Risk tolerance should not increase with age
Asset allocation: the right equity allocation for all ages
There is a traditional formula for dividing the portfolio - the asset allocation:
Equity quota = 100 - age …
The logic goes that if you are young, you can take more shares and thus more risk.
Those who are heading towards retirement should, however, increasingly switch to bonds.
It would be stupid if you found yourself in a stock market low in time for the start of retirement ...
At first glance, that seems logical. But do one dynamic asset allocation really make sense after this knitting pattern?
No, say the authors of a study published in 2012 entitled "The Glidepath Illusion".
Robert D. Arnott and co-workers come to the realization that precisely the opposite strategy promises more success (return).
They recommend an "inverse glidepath", that is, the equity quota increases with age increaseinstead of lowering them.
In this article you will find out how all of this fits together and whether an increasing equity quota is really practicable.
The reason for the traditional lowering of the equity quota with increasing age is this:
The authors of the study retrospectively examined for the years 1871 to 2011 how well this “standard strategy” performs.
They averaged a total of 101 fictitious investors, each of whom has built up assets over 41 years.
The first investor in their calculation model started his investment career in 1871 and retired at the end of 1911, the last started in 1971 and retired at the end of 2011. In between there are 99 other model investors.
Three strategies were tested:
- Standard course with falling equity quota (starting at 80 percent, ending at 20 percent)
- Static Asset allocation (50 percent stocks, 50 percent bonds)
- Inverse course with increasing equity quota (starting at 20 percent, ending at 80 percent)
Results of the study
Based on an annual investment of USD 1,000, the three strategies for asset allocation yielded the following results (in USD):
If you look at the mean values (AVERAGE), the standard deviation (STDEV) and the maximum values (MAX), you will learn the following, not surprisingly:
As expected, the higher return goes hand in hand with a higher risk. Measured against the range of final wealth (see standard deviation).
With the "inverse glidepath" one scores better on average than with the 80-20 standard curve.
Of the Averages you can buy very little, however.
Because just like statistical life expectancy does not provide information about how long you live. The averaged final wealth of 101 investors is not very meaningful for the final wealth of the individual.
When building assets over 40 years, every investor has just one try.
The real highlight of the study is hidden in the Minimum value (MIN). This makes it clear how the poor drip would have fared with the worst performance of all 101 model investors.
If you compare the respective worst-case scenario of both strategies, it becomes clear:
The final wealth in the "inverse glidepath" strategy falls higher than with the standard strategy.
In numbers: $ 53,040 vs. $ 49,940.
Protects a low equity quota in old age, for example worse before losses than a high?
Doesn't that turn everything we think we know about stocks and risk upside down?
Anyone who has set aside $ 1,000 in this model for 41 years and adjusted their savings rate to inflation (as assumed in the study) has ended up investing $ 41,000 adjusted for inflation.
Even if in the “worst” case the standard strategy turned out to be only USD 49,940, the paid-in capital has increased with a real return of 0.92 percent per year.
Is an increasing equity allocation better?
If you can't lose anything with a rising equity quota, what about the opportunities side?
With the standard course, at best $ 211,330 final assets were in it. With the inverse trend with increasing equity exposure, a total of USD 286,920.
So it is a risk that - as paradoxical as it may sound - can only be won: a so-called "upside risk".
The renowned financial author William J. Bernstein also comes to the conclusion in his treatise Deep Risk: How History Informs Portfolio Design (*):
“With a long time horizon, bonds are riskier than stocks because they are more susceptible to the investor's greatest nuisance: inflation. With a time horizon of less than 20 years, however, stocks carry significantly more risk than bonds. "
On paper, the “inverse glidepath” turns out to be the better variant of the dynamic asset allocation.
At least when it comes to achieving the highest possible net worth over a long period of time.
But what does it look like in “real life”?
What is plausible in theory does not necessarily have to work in practice. Because the decisive limiting factor in investing is and will always be people.
