Question from Fahd Pasha from our Globe Money Facebook group: As a 27-year old, with enough cash in the bank for emergency funds, is it acceptable to put 90 per cent my investments in products that are 100-per-cent equity-based? Keep in mind I have a huge tolerance to risk, and don’t plan on pulling funds until I am well into retirement years. Thoughts?
Benjamin Felix is an associate portfolio manager with PWL Capital in Ottawa.
Answer from Ben: The optimal mix between stocks and bonds is not something that can be determined without the benefit of hindsight. There are lots of rules of thumb out there, such as investing in the percentage in stocks equal to 100 minus your age, but they are probably not prudent rules to live by. Each individual has unique circumstances, knowledge, and perceptions that are not captured in a general rule. Some of the most sensible literature on asset allocation has been written by Larry Swedroe, who approaches asset allocation based on the ability, need, and willingness to take risk.
Before we jump into these three elements of risk, we have to define what exactly risk is. How we measure risk varies according to individual circumstances, but the ultimate definition is the probability of failing to achieve your goals.
I think that the most common definition of risk in people’s heads when they think about investing is the risk of losing all of their money. Losing all of your money is a material risk if you are investing in individual stocks. One company, or even 10 companies, could go bust. If you only owned those 10 companies you would lose all of your money. That is called company-specific risk. It is relatively easy avoid most of this risk by diversifying through low-cost index funds.
In a diversified portfolio of low-cost index funds, the main risk is the risk of the overall market. The market will certainly go up and down over time, which is called market volatility, but it is unlikely that the whole market will go to zero. If the whole market does go to zero, and stays there, capitalism, by definition, has failed, and the value of your portfolio is irrelevant.
Someone who is relying on their portfolio for income may well define risk as volatility, which is the traditional definition of risk used to talk about financial markets. If you are 65, retired, and fully reliant on your portfolio for income, then volatility has the potential to cause you to run out of money earlier than you would hope to. This is simply because you need to sell pieces of your portfolio over time to fund your lifestyle. In a market crash, you are forced to sell your assets when they have fallen in price. A riskier portfolio consisting of more stocks will fall more in a crash, exacerbating the problem.
However, a younger investor with stable income should not just completely ignore volatility, they should get excited about it, as it is an opportunity to buy cheap stocks. Volatility is probably not a sensible definition of risk for this younger investor. A more accurate definition might be the risk of having expected returns too low to meet their goals. For example, the lower your expected returns are, the more of your income you need to save, or the longer you need to work, to fund your lifestyle in retirement.
Whether we define risk as company-specific, volatility, or the risk of a shortfall in expected returns, there is another definition that might be more important. At any stage of life there is a substantial emotional risk to investing in risky assets. This risk may materialize as stress. In a worst-case scenario it could materialize as fear that leads to selling at the bottom of a market crash, and not getting back in for the recovery. This is an important consideration for any investor. An argument could be made that the younger investor with stable income should have more emotional capacity for drops in the market. However, this will not hold true for everyone, and may not be a realistic expectation.
Back to Swedroe’s elements of risk: The ability to take risk depends on both your investment time horizon (how long before you need the money) and your human capital (how stable is your ability to generate income?) If you have many years of work ahead of you, and you are confident that you will be able to maintain sufficient income from employment through a market crash, then you have the ability to take on lots of volatility in your portfolio.
The need to take risk speaks to your current financial position. If you have recently sold your start-up for $10 million, or know that you will receive a large inheritance, you may not need much risk in your portfolio to meet your goals. On the other hand, if you are starting from scratch and saving 20 per cent of your income, you need risk in your portfolio if you want to retire at a reasonable age with a reasonable amount of income.
Finally, even if you have the ability to take risk, the biggest constraint is often your willingness. Keeping in mind that volatility is not a real risk to a long-term investor, you still need to be comfortable with significant drops. To get a feel for this we can look at a set of portfolios consisting of the CRSP 1-10 index (U.S. total stock market) and 1-month U.S. Treasury bills to see the total drop over the worst 12 months going back to 1926.
These are extreme outcomes, but the point stands that to be a 100-per-cent equity investor you need to have the stomach to handle substantial drops. At the same time, there has been a meaningful long-term benefit for allocating more to riskier stocks. We can observe this benefit again using the CRSP 1-10 and Treasury bills, keeping in mind that the U.S. stock market has historically outperformed every other market. It goes without saying that history will not necessarily repeat itself. In any case, we can draw some insight from the relationship between risk and long-term wealth. I have looked at the trailing 30-year period ending Sept. 20, 2018.
The results are meaningful. After 30 years of accumulation, if we assume a 30-year retirement period with a 3.5 per cent withdrawal rate, the 100-per-cent equity accumulator would have a sustainable income from their portfolio of nearly $74,000, while the more conservative 60/40 accumulator would have about $33,000 to spend.
For young investors with a stable income and an ability to either ignore the market or stomach large drops, I see no problem with a 100-per-cent allocation to stocks; that is where your expected returns are highest.
To answer you question, Fahd, if you are comfortable with the potential for large drops, I see no reasons that you would not allocate 90 per cent or more of your long-term assets to stocks.
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