There's more to managing your money at different points in your life and career than simply increasing your bond allocation as you age. Here are six targeted techniques that can help you take control of your financial future.
Plotting your path to investing success might seem like a relatively stress-free exercise when you’ve got a raging bull market at your back. But not these days. There’s a growing fear that the sharp rally in stocks — the S&P 500 index has nearly doubled over the past four years and gained 15% during the first five months of 2013 alone — is unsustainable. Asset prices across the board, say skeptics, have been propped up by the easy-money policies of the Federal Reserve and other central banks around the world, and when those unprecedented stimulus efforts come to an end, it won’t be pretty. Indeed, those fears prompted long-term Treasury bond prices to drop by more than 7% in May, rattling investors.
Still, there’s reason for tempered optimism. The economy continues to show signs of solid improvement: Job growth is picking up, housing has rebounded, consumer confidence is higher, and corporate earnings are growing. And despite the run-up in prices, the S&P 500 is now trading at about 14.4 times next year’s estimated earnings, nowhere remotely close to the P/E ratio of 25 recorded back in 2000, when the dotcom bubble burst.
Of course, short-term market predictions are usually a crapshoot. What you can certainly foresee, though, is where you are on your own investing continuum. With that knowledge you can make better decisions about when it makes sense to take risk, when it makes sense not to — or whether your portfolio is in need of a significant overhaul. Naturally, it always pays to adhere to the basics: Save diligently, keep your fees low, rebalance regularly. But keeping your mind open to some nontraditional thinking can help too.
With that in mind, here are some customized strategies aimed at helping you navigate the path to investing success — whether you’re in the early, middle, or late stage of your career. We also asked five investors with outstanding track records to give us their top stock picks for investors of any age. And we also lay out for you the pluses and minuses of moving your residency to shelter income from taxes.
1. Double down on stocks. An almost universal investing principle is that young people should allocate the majority of their retirement savings to stocks. Yale professors Ian Ayres and Barry Nalebuff, co-authors of the book Lifecycle Investing, have put that concept on steroids: They recommend that investors in their twenties use leverage to get their stock exposure up to 200% of their assets, either by borrowing on margin or by purchasing long-term call options, thereby exaggerating potential gains (though it would do likewise for losses).
While this may sound insanely risky, Ayres and Nalebuff insist it is just the opposite. The standard retirement advice, they argue, underexposes young people to stocks and thus requires them to take far too much equity risk later in life, when they can least afford to lose money. For instance, a typical target-date retirement fund allocates about 90% of a 23-year-old’s savings to stocks, a proportion that gets pared down to around 50% by age 65. But the 90% allocation applies to a relatively minuscule amount of money — the few thousand dollars a twentysomething can scrape together — while the 50% equity allocation at age 65 places hundreds of thousands of dollars at risk. “You are forcing yourself to make a big bet on what happens to the stock market in your fifties and sixties,” says Nalebuff. A better strategy, say the professors, is to start with a 200% stock allocation at age 23 and scale down to 32% at age 67. “The approach works because you’re more evenly diversifying equity risk across your lifetime — it’s not as crazy as it sounds,” says Nalebuff.
It may, however, feel too crazy for you to act on. But here’s the important takeaway: Too many early-career investors are playing it too safe. The average twentysomething allocates about 75% of his or her retirement portfolio to equities, according to the Investment Company Institute. And almost 10% of twentysomethings have zero allocation to stocks. That doesn’t make any sense. At a minimum, young people should follow the 90% stock allocation followed by most target-date funds.
2. Lean into emerging markets. American investors as a group currently allocate a mere 6% of their equity holdings to emerging-markets stock funds, according to research firm Strategic Insight. For younger savers in particular, such a low proportion “makes no sense,” says Avi Nachmany, Strategic Insight’s director of research. A more reasonable allocation to emerging markets, he argues, would be one-third of their stock portfolios. “Young investors have to ask themselves what the world will look like in terms of emerging wealth and intellectual capital in 30 to 40 years,” he says.
Fears of a slowdown in fast-growing economies like China’s have caused returns for emerging markets to fall behind those of developed regions like the U.S. of late. But that just presents an even better buying opportunity, says Russ Koesterich, global chief investment strategist for BlackRock’s iShares business. He points out that emerging-markets equities are now trading for about 12 times trailing earnings, a 30% discount to developed markets. Emerging-markets stocks are infamous for their gut-wrenching price swings. To tone down the risk, focus on stocks with the highest dividend yields, which have historically delivered the best performance with less volatility. An easy way to gain exposure to a diversified basket of emerging-markets dividend stocks is through an exchange-traded fund, such as WisdomTree Emerging Markets
1. Embrace a new form of diversification. Diversification is a simple enough concept, but it can be tough to execute in volatile markets. Selling put options on stocks is one strategy the pros use to take better advantage of the stock market’s inevitable ups and downs — or even to make money when it goes nowhere. “The virtue of selling puts is that you’ll make money in a wider variety of markets,” says Ben Inker, co-head of asset allocation at investment firm GMO. “And that’s very useful diversification.” Once you understand the process, trading options is pretty easy on most online brokerage platforms.
Here’s how it works. When you sell a put option, you immediately collect a cash payment in return for agreeing to buy a stock at a predetermined strike price in the future. For instance, say you’ve been eyeing Costco stock but think the recent price of $111 a share is a little rich. If the price drops below $108 a share in the next couple of months, you’d be willing to buy it. So you would sell $108 put options on the stock today and pocket $1.50 for each share in the contract you sold. For 100 shares you’d get $150.
