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How should you invest your retirement dollars? That depends on your age, your risk tolerance, and your financial goals. But it also varies with what you assume will be the long-term average annual rate of return for stocks. Until recently, most planning tools would use about 10%--the average for the past 75 years--unless you specifically substituted another figure.
Now, the defaults are dropping, too. For instance, T. Rowe Price's retirement calculator assumes that large-cap stocks will deliver 9% a year, lower than the 9.7% average return for stocks from 1926 through July 23 of this year. Even that may be too high. "Almost every money manager we talk to says a reasonable rate of return for the S&P 500 index going forward is in the 7%-to-7.5% range," says Jeremy DeGroot, director of research at Litman/Gregory Asset Management, a mutual-fund-research and money-management firm.
Such reduced expectations can have a profound effect on how you invest your 401(k). If stocks deliver only 7% over time, they don't look so attractive relative to bonds anymore, and you may not wish to commit as much money to them. After all, long-term government bonds yield around 5%--and you know you'll get your money if you hold them to maturity. Investment-grade corporate bonds pay 6.5%, and high-yield bonds more than 11%. Sure there's more risk in those bonds, but not as much as in some stocks. That's why DeGroot has been recommending high-yield-bond funds as a substitute for equity.
There's a term for moving money around to take advantage of changing valuations and risk: tactical asset allocation. For such a strategy, an investor makes a forecast on an asset class or sector and overweights or underweights it accordingly. The moves are usually short-term: They end when the extremes in valuation return to normal--and they're small bets on the margin. You never jettison your entire equity stake to buy junk bonds.
Tactical allocation is the next step after the more familiar strategic asset allocation. That's the process in which you determine an allocation of stocks, bonds, and cash--based on your risk tolerance, time horizon, and investment goals. But lately, because the market has been so volatile, it may be advantageous to tweak allocations on the margin.
How much shifting should you do? That depends on how confident you are in the call you're making. DeGroot, who does this for a living, will shift as much as 20 percentage points away from his clients' target allocation (table). Jerry Wade, a Minneapolis financial planner, overweights or underweights as much as 5% in stocks relative to bonds, but will do more shifting within the asset classes. "We might tilt more towards value stocks, or more towards growth or international or small-cap stocks," he says.
The moves can be subtle as well. You may decide to leave your current holdings untouched but direct future 401(k) contributions to a sector that seems the most promising. That could be junk bonds, real estate investment trusts, or even beaten-up tech stocks. Regardless of what they are, your tactical shifts will require a shift in your thinking. By Lewis Braham