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moneysense.ca, 11/02/08
How Much in Equities?
The portion of your portfolio that should be allocated to equities depends on your ability, willingness and need to take risk. One of the factors affecting the ability to take risk is time horizon: investors with a long time horizon can allocate a greater percentage to equities than investors with a shorter time horizon. Larry Swedroe in Rational Investing in Irrational Times provides the following guidelines for the maximum equity exposure depending on time horizon:
0 to 3 years – 0%
4 years – 10%
5 years – 20%
6 years – 30%
7 years – 40%
8 years – 50%
9 years – 60%
10 years – 70%
11 to 14 years – 80%
15 to 19 years – 90%
20 years or longer – 100%
Note that other factors such as your willingness and need to take risk will determine how much you actually allocate to equities. I found this table interesting because it provides a rough guideline of how much could be allocated to equities.
moneysense.ca, 11/02/08
I suppose a lot of it depends on one’s income from their portfolio. If someone is wealthy, with a $10 million net worth, and generates $200,000 in dividend income, why not be 100% equities, assuming they can live below their ample means?
I think a more useful way of looking at it might be to think of a portfolio’s depletion. If one can live off 2% of a portfolio, there is no need to get out of equities. It could be argued that if someone nest egg is too small for retirement, they should stay in equities as long as possible to try to grow it, but that would be a contentious issue, for sure, since although stocks have a higher average return than bonds and bank accounts, the risk of loss in short time periods is higher.
The formula is certainly concise and easy to apply.
Withdrawals from my son`s RESP should start within 5 years. We`ve invested 100% in equities and the formula says 20%. That gives something to think about.
My Dad is almost 80 and is 100% invested in equities and always has been. The main difference is his is investing for dividends and not for capital gains, so the fact that the banks declined 25% this year doens’t matter to him. Actually on his DRIP stocks where he is reinvesting his dividends it actually helps. Outside of my Wife’s locked in RSP I plan to do the same.
A far more important concern should be not your fixed income to equities ratio but how much your MF is gouging you on fees.
Riscario Insider, your situation is much different as you planning on w/d the money when/if your son goes to college. A bear market could dismate your holdings.
I haven’t read Swedroe’s book, but I’d be curious to know how he justifies this rule. I’m less conservative than this. As it happpens, my post today is on the subject of asset allocation and how conservative invesors are: link.
Michael: I’m more conservative than Swedroe’s suggestion too. And time horizon is only one consideration – willingness and need to take risk should also be considered.
What is the time horizon here? Til death or til retirement? I’ve always thought that you should have some equity exposure in early retirement at least (say 10-15%).
noblea: Considering someone retiring at the traditional age of 65 has about a 25 year horizon (between two spouses), I would say a retiree has to keep a portion in stocks as well.
One should always have diversification in their portfolio. One asset class acts as a hedge against others, and helps to smooth out volatility in the overall portfolio. While it is commonly agreed that equity exposure should be reduced as one gets closer to retirement, I don’t see the justification for having no equity exposure at all. It would actually add risk and volatility!
There is definitely risk in cash and bonds and that is you do not keep up with inflation. Not a problem on short horizons, but a huge problem on long term portfolios.
Most RSPs are very long term portfolios. Even someone just retiring may need their money to last them 20-30 years.
Bond returns over the last twenty to thirty years have been pretty strong because of a long general decline in interest rates (bond prices move inversly with rates).
If we are at the beginning of a long-term increase in rates (and I would argue we are), then the future real return from bonds will be negative.
In my humble opinion, people always overestimate risk to their principal at the moment, and always underestimate the risk to purchasing power over time.
Stocks provide better protection to inflation because when prices rise, a company can raise their prices too. Bonds can’t do this (real return bonds being the only exception).
For my money, I feel much safer in a portfolio of high-quality stocks (banks, insurance companies, retailers, etc) bought at low prices (low PE, so not the prices you have to pay for hot names such as, say, Apple, RIM or Google).
I think the risk adjusted returns will be far, far higher with the stock approach.
It is not being ‘tolerent’ to risk, it is understanding exactly which risks you are taking when you invest – and then making sure you are compensated appropriately.
Rob: I would argue that stock returns have been boosted by the same fall in interest rates boosting the price investors are willing to pay for a dollar of earnings.
In Chapter 2 of The Intelligent Investor Benjamin Graham discusses inflation and shows that there is no proof for the theory that inflation boosts corporate earnings (and stock prices) in past experience. In a period of sustained inflation, stocks are likely to offer more protection than bonds but no certainty that the protection will be adequate. That’s why we diversify, holding stocks, bonds, REITs and some real-return bonds.
CC – good point that stocks would also receive a boost from falling rates, but I still think the rate sensitivity of bonds and preferred shares would be higher than common stocks.
The Intelligent Investor was first published in 1949 and – while it is probably the best book ever written on investing – it does not cover the massive inflation in 1970s and early 1980s. It would be interesting to see a more recent study – there must be some acedemic somewhere that has looked at this with more recent data.
I am not saying that diversifying is a bad thing. Only a fool would argue that. I am saying that inflation is the major foe and first basic hurdle you must overcome in your retirement savings. Real return bonds are good, but priced so dear because there are not enough of them (let’s hope this changes). Real estate goes through long up and down cycles, so you have to buy in lows…and most people have so much of their net worth tied up in real estate, I question the diversification benefits to the majority of savers reading this blog.
I get your point and I have zero doubt your portfolio is well balanced and performing strongly.
