigger shortfall than the numbers I have just talked about.

Zoll: So, is there a reason for younger investors to be concerned if they do see … the value of their retirement portfolios take a downturn during a market correction or a bear market. Is that something that they should be concerned about, or generally is time on their side and they should just ride that out?

Benz: Well, the latter. So it's counterintuitive, but for people who are in accumulation mode, these big downdrafts that we periodically see are actually buying opportunities. So, they are reasons to be optimistic. Certainly, if you're later in your investing career and you get hit by one of those big market downdrafts, that's bad news because you might not have much time to recover from it. If you're young and you have a big downturn in the market, you'd want to see that as an opportunity to actually stay invested, if not invest more at that point, because you will be positioning yourself for better results ahead.

Zoll: Thank you, Christine, for being here today. And thanks for talking with us about retirement savings strategies for younger investors.

Benz: Thanks, Adam.

Zoll: For Morningstar, I'm Adam Zoll.

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