Avoid This Very Stupid Way to Invest Your Money
Does the stock market get less risky over time?
There are few things that financial advisors, finfluncers, and economists all agree on.
One of those rare issues of agreement is that younger people should invest a higher percentage of their money into risky assets like stocks.
While nearly everyone agrees with that statement, they take very different routes to arrive at that conclusion.
In this entry of Calling Financial Bull$hit, I explain why investing in stocks does not get less risky with time and lay out a more rational way to determine how much of your money you should invest in risky assets.
The “time horizon” argument financial advisors like to make
When I used to work as a financial salesperson advisor, one of the first things I was taught was that a client’s “time horizon,” aka years until retirement was the most important factor to help determine how aggressive their portfolio should be.
The argument often goes that younger people should invest heavily in risky assets like stocks because, given their long-time horizon, they have more time to recover from a stock market crash.
This is often referred to as “time diversification,” where the central argument is that risky assets like stocks become less risky over time.
Here’s what proponents of time diversification get right:
The longer you invest and the more consistent you are with your investment and savings, the higher the probability of a successful outcome.
As I write in The Rational Investor, nobody in history has ever lost money when they bought an S&P 500 index fund and sat on it for 20 years.
I am not here to argue against long-term investing strategies. Keeping your money invested for as long as possible remains the most rational strategy to accumulate wealth and has a near-perfect track record for index investors.
But…
It’s important to remember that a long-time horizon does not make the stock market “less risky.” If the stock market is risky this year, it's just as risky 10, 20, or 50 years from now.
If an asset is risky, it will always be risky, no matter the time frame.
All that matters is your ability to handle that risk, which means assessing your risk tolerance and capacity to handle downturns in the market.
The concept of Time Diversification is not Financial Bull$hit, but it doesn’t give the complete picture when it comes to deciding how much to invest in stocks.
How Economists think about asset allocation
If you were to ask an economist why young people should invest more in stocks than those in or near retirement, they would tell you it’s all about building a balanced portfolio.
Young people and older people likely have a similar amount of wealth, just in radically different forms.
The old are rich in financial capital. After a lifetime of saving and investing, people in their 60s and 70s tend to be flush with cash, stocks, bonds, and real estate.
The young are rich in human capital. Your human capital is your ability to earn a paycheck. The more paychecks you have left to collect in your life, the more human capital you own.
If you’re 25 and plan on working until 65, you have as many as 1,040 paychecks left to collect in your life. These paychecks you have yet to collect are nothing but a stream of future cash flows. Like any stream of future cash flows, economists can put a present value on them.
If you have 40 years of future cash flows (paychecks) to collect, the present value is probably as big as a retiree’s 401k + the value of their house.
If you have a 9-5 job, the paychecks you collect look a lot like coupon payments from a bond. Every two weeks, the same amount of money hits your bank account like clockwork, just like a bond.
Economists look at your total portfolio as your financial capital (stocks, cash bonds, etc.) + your human capital (value of future paychecks.)
Young people should load up on stocks because they are potentially sitting on millions of dollars worth of “bond-like” human capital. In comparison, they probably have very little risky financial capital like stocks.
The economist would look at this and say that the young person’s total portfolio (financial + human capital) is too concentrated in bonds (future paychecks.)
An economist would say that young people must over-invest in stocks because they already have too many bonds in their portfolio of human capital. That means their financial capital needs more stocks to balance out their total portfolio.
If your human capital is the present value of future paychecks, what happens when you retire? You have no more paychecks, and your human capital is $0 (assuming you don’t work in retirement.) As you age and your human capital dries up, you begin derisking your financial capital.
By the time your human capital is worth $0, you transition to living off your financial capital. To maintain a properly diversified portfolio, you should have a more balanced mix of risky stocks and less risky bonds.
Why not stay heavily invested in stocks during retirement?
Because the stock market remains incredibly risky. If 100% of your retirement income comes from the stock market, what happens if your portfolio gets cut in half two years into retirement?
You’ll run out of money.
Your total portfolio should always have a balance of stocks and bonds.
Stocks to grow and bonds to provide steady, predictable income. When you’re young, your bonds come in the form of human capital. As you age and you have fewer paychecks to collect, your bonds should come in the form of literal bonds in your portfolio of financial capital.
(That explanation of human/financial capital was lifted from my book The Rational Investor. If you found that useful, pick up a copy of the book for 280 pages filled with that type of analysis.)
A very stupid way to invest your money
Let’s recap what we have learned so far.
The longer you stay invested, the better your odds of success.
When deciding how much to invest in stocks, consider your total wealth, which is your human capital + financial capital.
Let’s discuss in more detail how you might go about choosing an asset allocation between stocks and bonds.
A very simple—and very dumb—way to approach that question would be to use the rule of 110.
The rule of 110 states that the amount of your portfolio you allocate to risky investments like stocks should be equal to 110 minus your current age.
A 20-year-old using the rule of 110 would have a portfolio of 90% stocks and 10% bonds.
A 60-year-old using the rule of 100 would have a portfolio of 50% stocks and 50% bonds.
Every rule of thumb makes a trade-off between simplicity and accuracy.
Sometimes, that trade-off is tolerable, especially simple modifications that can be made to the rule of thumb.
The rule of 110 is too simplistic and only considers one factor, the investor’s age. It largely ignores the two most important factors in determining asset allocation:
Yorisk toleranceisk—How likely are you to panic when the market dips?
Your capacity to withstand risk— how secure is your income and what other assets and income streams do you have?
The rule of 110 is Financial Bull$hit and should be thrown in the garbage.
There is an actual equation to answer this question
In his brilliant book "The 7 Most Important Equations For Your Retirement,” Moshe Milevsky does what economists do and creates a formula for how much you should invest in stocks.
Here's the equation (it looks intimidating, but I'll explain it)
Ψ= 1/γ(HC + FC) (μ-R/ σ2)
Where;
Ψ= The amount of dollars you should have invested in the stock market.
γ= Your level of risk aversion ( on a scale of 1-8)
HC= Human Capital= The present value of your net take-home pay between now and retirement.
FC= Your current amount of financial capital
μ= Expected return of the stock market
R=The expected rate of return on risk-free assets.
σ2= Expected volatility of the stock market.
Is it reasonable for anyone reading this to be able to accurately come up with the assumptions required to use this equation?
No.
But, if you're paying a financial advisor to help you manage your money, they damn well better be able to sit down with you and build an estimate using this framework.
7 Simple takeaways
The more squeamish you get about investment risk, you should invest less in stocks—Vanguard’s risk profile tool is a good place to start thinking about this.
The more paychecks you have left to collect, you should invest more in stocks.
Higher job security= more capacity to invest in stocks and vice versa.
Multiple income streams (either yours or your partner's)= more capacity to invest in stocks and vice versa.
The higher the expected return in the stock market, you should invest more in stocks.
The more financial capital—stocks, bonds, cash—relative to your cost of living, the less you need to invest in stocks going forward.
The higher the rate of risk-free assets like government bonds, the less you should invest in stocks.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
Very interesting equation. It does however ask you to tactically shift your asset allocation between stocks and bonds as risk free rate changes, and potentially having you inadvertently sell low and buy high, no?