If Costco stock traded below $108 by the option’s expiration date, you’d be obligated to buy the shares at $108. But since you already collected $1.50 upfront, your effective purchase price would be $106.50. So for 100 shares, that would be $10,650. If Costco shares never traded below $108, the options would simply expire worthless; you wouldn’t own the stock, and you’d miss out on any upside. But you’d still get to keep the $1.50 you received from selling the put options. And that upfront payment would give you a nice return, even if Costco’s stock price went nowhere.
2. Don’t get blindsided by steep inflation. Inflation may be tame right now, but many observers don’t expect it to stay that way, given the trillions of dollars the Federal Reserve has flooded into the economy since the financial crisis. Stocks have traditionally been viewed as a good defense against moderately rising inflation, but if prices spike quickly, investors could get hurt badly. UBS analyst Stephane Deo calculates that if the inflation rate rises above 4% (it has averaged 2% over the past year), stocks will start to lose their effectiveness as a hedge; above 6.5%, stocks will rapidly become useless against rising prices, as companies struggle to pass along their increased costs to customers and profits get squeezed.
Indeed, history shows that during periods of very high inflation, such as the 1970s, stocks have performed miserably. Commodities, meanwhile, are another asset class traditionally viewed as a hedge against inflation. But they also come with stomach-churning volatility.
For more reliable protection against rapidly rising prices, consider instead Treasury Inflation-Protected Securities, or TIPS. Unlike normal Treasury bonds, the principal value of TIPS is adjusted twice a year to reflect changes in the consumer price index. Interest is based on the adjusted principal amount, so when the CPI rises, so does the interest payment. Inflation-wary investors have been flocking to them of late, driving up prices and sending yields into negative territory.
Still, the TIPS “inflation breakeven” rate — calculated by subtracting the current TIPS yield from the current nominal rate for the 10-year Treasury — now stands at about 2.1%, well below the long-run average annual rate of 3.6% since 1980. As with any bond, TIPS prices will be negatively impacted if interest rates rise, but not nearly to the same extent as regular Treasuries. And while TIPS aren’t particularly cheap now, pros like legendary bond investor Bill Gross have been buying them recently.
You can purchase TIPS directly from the government at TreasuryDirect.gov. Or you can buy them through an exchange-traded fund, such as Pimco 1-5 Year U.S. TIPS Index or iShares Barclays TIPS Bond.
1. Ratchet up your foreign bond exposure. With the exception of inflation-protected bonds, market sages aren’t showing a whole lot of love for long-term U.S. bonds these days. No less an authority than Warren Buffett recently called them “terrible investments.” What Buffett and others worry about is that bond prices have been artificially propped up by the Federal Reserve’s massive bond-buying program; once that ends, prices are bound to get whacked. For late-career savers and retirees in particular, that’s hardly an ideal scenario.
The typical U.S. investor currently allocates only 13% of his fixed-income portfolio to non-U.S. bonds, says Strategic Insight’s Nachmany. Most experts agree that a much higher allocation to high-quality foreign bonds — at least one-quarter of your total bond holdings — is more appropriate. That’s what the pros are doing: The average go-anywhere, world-allocation mutual fund allocates 40% of its fixed-income holdings to non-U.S. bonds, according to Morningstar. For investors with scant or no foreign bond exposure, “my advice is to avoid new purchases of long-term U.S. bonds altogether and start rebalancing into international bonds,” says Jason Hsu, chief investment officer of Research Affiliates.
The good news is that you’ve got a lot of choice: Foreign bonds now account for about three-quarters of all bonds that get issued worldwide. Currency movements can cause foreign bond prices to swing dramatically, so to minimize volatility, opt for a fund specifically designed to neutralize that impact. Two low-cost funds that fit the bill: iShares JP Morgan USD Emerging Markets Bond and Vanguard Total International Bond Index.
2. Park some cash outside the U.S. As you move closer to retirement, cash naturally plays a more strategic role in your portfolio. But beyond simply upping your allocation to cash, it also makes sense to hedge against the possibility that a falling U.S. dollar could hamper the future purchasing power of your savings. To be sure, the U.S. dollar has been showing signs of strength lately. The economy has continued to improve, and at the same time, governments around the world have been deliberately weakening their currencies against the U.S. to make their exports more competitive.
But much can change over the long span of your retirement. At the very least, concerns about the U.S. dollar still abound. The federal debt burden is ballooning, entitlement spending continues to escalate at an unsustainable pace, and trade imbalances with emerging countries are gaping wider. “In the long run we would expect the dollar to weaken, especially against emerging-market currencies,” says Hsu.
To hedge against this possibility, you can park some of your money in a U.S. bank account that offers foreign currency investments. Florida-based EverBank, for example, offers short-term certificates of deposit denominated in baskets of foreign currencies. The CDs are FDIC-insured and pay interest based on the rates prevailing in each relevant country.
Or you might consider moving a modest portion of your cash into an unhedged emerging-markets bond fund — one that packs the full punch of currency swings. They’re a riskier option than CDs, but the bonds’ higher yields (currently averaging around 4%) help to compensate for it. WisdomTree Emerging Markets Local Debt and Market Vectors EM Local Currency Bond are two low-cost choices. And successful investors must be willing to take the right risks.
This story is from the July 1, 2013 issue of Fortune.