How to Earn 5% No Matter What the Economy Looks Like

A new study suggests that investing your retirement money half in bonds and half in stocks will produce 5% annual returns like clockwork, despite bumps in the economy. But is this a smart strategy for everyone? No.

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A rich person who works on Wall Street once told me that he never invests in stocks. He keeps his money in Treasury bonds, where his savings will always be safe. He told me that he simply did not understand why anyone would risk their retirement security gambling on something so unpredictable as the stock market.

As a non-rich person, I was offended. Not exactly Occupy Wall Street offended. Let me be clear about that. This person worked hard and earned a big salary. Good for him. But he plainly did not understand what it takes for the 99% to retire. So I tried to explain.

“You don’t have to take risks,” I said. “You’re already wealthy. All you need to do is protect what you have. But the rest of us must bank on the long-run superior return of stocks in order to get from here to there. We must risk short-term losses knowing that stocks have always paid off over 20 or more years. If it stops working that way, well, we’re screwed. But we have to take the shot.”

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This story crossed my mind as I was reading about The 50-50 Solution in The New York Times. The story, based on fund company Vanguard’s research titled Recessions and Balanced Portfolio Returns, posits that you can ignore economic cycles and clock annual after-inflation gains of about 5% by sticking to a portfolio mix that is half stocks and half bonds.

It’s a noteworthy finding. Because bonds outperform around down cycles and stocks outperform around up cycles, Vanguard found that a 50-50 approach basically took the economy out of the equation. Since 1926, the firm concluded, a 50-50 portfolio rose on average 5.6% after inflation during expansions and rose on average 5.3% during recessions. Bingo: 5% growth through thick and thin.

That’s comforting if you’ve already saved a lot and are close to retirement–and find yourself torn by arguments for and against a double-dip recession. Just play it safe with a 50-50 strategy. Yet for anyone under 50, a 50-50 mix is so conservative that you risk falling short of your long-term goals.

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Consider someone who is 40, has $50,000 of savings and is saving $5,000 a year. If their money grows at 5% a year, by age 70 they will have $1.4 million. But if it grows at 7% after inflation, reasonable for a stock-heavy portfolio, they will have $2.1 million – 50% more simply for taking a calculated risk.

The Vanguard study acknowledges the danger of playing it too safe. Stocks have risen 11.9% a year after inflation during expansions; even a modestly stock-tilted 60-40 mix averaged 6.8% gains. Of course, these stock-heavy portfolio returns fell short of a perfectly balanced portfolio’s returns during recessions. Then again, recessions typically do not last anywhere near as long as expansions, when the gains more than make up for any bumps along the way.

Capital preservation is paramount if you’re already wealthy or in or near retirement. But if you’re not there yet, near-term volatility is an unfortunate but necessary evil. A 50-50 solution may let you sleep well for now, but not forever.

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