One of my favorite blogs, Bad Money Advice, recently linked to an older article of his that I hadn’t read. In the article, Frank challenges the assumption that “as you get older you should take fewer risks in your investment portfolio.”
This stopped me in my tracks given that:
- I do generally think that investors should take less risk in their portfolios as they age (assuming, that is, that the intention is to consume the portfolio over the course of their lives rather than leave it to heirs).
- Frank is not crazy. (Or at least, he appears to be as sane as anybody using the pen name “Frank Curmudgeon” could be.)
- Frank is not dumb. (If you read his blog, it’s clear that he’s downright brilliant.)
Does order of returns matter?
A portion of Frank’s argument is that returns are multiplicative and that, therefore, the order doesn’t matter. As he puts it,
“Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in. So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.”
Given the context of the quote–a scenario in which an investor is investing a lump sum at the beginning–Frank’s statement is true. In real life, however, most investors are systematically investing over time. That is, there’s addition in the equation (and later, subtraction) as well as multiplication.
So as far as I can tell, the order of returns does matter. It matters a lot. And if the impact of volatility (i.e., the harm suffered as a result of a very poor year or the benefit derived as a result of a very good year) is significantly higher when an investor gets closer to retirement, wouldn’t it make sense to adjust one’s asset allocation to deal with that?
Time to Make Adjustments
Further, I think there’s something to be said for having time to make adjustments.
For example, in the case of somebody investing monthly in a 529 plan for her child’s education, if she were she to keep a constant 100% stock allocation, a bear market during the child’s late teenage years would be much more problematic than a bear market while the child is still a toddler.
I think that’s partly due to the fact that there’s not much that can be done at that point. If things go poorly in years 1-3, you have plenty of time to make adjustments to the plan. If something goes wrong in year 18, there’s not much you can do.
And I think the same thing applies to other investing goals. The farther into the future the goal is, the greater your ability to make adjustments if things don’t go according to plan.
Factors in Determining Asset Allocation
Frank argues that,
“How much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology.”
I absolutely agree that a person’s psychological makeup has a huge role in what asset allocation they should have. And while I’d agree that age, as such, doesn’t matter, I would argue that:
- For most people, their age has a lot to do with how much money they’ve got (which does matter), and
- Expected holding period (which is generally related to age) also matters.
What do you think? Is there something I’m missing–some aspect of Frank’s argument that I’m not understanding? Or should we go on assuming that asset allocation and time horizon should generally be linked?
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{ 17 comments… read them below or add one }
I think that they are in ways linked, depending on how you want to adjust to meet your goals, or if you need to adjust in order to meet your goals. That said, I don’t see my personal asset allocation changing much as I approach retirement. I’m such a horribly boring investor that I’ve got most of my stuff in low cost funds, and I don’t see that changing. I go over things every so often, and rebalance a little, but I don’t usually feel the need for adjustment. I’m on track, and content with the knowledge that I’ll probably have enough.
There’s too much here to comment on, between your post and Frank’s, you both raise many questions.
I’d say that one’s allocation certainly depends on asset total. If I need $40,000/yr, but have $5M in savings, my allocation can be far riskier (nearly 80% can be in darn near anything) than if I had say, $1M.
He is right, in a sense that order doesn’t matter too much when accumulating, not in the cycle he suggests. Yes, you’re adding each year, but once you are far enough along, the additions are a small impact. e.g. we have 10X our salary now saved. The 20% we put away each year is only a 2% addition to the gross figure. On the other hand, at withdrawal time, the order is key, impacting your lifetime withdrawals. Yes, these two posts can inspire a bunch more analysis.
I take a middle position between you and Frank, Mike.
I strongly believe that the order of returns matters. You have far more money at risk in the years just before retirement. To suffer a 50 percent loss then is devastating.
However, I believe that the valuations effect (Surprise! Surprise!) is the far bigger factor. A young investor who ignores valuations is taking on more risk than a near-retirement investor who pays attention to valuations. The loss for failing to consider valuations can be huge for the young investor because he loses not only the immediate portfolio losses but also decades of compounding returns on those losses. The risk for the near-retirement investor who considers valuations is minimal because we have never yet seen a significant loss that remained in place for a long time starting from a time of low or moderate valuations.
Rob
I think Frank’s got this one wrong here. First, his math is wrong. Order of returns does matter. Just using the numbers he cites, it’s true that the average annual return is always the same. Switching the order of returns, however, gives you four different absolute returns. Second, early in your life, you are likely contributing more to your investments relative to the total amount of investments your have. Not only to you have more time to recover from any market losses, those losses allow you to buy more of the market (relative to your total portfolio) at lower prices.
The order of returns is also very important once you stop contributing and begin withdrawing in retirement. Once you withdraw the funds, you’ll never get the return on that back.
