Age is Just a Number
…and that number is not a driver of sound investment recommendations. Let me explain with a story….
Earlier this week a client sent me their quarterly 401(k) plan statement.
The below chart was on the first page of the statement. Give it a look.
While I don’t directly manage workplace 401(k)s for clients (the only assets we directly control are those held at Altruist on behalf of clients), we do consult the strategy of assets held outside of Altruist. If it’s important to a client’s life, we take a look at it and try to what we can to help ensure it’s working towards their objectives.
In this case, the client and I considered how this account fits into her life and her objectives, developed a contribution strategy, reviewed available fund options within the plan, and allocated the account accordingly with those things in mind.
In the chart above, you can see that the asset mix we elected was 100% Stock.
*Before I go any further, let me highlight that we arrived at this mix based on her unique situation and the available funds in the 401(k) Plan. A recommendation for you or someone else may be different.
Now let’s talk about the pie chart to the right of her current asset mix.
The “Model Asset Mix for Your Age*” chart highlights what the 401(k) plan suggests for a person this age — in this case, the investor is 61 years old. You can see that they believe an investor her age should have a more conservative portfolio with 41.6% Bonds to help balance out the 58.3% Stock position.
That’s right, their recommendation is a difference of about 40% less stock just because they think age is a primary determinant of investment strategy.
You might be thinking; But Adam, we get closer to retirement with every passing year, so don’t we need to be more conservative as we approach retirement?
In some cases, the answer to this question is yes.
However, the 401(k) provider hasn’t asked this individual if they plan to retire in one year (age 62) or in ten years (age 71). If you need to withdraw funds in one year then the investment strategy is wildly different than if you need to withdraw funds in ten years. I work with many retired individuals who aren’t spending their retirement account funds because they don’t need to (yet).
Let’s pause for just a moment to consider the actual reason for recommendations of these lower risk strategies (like bonds and cash).
As an asset manager, the thing you don’t want to do is adopt an aggressive strategy with good long term growth potential in exchange for higher risk of shorter term declines, and then have to sell an investment after one of those short term decline because the investor needs the money. If someone doesn’t need the actual cash for a long time, then usually more of it can stay invested in something with more upside. But if they need cash next week, next month, or next year, then we need to consider that in the investment mix and adopt a more conservative strategy accordingly.
For the sake of argument, let’s assume for a minute that the 401(k) plan did know that the individual was planning on retiring next year and that is why they’re recommending the more conservative mix. Now would this be appropriate for her?
Nope.
Here’s why:
A 401(k) is never the single component to an individual’s financial life.
Again, we often want to be more conservatively invested when we know there is a pending need for funds from the portfolio. The rest of someone’s life ends up letting us know if they may need funds from the account.
Here are some things that could keep her from having to spend the money in the 401(k) even if she retired:
- Her spouse may still be working and that income covers the bills.
- Social Security, Pensions, or Rental Income may be enough to meet ongoing needs.
- The investment strategy in other retirement accounts (IRAs and Roth IRAs) has a conservative element which can provide a place to draw funds.
- She has a large emergency fund in cash at the bank.
- She has an individual, joint, or trust investment account to draw from.
- The size of her portfolio is large compared to the amount she needs to withdraw, so even selling investments after a dip isn’t problematic to the long term health of her financial plan.
- The need for funds is flexible.
That’s a lot to consider.
In fact, when you think about ALL of those things which could affect the need for funds and the underlying investment strategy, one thing about the initial recommended “Asset Mix for Your Age” above becomes kind of laughable:
The fact that they felt it was worth specifying 58.3% in stock and 41.6% in bonds. Yes, someone believes it was worth dialing this recommendation down to 1/10ths of one percent even though the diagnosis and basis for recommendation is pretty simplistic… Fifty-Eight-Point-Three Percent!
Okay, so I know I’m being a little hard on them right now, but this is a great example of how traditional finance and ‘Wall Street Culture’ often aims to provide a false sense of precision when making these investment recommendations.
We can’t know what the future holds in terms of rate of return, inflation, taxes, interest rates, spending needs, life expectancy, income, etc. so rather than pretending that ‘certainty’ exists, the primary thing we need to be is flexible.
Your financial plan and investment portfolio should embody some flexibility and wiggle room to be okay if we do not get things exactly right.
This brings us to the formula I’ve created to help diagnose an investment approach:
That’s right, Investment Objective Timeline + Investment Objective Type + Risk Capacity + Risk Tolerance = Strategy… Let’s explore these components.
Investment Objective Timeline
How long until you need to turn the investments into cash? In the case of retirement, when you do need to start withdrawing funds and for how many years?
Longer timeline = More Aggressive.
Investment Objective Type
What is the investment for? If there is a need to pull funds from the portfolio for food, shelter, healthcare, education, etc. then we may invest differently than if we want to pull funds out for a Range Rover. In economics we call this Demand Elasticity. We have “elastic” demand for Range Rovers and “inelastic” demand for food.
Greater Elasticity = More Aggressive
Risk Capacity
This is about how much risk a person can take. Do they have a secure job? Do they have a low cost of living? Do they have an emergency fund? Will there be an inheritance?
Many things affect the capacity an investor has for risk.
More Risk Capacity = More Aggressive
Risk Tolerance
Being able to take on risk is one thing, being able to tolerate it is another. There are certain cases where an individual’s investment timeline, investment type, and risk capacity may all be pointing towards an aggressive approach, but the ups and downs of an aggressive strategy may be too much to stomach.
An investor can have a technically sound, empirically perfect portfolio for several years and then undo loads of progress by making a short term emotional reaction to a portfolio that’s too aggressive for their risk tolerance.
To be fair, this one is hard to diagnose because people like risk when things are going well and they hate it when things are falling apart. Unfortunately, both elements are required — the downside is the cost of admission for the upside. However, investors who’ve benefitted from adopting risk tend to be more tolerant of it in the future, so this is something which investors can become more comfortable with over time.
More Risk Tolerance = More Aggressive
Conclusion / What To Do?
When I started in this industry there was a rule of thumb suggesting that investors should take their age and subtract it from 100 to determine the % of stocks they should have in their portfolio. So a 70 year old person would have 30% stocks while a 20 year old would have 80% stocks. Of course, for all of the reasons I’ve mentioned above, this is a very simplistic way to look at the world and our investment decisions.
Rules like the “100 rule” aren’t very sensible to rely on, but they do make sense for some investors— Why? Because people are always searching for a clear formula to follow.
However, my message is this: there is no decisive formula.
We’re too human and there are too many assumptions (i.e. guesses) we need to make about the future; any reasonable formula won’t be reliable without constant edits. But that’s okay. Build an approach that abandons the need for precision while highlighting the need for flexibility. That’s how you win.
That’s all for now.
Onward,
Adam Harding | CFP | Advisor | Owner @ Harding Wealth Inc. | Smartvestor
Mobile Number: 480-205-1743
Copyright (C) 2021 Harding Wealth, Inc. All rights reserved.
*For educational purposes only. Not investment, tax, or legal advice.
