James d. Gwartney

ELEMENT 4.10
Invest in stocks for long-run objectives, but as the need for money approaches, increase the
proportion of bonds or even cash.

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specific stream of real purchasing power from their assets.
(121)
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 €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 is more volatility (or risk) than
you want to take if you are saving for something you expect to buy in five years. If you hold
the bond for the full thirty years, however, you will get back your entire €1,000 and the price
changes that happened while you held the bond no longer matter. So this is a good reason to
match the maturity of the bond to when you need the money.
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 in order to place 20 percent down to buy a house or flat may
be better off avoiding the stock market entirely—for that portion of their savings only—and
investing it in bonds. That is because purchasing a house or condominium often involves
saving for just a few years. In contrast, a couple might save for eighteen years to finance a
university education for a newborn or thirty-five to forty-five 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 the 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. As the plunge in stock prices during the Great Recession of 2008–2009 illustrates,
however, even with an eighteen-year horizon, stock holdings involve risk. Again, investors
seeking to reduce risk in their university funds can do so by holding fewer stocks and more

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bonds, especially as the time approaches when the funds will be needed. Investing a certain
amount each month has an important role in improving your returns: If the market drops, you
will be buying the new stocks more cheaply, which smooths out the impact of the downturn.
As people earn more and live longer, saving for retirement expenses becomes ever
more important. We don’t 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 probably makes the best investment
portfolio. For the more conservative saver, having 10, 20, or even 40 percent of one’s portfolio
in bonds or cash 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 most wealthy
among us to begin to switch 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
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.
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% of the person’s salary, and investment return is not
taxed, so the total accumulates faster.
(122)
 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.
(123)
 While some CEE countries do
not have private pension investments available yet, there is a global trend to increase voluntary
pension contributions through tax incentives. If you can’t access tax-advantaged private
retirement accounts, continue to save; that way, when the accounts become available, you will
be able to save the maximum allowed amount each year.
So far we have talked about risks from the financial market, but there is another,

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perhaps much more important risk in saving for retirement. No one knows for sure how much
longer they will live. All we know is the average life expectancy (perhaps adjusted for past
behavior such as smoking or drinking). In Poland or the Czech Republic, a 60 year old can
expect to live for another 21 years, but some will die next year and some will live to be 100.
How do you plan for such uncertainty? One possibility would be to save as much as you might
need if you lived a very long life. Then, if you died sooner, arrange to leave your savings to
your family or a worthy charity (perhaps supporting economic education!). Most risk-averse
people, however, choose another option. While it is impossible to know how long any given
individual will live, demographers can predict very accurately the average remaining life
among any group. Just like other types of insurance discussed in Element 4.12, you can insure
yourself against living “too long.” Since actuaries can precisely predict how long the average
member of a group will live, why not just pool everyone’s savings and let those who die soon
subsidize those who live longer? Such an agreement is called an “annuity.”
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 any favorable tax treatment provided for retirement
plans.
There are many things to watch out for in deciding how and where to invest. You
should keep these warnings in mind.