Do you need stocks in your portfolio?
by Raul Elizalde - 2017-08-10
Most financial professionals would tell investors not to focus on matching or beating market indices, but rather on making sure that they stay on track to meet their financial goals.
Some investors push back against this advice, perhaps thinking that it is an excuse advisors have for not being able to beat the market. Yet, the advice is sound. While some investors need full exposure to equities, others do not need to take that much risk and some would be much better off having no exposure to stocks at all.
How much risk one takes depends on personal circumstances. Unfortunately, investors are bombarded with 24/7 stock recommendations, and they become more receptive to them when the market has been strong and steady as it has been in the last few years. While bull markets make people feel more confident taking on risk, relying on your level of confidence to decide how much risk to take is the wrong way to pursue your financial objectives. The risk inherent in the stock market is high, and it should be handled with care.
Consider a 75-yr old widow (i.e. without a significant other, for simplicity) who wants to make sure that her $2.2mm in savings will be enough to pay for $100,000 of yearly expenses for the rest of her life. As that rate, she will spend $2mm by the time she reaches 95, leaving $200,000 to spare. Probably her best bet is to invest those savings in short-term, high-quality fixed income products to protect them against inflation. This ultra-low-risk strategy would be aligned with her goal, which is to minimize the chance of running out of money. It would have the important benefit of being highly predictable and likely devoid of unpleasant surprises.
What about a 75-year old single man who has the same expenditures but $1.5mm in the bank? Spending $100,000 per year will deplete his savings in 15 years, or sooner if he spends more due to inflation. Because there is 100% certainty that he will run out of money way before he reaches 95, he needs the extra return of stocks to make his portfolio last.
How much stock exposure does the less-wealthy investor need?
One way of answering that question is by simulating sequences of stock market returns and examining how his portfolio would fare under each sequence. This can give a sense of how his situation can be improved.
Without stocks, his portfolio will inexorably shrink by $100,000 per year. Because stocks are volatile, adding them to the portfolio will make it less predictable. The higher the proportion of stocks, the more it will depart from that steady declining path. To illustrate this, we ran a few possible ways his portfolio can depart from the no-stock scenario (see first graph).
Adding stocks clearly makes it possible for this retiree to stretch his portfolio past year 20. But it can also make his portfolio run out of money sooner than 15 years, or subject it to a terrible start such as a 25% decline in the very first year.
How would he react to a bad start? If his tolerance for risk is low, he may close out his positions right away, book a loss, and end up worse off than before. Every investor should consider his or her risk tolerance carefully with the help of a professional.
Things can go very wrong when the volatility of stocks is not properly understood. Imagine that the widow in the first example, even though she has plenty of savings and little need to invest, becomes convinced that she is “leaving money on the table” by not keeping up with a rising stock market. She decides (or is encouraged) to deploy all her portfolio in an S&P 500 index fund.
While her final portfolio could potentially be much bigger than without any exposure to stocks, she now has a small but very real chance that she could run out of money – a scenario that, before switching to stocks, she was virtually assured not to face (see second graph). In exchange for the chance of having more money at the end of her life (when it is least useful) she introduced the risk of being wiped out sooner, or experiencing distressing early losses that could prompt her to close out positions in a panic and lock her out of her goal.
It is tempting to invest in stocks when they seem to carry little risk. Investors should not rely on forecasts; instead, they should examine their own situations, understand their tolerance for risk, and develop an appreciation for what ccould go wrong with their investment strategies.
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