Element 4.10: Match the Length of Your Investments to the Timing of Your Needs

“You shouldn't own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”

When making long-term investments, such as the funds allocated into a retirement plan, a stock index fund is generally your best investment. While the long-term return of stocks is substantially greater than bonds or cash in a bank account, the value of the latter is more stable over short (and even medium) time periods. As the time approaches when the funds from an investment plan may be needed, it will make sense to shift funds toward these more stable investments. Given a five-year horizon, purchasing a bond that matures in five years, at which point you will receive your initial investment plus interest, is a relatively safe investment. As a general proposition, buy bonds that mature at about the time you will need the funds, perhaps for graduate school tuition, a down payment on a home or income during retirement.

The primary risk of owning bonds is inflation, which lessens the value of both the principal and the fixed-interest payments. This risk may be reduced through the ownership of Inflation-Protected Bonds, such as Treasury Inflation Protected Securities (TIPS) in the United States, or Obligations Assimilables du Trésor (OATs) in France, which pay a market-determined fixed interest rate set at the time they are purchased, plus an annual adjusted yield for the rate of inflation during the life of the bond. Germany, Canada, Greece, Australia, Italy, Japan, Sweden, Israel, and Iceland also issue Inflation-Protected Bonds. Because unanticipated inflation is one of the factors that causes the return from bonds to be worth less than expected, buying and holding Inflation-Protected Bonds will protect the holder against that risk. When people expect inflation, the initial fixed interest rate of Inflation-Protected Bonds will tend to be lower than the rate for regular government securities, which already incorporate some expected inflation in their committed payback. If the actual rate of inflation is higher than was expected, Inflation-Protected Bonds will generally yield a higher rate of return than regular government securities, but the opposite will be the case when the actual rate of inflation is less than what was expected. Thus, Inflation-Protected Bonds provide the bondholder with protection against an unanticipated surge in the inflation rate by offering her less money when there is an unexpected fall. Inflation-Protected Bonds are particularly attractive for retirees seeking to generate a specific stream of real purchasing power from their assets. However, their short-term value will also be influenced by changes in interest rates and how policy is expected to impact the future rate of inflation. Therefore, we recommend that one consult with a financial advisor before investing heavily in Inflation-Protected Bonds.⁽¹⁵⁴⁾

An additional risk associated with bonds is the impact of changes in interest rates. Suppose you buy a €1,000, thirty-year bond that pays 5 percent interest. This bond promises to pay you €50 in interest every year for thirty years, at which time it matures, and you get €1,000. But if the overall or general interest rate increases to 10 percent soon after you buy this bond, then your bond will immediately fall in value to about one-half of what you paid for it. The reason? At a 10 percent interest rate, an investor can get €50 in interest every year by buying a €500 bond. So now, €500 is about all anyone will be willing to pay for your €1,000 bond. Of course, if the interest rate drops to 2.5 percent soon after you buy your thirty-year 5 percent bond, then its price will approximately double in value. But this volatility (or risk) is more than you may want to assume if you are saving for something you expect to buy in five years.

How long should a portfolio consist of stocks, and when should the move to bonds be made? That depends on the length of time before you want to access the investment funds. As we suggested above, relatively short-term investments may do best in bonds exclusively. For example, a young couple saving to make a 20 percent downpayment on a mortgage to buy a house may be better off avoiding the stock market entirely—for that portion of their savings only—and investing it in bonds. That is because placing a down payment on a house or condominium often involves saving for just a few years. In contrast, a couple might save for 18 years to finance university education for a newborn, or 35 to 45 years to build up savings for their retirement. In these two cases, equities should be an important part of, or perhaps the entire investment fund for most of their saving years.

The parents of a newborn who begin saving right away for the child’s university education have more years to build wealth and to diversify the risk of capitalizing on stocks to build it faster. In that case, having some of that university portfolio in equities may make sense. However, as the plunge in stock prices during the Great Recession of 2008 and the market decline in 2022 illustrates, even with an 18-year horizon, stockholdings involve risk. Again, investors seeking to reduce risk in their university funds can do so by holding fewer stocks and more bonds, especially as the time approaches when the funds will be needed.

As people earn more and live longer, saving for retirement expenses becomes ever more important. We do not want to drastically, and negatively, alter our lifestyle upon retirement; and we cannot afford to outlive our retirement nest eggs. For the saver whose retirement is more than ten years ahead, a diversified portfolio of stocks, such as a mutual fund indexed to the S&P 500, probably makes the best investment portfolio. For the more conservative saver, having 10, 20, or even 40 percent of one’s portfolio in bonds will generally provide more stability in the value of one’s retirement assets, even though total returns will probably be lower in the end.

As the need for retirement income approaches, it is prudent for all but the wealthiest among us to begin to switch from an all-stock portfolio gradually into bonds. When that switch should begin depends partly on when and how much monthly income is needed during retirement. For those individuals with a large portfolio or a good pension income relative to their retirement income needs, much of their savings can be left longer in equities to maximize the expected total return. The goal of switching to bonds is primarily to avoid the need to sell stocks at temporarily low prices. The sooner you expect to turn to your portfolio to meet monthly living expenses, the more important it is to reduce risk by moving strategically and gradually into bonds.

Regarding retirement investments, it is also vitally important to consider the tax treatment of both your investment contributions and retirement income. In many countries, saving for retirement is protected from some income taxes, allowing your savings to grow faster. For example, in Ukraine, contributions to non-state pension funds are deductible from gross income up to 15 percent of the person’s salary, and investment return is not taxed, so the total accumulates faster.⁽¹⁵⁵⁾ Lower taxes are a way governments can encourage citizens to save for retirement. Some countries, such as Bulgaria, even exempt savings, returns, and distributions from private pension funds from all taxes.⁽¹⁵⁶⁾ While some Central and Eastern Europe countries do not yet have private pension investments available, there is a global trend to increase voluntary pension contributions through tax incentives. If you cannot access tax-advantaged private retirement accounts, continue to save; that way, when the accounts become available, you will be able to save the maximum amount allowed each year.

Our advice to those seeking to prepare for future retirement can be summed up this way: Start saving for retirement early, stay with diversified portfolios of stocks until the need for funds is near enough in time to justify gradual shifts toward lower-risk, lower-return assets such as bonds, and take advantage of the favorable tax treatment provided for retirement plans.