Gen Y: Learn to live with stock market risk

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In the University of Western Ontario employee pension plan, the youngest members are among the most safety-conscious as investors. The younger you are, the better positioned you are to live with stock market risk. And yet, Western employees under 25 have an average 58.8 per cent of their portfolio exposed to stocks in their defined contribution pensions, while those aged 25 to 30 average 60.4 per cent. Those numbers sound about right for someone who is between 50 and 60, not a young adult with 40-odd years to go until retirement. "We feel they're too low," said Martin Belanger, director of investments at Western.

One of the most counter-intuitive investing stories of recent years is the marked preference of young adult investors to invest conservatively. A 20– or early 30-something might have 35 to 40 years of investing until retirement, a perfect time frame for benefiting from the stock market's high long-term rates of return.

Young investors can go as high as 90 or even 100 per cent exposure to stocks. Or, they can put an emphasis on safety and split their portfolios 50-50 between stocks and bonds. What's important is to understand the trade-offs of both approaches and make an informed choice between them. Invest with your brain, not your gut.

I've been writing all week about the problems that the young adults of Generation Y are having in establishing their financial independence from their parents. Members of Gen Y find it tough to save for retirement, and many are doubtful that they'll ever be able to retire. These challenges put all the more onus on young adults to get their investment plan right.

Fear of stocks is a big issue for young investors, and not just those in Canada. A U.S. poll done in April found that just 27 per cent of 18– to 29-year-olds reported owning stocks either directly or through funds, down from 33 per cent in April, 2008. Mr. Belanger said it's possible the 2008-09 stock market crash has traumatized those who are new to investing. "Young people may have been scared more than those who have been investing for a longer time."

Western's pension plan offers a choice of 15 low-cost pooled funds, including stock and bond funds and balanced funds that mix both in varying degrees. The default investment for members who do not pick their own mix is a balanced fund with 70 per cent of its holdings in stocks.

The youngest members of the plan have considerably less exposure to stocks than this, which tells us they have taken steps to reduce their stock market exposure. Mr. Belanger asked a university pension and benefits consultant about the mindset of young adult investors, and was told that they're shying away from stocks because they fear losses and prefer to wait and get more comfortable with them.

"The problem with doing that is that they tend to wait for the stock market to have a good run before they decide to invest, which means buying at the top and potentially suffering a loss soon after the investment is made," Mr. Belanger said in an e-mail.

Members of the Western pension plan in the 40-to-45 age range have the highest stock market weighting, on average, at 66.1 per cent. At the fund's annual meeting earlier this month (full disclosure: I was paid to give a talk on retirement trends at this event), Mr. Belanger suggested that a 90-per-cent weighting in stocks was reasonable for young investors.

He wasn't recommending this portfolio mix, just pointing out that so-called target funds catering to investors retiring in 40 years have an average of a little more than 90 per cent of their assets in stocks. Target funds gradually ratchet down your stock market exposure as you approach retirement in a particular year in the near, medium or long term.

If you're not in stocks, then your choices as a young investor are basically bonds and cash. Neither are likely to fall as much as stocks, nor offer returns equal to stocks over a period of decades.

"Over a 10-year horizon, equities typically do better than bonds," Mr. Belanger said. "The odds that an equity investment will generate less than bonds over 40 years? I don't see that happening."

Justin Bender, a portfolio manager with PWL Capital, suggests young investors go with a mix of 25 per cent bonds and 75 per cent stocks, the same blend he uses (he's 32). He's not militant about this asset mix, though. Far more important than the mix of stocks and bonds for young investors is the commitment to regularly put money aside.

"If they're not saving or accumulating anything, their asset allocation decision probably isn't going to have a huge impact," Mr. Bender said. He believes asset mix starts to have a bigger impact when a portfolio reaches $50,000 to $100,000 in value.

Mr. Bender does have a couple of cautionary notes for conservative investors, though. One is that the lower returns from owning less risky investments means a person will likely have to save more over a lifetime. If you invest $1,000 annually for 10 years and get a return of 6 per cent annually after fees, you'll end up with $13,792. To end up with roughly that much at a 3-per-cent annual rate of return, you'd need to invest 17 per cent more each year, or $1,170.

Also, conservative investors must be especially careful about controlling fees. With yields on bonds and guaranteed investment certificates topping out in the 2-per-cent range for five years or less, fees will bite deeply into returns.

If the 2008-09 crash is your rationale for a fear of stocks, then you're misreading history. For long-term investors, the lesson of that event is that the market can come back even from historically awful setbacks. As of April 30, the 10-year annualized return from the S&P/TSX Composite Total Return Index was 8.8 per cent (that's share price changes plus dividends). Lodged somewhere near the middle of that period was the 33-per-cent decline in 2008.

Young investors should tap into this power to generate long-term gains to whatever extent they can. Invest aggressively, or be prepared to save aggressively.