I agree that Frank is pretty brilliant- and does come up with some very good insights. However, you are correct the order is important once you start withdrawing or contributing. If your withdrawal or contribution is a small percent the difference isn’t huge for a few years, but over 30 years it could matter a LOT. I guess I’ve got another post idea :->
-Rick
If returns were additive & lump sum investment, then asset allocation vs. time makes perfect sense; By having money in the stock market earlier and assuming higher variance & mean, then you can use time to smooth out the summed variance.
?
I have trouble thinking about it when it’s no longer additive. Some kind of markov chain analysis
The order can be pretty significant. I came up with a table of 40 return rates and calculated the total return investing $1000/year. One order was 2.09 times larger than another order.
-Rick
With only two cash flows, all in followed by all out, the order of returns does not matter. However, once you introduce multiple ins and multiple outs, the sequence becomes very important, more important than its average.
I think asset allocation id influenced by the time you have left (age) in life. While the recession affected both risky and non-risky allocations, it would be foolish to continue an 80% stock allocationn if you are 2 years from retirement. I think it’s OK to have a risky investment fund as long as you have many more that are more balanced and low risk.
Rick – you have more details, the spreadsheet somewhere you can post?
Conventional wisdom is that younger investors should take more risk, for instance by having a higher allocation to stocks.
I think the conclusion is correct (buy more stocks when your expected holding period is longer), but the reasoning is backwards.
As a young investor, I have 80-90% of my funds in stocks. This is not because I have a higher tolerance for risk, but because the riskiness of stocks declines the longer you hold them.
Market risk is mostly due to short term (several years) swings in valuations (ie market-wide P/E ratios). This risk is non-compounding, in fact in the long-run, valuation swings are mean-reverting.
Market returns on the other hand are mostly due to
1) Earnings growth
2) Distributions to shareholders (dividends, buybacks)
Both of these factors are compounding (assuming you reinvest dividends).
With a short holding period, valuation changes dominate returns. With a long holding period, valuation changes are as likely as not to cancel each other out over time, and the slow compounding of reinvested profits and dividends dominates returns.
So from my perspective, with 30+ years for my market investments to compound, stocks don’t look like a risky investment at all.
For someone who needs their money in just a few years, stocks are a very risky investment, hence the advice to put more money in bonds and accept a slightly lower return.
Joe,
I did one better and made a post check out:
http://ponderingmoney.com/2009/11/06/start-investing-and-pray-for-a-crash/
-Rick Francis
I just read his post. I agree he seems wrong, but I think he’s making a rather subtle point about how essentially it all comes down to how much you’re prepared to risk for your reward.
The trouble is his 50 year old is taking a bigger risk swinging for the fences than a 30 year old because of the lack of time to catch up. Also the 30 year old can lock in any home runs en route, which is a big advantage.
It seems a bit willfully contrary to me.
Willfully contrary? Moi?
If we can agree that with only two cash flows, one in and one out, the order of returns doesn’t matter, so it would not make sense to alter risk level over time, then we’ve all gone pretty far off the conventional wisdom beaten path. I’ll settle for that. For now.
Hey alright, Frank chimed in!
I’d like to think that most investors would recognize that with only one “buy” and one “sell” that order of returns (and therefore high risk early vs. high risk later) doesn’t matter.
Of course, I don’t think that. I’d just like to.
Actually, as a follow up to Frank’s above example:
If you have 1 million to invest for 10 yrs, 20 yrs, 30 yrs, etc… does your strategy change? Would you invest more money in the stock market if you are given a longer time horizon?
In that sense it makes perfect sense for it to change your allocation over time as your essentially simulating that.
Age does matter when constructing a portfolio, one must consider Chronological and an Allocation age. Allocation age is for contibutions and how they should represent your level of risk tolerance, Chronological age is determined by how that portfolio will support you and grow enough for the sunset years and be part of a legacy for your heirs or charity if you choose and/or do not spend down the balance. These last few years the number of individuals rceiving portfolios as part of their inheritance has increased. The recipients are spending a great deal of time and money redoing the allocations their parents had , mostly fixed income with cd’s, muni’s, etc.. If the parents had planned for short, mid-term and long-term needs, the mix would have been more approapriate, should they live to 100. The mix would have provided a portion for cashflow and an emergency fund to alleviate the need to cashout in a down market.. Near-term needs; semi-safe investments for 3-10 years out, including the cashflow growth from dividends and interest and a growth component to combat the ravages of inflation. As the short-term funds are depleted, refill with cashflow assets from the mid-term portion. Allowing the long-term portion to grow. Rebalancing would require “tweaking” periodically, not a full rebalance as it often is. Avoid cookie-cutter allocations, make it personal for you and your goals.