A high quality stock portfolio will have bigger ups and downs than a portfolio with several low correlated asset classes. At the same time, for long term money when I am just under 40, I still feel so much safer in high quality stocks.
I think the size of your portfolio relative to your income can play an important role in how much you can allocate to equities. For example, experiencing a 20% decline in a a $10K portfolio would feel much different than a 20% decline in a $100K portfolio.
Rob: Actually, I was mistaken that the Graham book was dated as well (I purchased the first edition) but Graham updated it roughly every five years and the tables I found is from the last edition (1972) of his book with commentary by Jason Zweig.
I agree with your point that (long) bonds will almost certainly suffer in a period of high inflation. I’ll also agree that stocks are more likely to provide some inflation protection. I’m certainly not advocating buying any asset class at any price. I guess my point is that stocks will likely provide some protection against inflation but there is no evidence that earnings keep up with inflation (at least according to Graham).
yhat: I agree with you that an investor’s perception of risk changes over time. Someone with a $300K portfolio will probably look at a 20% correction and think “I’ve just lost x years of savings!”.
CC- I have read that book four times in the last 15 years and every time I get more out of it. It is a classic in every sense of the word.
The final edition of 1972 is still before the major inflation that started around the Vietnam war and continued into the early eighties. Graham was a stock picker, not an economist, and there must be a economic study on that with current data.
Without having that however, let’s look at another approach. If inflation is going up, other than higher possible borrowing costs, it may lag slightly in the short run but why would earnings not keep pace? Even borrowing costs would only apply in the short run becuase economic laws dictate that supply would be cut if required returns are not there, and revenues will subsequently rise. Higher input costs, including higher borrowing costs, are just higher revenue to other businesses. Lastly, people accelarate purchases in inflationary times because prices rise if they wait.
In other words, the money has to go somewhere. If labour prices rise, then there is more money to accomodate businesses to raise prices. Where is the money going if not to also going to earnings?
I think all your points are valid CC, and I don’t suggest for a second that you would buy an asset class regardless of price. Your point that equitie returns may not be sufficient to keep pace with inflation is certainly fair and valid. I think the risk adjusted returns of an slight laggard in equities, beats the return give up required to receive an exact inflation hedge (say real return bonds as the market for them exists now).
As always, love the blog and your approach to objectively exploring financial issues and sharing your thoughts and analysis with your many readers.
Hi Rob: Inflation has two opposing effects on stock prices: one is the positive effect on earnings as you point out (revenues rise as price of goods and service rise and a portion of it, if not all, falls to the bottom line) but the other is the negative effect of a higher discount rate demanded by investors to invest in equities. The question is which effect is stronger. I’ve tried to Google for papers on this topic and have so far come up empty. I’ll keep you posted if I am able to find some research that sheds light on this topic.
The following is an excerpt that I’ve taken from Bogleheads.org web site. For retirement purposes, it implies that you need 1 year’s income in a money market fund and 5-7 years of income in short term bonds. If you want to be more cautious, the number of years of income in bonds can be increased. The rest of your portfolio can be in stocks.
A Longer-Lasting Portfolio
To make your retirement portfolio last, follow this strategy devised by financial planner Frank Armstrong.
1. Divide your assets into three parts: cash, bonds, and stocks.
2. Keep one year’s worth of living expenses in cash. That’s the money you’ll be living off of, so a money-market account will be fine. You want a year’s worth of expenses because you don’t want to dip into investments when they’re down. You don’t want to put much more in the cash pile, though–you could miss out on some of the gains you’d get from investing.
3. Put between five and seven years’ worth of living expenses in a short-term bond fund. This is the key to the strategy: Seven years would have carried you through the longest stock-market declines in U.S. history. This should allow you to survive a down market without selling your stock funds.
4. The rest of your portfolio remains in a diversified collection of stock mutual funds.
Setting the Plan in Motion
For convenience, have your funds pay dividends or capital-gains distributions into your money-market account. That means that you won’t have to sell as many shares to refill your money-market account yourself, which will limit additional capital-gains taxes. At the end of each year, transfer whatever amount you need to keep a year’s worth of living expenses in the money-market account.
Where will the cash come from?
That depends on how your bond and stock funds performed in the previous year.
Scenario One: Bonds and stocks are both up for the year. In this case, reduce your bond position so that it once again covers seven year’s worth of expenses before you tap into your stock funds. Your stock funds are the fuel for your portfolio, so the less you have to draw on them, the better.
Scenario Two: Stocks up, bonds down. Replenish your money-market account by using the gains from your stock funds first. Don’t dip below their profits for the year, though, because that would cut into your principal. If your stock gains aren’t sufficient, make it up by selling bond funds. Fill your bond stake again with future stock gains.
Scenario Three: Stocks and bonds are both down. The golden rule of this strategy is to never sell stocks when they’re down. Draw on the bond funds instead–that’s why you have seven years’ worth of living expenses in them. Restore your bond stake by selling stock funds the next year they gain ground. Remember not to sell off more than you made, though.
Scenario Four: Stocks down, bonds up. As I mentioned in the third scenario, the golden rule of this strategy is to never sell stocks when they’re down. Draw on the bond funds and restore your bond stake by selling stock funds the next year they gain ground. When you restore your bond stake, remember not to sell off more than you made in stocks, though.
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The portfolio I suggested above would be a simple solution, that you could work into the “Longer Lasting Portfolio” withdrawal strategy proposed by Frank Armstrong.
In market conditions like these, would investing in equities make sense if one was looking at a 15 year time horizon?
G.