Ultimately, it depends on the individual risk tolerance of the investor whether he brings his investment horsepower fully on the street or on the stock market.
Or whether he prefers to drive through the area at low speed with the handbrake on ...
Even if the final capacity with the "inverse glidepath" may be greater than with the "standard glidepath", even with the most unfavorable course:
Anyone in their early 60s who has to watch their ETF portfolio lose 30 percent of its value within a year ...
... can persuade himself that due to his courage to have a high share quota he still has more assets than if he had gone to work with a falling share quota.
But how many people think or feel that way?
"Financial losses are processed in the same brain areas as danger to life."
Jason Zweig in Your Money and your brain (*)
Every depot needs a certain "feel-good factor":
An investor with smaller portfolio assets but less fluctuations in value will probably feel better than ...
... an investor with a larger portfolio, but more susceptible to a full "drawdown" shortly before retirement.
The point of reference is always the actual deposit balance and not a hypothetical balance that can be found with a different investment strategy maybe would have achieved.
According to the peak-end theory, people judge unpleasant events, such as a colonoscopy, based on two criteria:
First, according to the intensity of the pain during the procedure and, second, according to the feeling at the end.
How long the examination lasts and how high the average pain level is, is irrelevant in retrospect.
You don't need too much imagination to imagine that a loss of - let's say - 30 percent of your depository assets is really painful, especially at the end of the savings phase.
An investor who loses "only" 15 percent before retiring will certainly rate the past 40 stock market years more positively than someone who has to deal with a loss of value of 30 percent shortly before the goal.
Height of the final wealth or not.
Other points of criticism
Regardless of behavioral economic aspects, other points can be discussed:
Does not work with a short investment horizon
While an “inverse glidepath” for building up wealth in the context of old-age provision is definitely debatable, it seems to me completely unsuitable for building up wealth for the study of children, for example.
The ratio of the savings phase to the withdrawal phase for old-age provision (for a 30-year-old investor) is around 35 to 25 years.
When building up assets to finance a degree, however, it is only 18 to 5-6 years.
In other words: After 18 years, the sum X must be available at the point, which will be completely consumed in just 5 or 6 years.
In this scenario, in my opinion, there is no getting around the standard trend with a falling equity exposure over 18 years.
Inverse course nonsensical
Even if you can imagine why an "inverse glidepath" was chosen in the study with a course of the equity quota from 20 to 80 percent (simple reversal of the course from 80 to 20):
That hardly makes sense.
If you can cope with an equity quota of 80 percent in your mid-60s, should you really be able to do so in your mid-20s, or not?
Development of risk aversion
If the equity quota increases with age, ideally the investor's willingness to take risks should also increase.
The risk tolerance, however, is a shy deer that is exposed to countless unconscious influences on an emotional level.
It should be easier to nail a pudding to the wall than to validly determine a person's willingness to take risks.
A job change, job loss, the loss of a close relative, a life-threatening illness and other strokes of fate will certainly not leave a person and his attitude to money without a trace.
Unfortunately, the above-mentioned events become more and more likely with increasing age ...
Asset Allocation - The Bottom Line
For savings projects with a short withdrawal phase, an inverse course of the asset allocation is not an option. At most, for building up assets in the context of old-age provision.
An equity quota that increases with age or is consistently high is the way forward for highly rational investors with below-average risk aversion.
If you don't know which group you belong to, you won't go wrong with a fixed allocation of 50 percent shares and 50 percent bonds.
But the most important thing is that you feel comfortable with the risk level of your portfolio and that you stick to the strategy you have chosen even in bad times.
There is a simple method with which you can make provisions for old age and build up a lot of wealth thanks to a return of 6-7% p.a. …
- without to spend significant time on it
- without to take too big risks
- without Getting addicted to the bank or a financial advisor
- without To have to go into debt up to your ears for a property
Click here to read more.
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