When doing work with clients, I have several ways to determine the correct allocation they should have to stocks and bonds. More often than not, I find that clients are over allocated to stocks and are therefore taking more risk in their portfolios than is needed. Today, I want to discuss why investing more conservatively is usually better at helping clients meet their financial goals.
Having a lower allocation to stocks may seem counterintuitive but it would help you reach your goals with less risk.
When we run simulations for clients, one of the items we check is the impact of the allocation on the success. By reducing the client’s stock allocation, they are usually surprised that their rate of success increases. The reason is twofold, by limiting risk you keep more of what you earn, and you are also more likely to stick to your investment strategy. Our planning model can quantify the effect of keeping more of what you earn, but it can’t quantify the likelihood that a client’s investment strategy will change during the downturn. Therefore, the increase to success is probably even greater than shown in our Monte Carlo simulations!
When we are determining a client’s rate of success, we are rarely aiming for an infinite amount of money. Instead, we are trying to get the client through their lives while having enough money to meet their spending needs, while also leaving some assets to their heirs. Our goal is a number greater than zero. Some clients have an inheritance goal, say $1,000,000 per child, and this is still much easier to target than “as much money as possible.”
How Much Risk to Take?
Because we are shooting for an actual number, we can determine the minimum rate of return to reliably reach this figure. Any deviation from this rate of return can be defined as “risk.” To reach our goal, we want to stay as close to on track as possible.
Usually, investors don’t view above-average returns as risk. Therefore, when stock markets are trending upwards, investors tend to increase their allocation to stocks in order to grab the higher returns. This increases the percentage of stocks in their portfolio in two ways. Firstly, they are either selling other assets and moving them to stocks or they are simply adding more money to the stock portion of their portfolios. Secondly, the overall value of the stocks are increasing, which in and of itself would increase the percentage of stocks in their portfolio. This often makes investors over allocated to stocks in the latter part of a bull market.
When the downturn comes, those investors will likely experience outsized losses in their portfolios, especially compared to their original expectations. For example, if you started out investing 60% in stocks and the market increases by 100%, you will now have a 75% stock allocation if you did not rebalance. The normal portfolio decline in a bear market is 21% for a 60% stock investor. However, since the stock allocation is now at 75% this investor has an increased decline of 26%.
The takeaway here is to determine the required rate of return to meet your goals. It’s easy to find historical rates of return for stocks and bonds, so with the target rate of return, it should be fairly easy math to come to a portfolio allocation. In my planning process, this is one of the three pieces of the puzzle we use to come to a recommendation on portfolio allocation.
Keeping What You Earn
I would submit that limiting your risk allows you to keep more of what you earn, rather than giving a large portion of it back when the next downturn comes. With that in mind, lower stock allocations through rebalancing may limit the upside, but it also limits the downside and can actually increase terminal portfolio value after a full stock market cycle.
For argument’s sake, please endure my simplified math of investment returns. I have used a 12% rate of return for stocks and zero for bonds. I chose these numbers due to the “Rule of 72” which tells you how long it will take (approximately) for your money to double.
If you invested $10,000 with an original allocation of 60% stocks and 40% bonds, after a 100% increase in stocks over six years, your account will likely have $15,840 in it. If stocks then decline by 35%, you will end up with $11,700.
Alternatively, if you maintain your 60% allocation to stocks by rebalancing the portfolio at the end of the year that your allocation rises above 65% stocks, you will have a total account value of 15,300. If stocks now decline by 35%, your 60% allocation will limit portfolio losses to 21%, or a decline in portfolio value to $12,100.
By using a properly allocated and rebalanced portfolio, you will have less of a wild ride up, but save yourself the terror of the rollercoaster ride down.
Keeping Emotions in Check
With the above examples, would you have stuck it out during the downturn? In reading the first example, I’m sure you would have been emphatic that you would have stuck to your guns. However, after reading the second example, maybe you’re not so sure.
I think that educated investors know that their stocks are not going to go to zero. Therefore, during a downturn, they’re not thinking about losing all of their money forever. Instead, the siren song of “they’re not losing as much as me” or “maybe I was taking too much risk” creeps in and they change their allocation at or near the bottom. It’s the comparison game that comes in to bite us!
It’s important to manage your emotions as an investor. I think the easiest way to do so is to dial back your risk when times are good, so to limit your risk during those downturns. Sure, the loss of upside will be painful, but let me be clear, the pain in the downturns is exponentially worse!
The best way to systematically reduce risk is by rebalancing when your allocation gets out of whack. This works during the downturns as well, allowing you to replenish your stock allocation as markets are falling and stocks get cheaper. Once again, this takes emotions out of the picture, allowing you to maintain the target allocation and make purchases while others are running from stocks.
Academic literature would say that rebalancing hinders accumulation of wealth, since letting your stock allocation continue to rise will statistically increase future returns. The higher stock allocation is self-perpetuating since stocks rise more often than they fall.
However, if your ultimate goal is to reach the end of your life with enough money to meet your spending needs and leave money to heirs, you don’t need to target infinity, just a number greater than $0. Limiting your risk, while eliminating the chance to reach infinity, will allow you to sleep better at night, all while helping you achieve your goals. Heck, it may allow you to live longer by reducing the chances of a heart attack when you open those brokerage statements way in the future!