JUST AS ANYONE around on Sept. 11, 2001, Nov. 22, 1963, or Dec. 7, 1941, remembers where they were when they first heard the news, one date resonates for investors of a certain age: Oct. 19, 1987.
As a young practicing physician, I was just finishing up the day’s charting when I took a call from one of my colleagues: “Did the Dow fall enough for you today?” Indeed it had, by 508 points, or nearly 23%, and 36% off its peak of some weeks before.
Gulp. My net worth had plunged nearly six figures in just a few hours. In my unhappy state, though, it occurred to me that if I was comfortable owning stocks at Dow 2700, shouldn’t I be even more comfy owning them at Dow 1800?
And so I held my breath and increased my stock exposure. This one salutary move, though, did not exactly herald a full flowering of financial wisdom. I continued to make mistakes: reading market-timing newsletters, trying to pick both stocks and active fund managers and time the market, and allowing my spirits to rise and fall on a daily basis with share prices. I even got taken in by 1989’s spurious cold fusion excitement and went long palladium futures.
Fortunately, my financial journey got better from there. Not long after, I came across the books of Burton Malkiel and Jack Bogle, and began to immerse myself in the world of academic finance, particularly Eugene Fama and Kenneth French’s work on market efficiency and factor investing. I taught myself to spreadsheet, which was far less ubiquitous back then than it is now. My portfolio, whose stock exposure now consisted entirely of low-cost passively managed funds, prospered. Perhaps most fortuitously, in the early 1990s, I came across Charles Mackay’s Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, which immunized me from the dot-com bubble that blew up a few years later.
Even so, I could have done things better. Here are two lessons that took me decades more to learn—and which could have made my financial journey far smoother:
First, a suboptimal portfolio you can execute is better than an optimal one you can’t.
Yes, it’s true that, over most long periods, the more stock-heavy a portfolio, the higher its returns will be. The problem is that we humans are overconfident about most things, and none is more deadly to financial success than overestimating our risk tolerance. It’s one thing to fire up a spreadsheet and simulate losing a large chunk of assets, but quite another when it happens in real-time. A good analogy is how experiencing a plane crash in a simulator compares with the real thing.
Never forget humorist and financial journalist Fred Schwed’s famous injunction: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”
Over the past four decades, I’ve learned that the prime prerequisite for a successful portfolio is that it survives. One occasionally comes across newspaper articles about a recently deceased janitor, secretary or kindergarten teacher’s estate that surprises a charity with a multi-million-dollar bequest. Such stories always feature two common elements: first, the departed’s frugality (anecdotes involving bus and subway transport are mandatory journalistic elements); and, second, that they invested over periods of around half a century.
By the same token, it’s not uncommon to read about star money managers who flame out after a few years of shooting the lights out. The difference between these two narratives? The first group made sure their portfolios survived long enough for compound interest to work its magic. The best way of ensuring that is to have a portfolio that can be held through the inevitable episodes of economic and financial excrement hitting the ventilating system.
To wrap this first lesson up, I’ll risk one more analogy. The financial markets are a car that conveys your assets across town from your present self to your future self. The roads are slick with ice and studded with giant potholes. If you drive fast, you might indeed get to your destination a lot quicker. But it’s usually a bad idea.
Second, mentally compartmentalize your portfolio.
For decades, whether it was my money or that of clients, I hewed to the conventional academic and financial practitioner wisdom of designing a single overall portfolio encompassing all assets. I still go through that exercise, and it still drives the security purchases and sales we make for ourselves and for our clients.
But here’s what I’m doing behind the scenes: I’m mentally dividing a given portfolio into two completely separate pools, the safe assets necessary to sustain body and soul—more on that in a bit—and the risky assets aimed at consumption decades hence. This mental shortcut is commonly called the “two bucket” approach to asset allocation. You have a retirement bucket for your basic needs, along with a risk bucket earmarked for your aspirational desires—think BMW or first-class travel—and for future generations.
Investment guru and writer Charles Ellis observes that you can win the investment game in one of three ways: by being smarter, working harder or being more emotionally disciplined than the other participants.
The first two are clearly impossible. Wall Street is packed with folks with 175 IQs working 90 hours per week. But winning the emotional game is doable. The secret is to be able to say to yourself after share prices have halved, “I don’t need to tap my stocks for decades. In fact, if I manage my portfolio well enough, in the long run that money will be going to my heirs and charities.” If you can do that, you’ll sleep soundly, your stocks will eventually recover and, when they do, you just might sell some and fatten your safe portfolio a bit. Remember, your portfolio’s prime directive is to survive, and there’s no better portfolio longevity tonic than a nice pile of “sleeping money.”
The implications of this strategy are manifold, and apply differently at different ages. The young person might say, “Wait a minute. My portfolio is tiny. My safe assets won’t even last me three months.” While that’s literally true, she still owns a large amount of bond-like assets in the form of her human capital, which dwarfs her retirement portfolio. What does it matter if her portfolio craters today? Three or four decades from now, it’ll be fine, and the money added to it at today’s low prices will likely be some of the best investments she’ll ever make.
The retiree, because she has no human capital left, is in a completely different place, and she had better have a nice pile of safe assets to see her through the hard times. How big should that pile be? Consider the graph below, which shows the 10-year after-inflation (or “real”) total return of the S&P 500 in periods when there are losses:
What this graph tells us is that, if you had owned stocks, the spending power of your stocks fell significantly over 10 years on three separate occasions—by about 25% in the 1930s, 35% in the 1970s to 1980s, and by 45% during the 2007-09 global financial crisis. Further, notice that, despite the fact that overall long-term U.S. stock returns have held up well over the past century, the inflation-adjusted drawdowns seem to be getting worse.
Why is this? At the beginning of the 20th century, each dollar invested in stocks yielded about five cents in annual dividends. Even if stock prices fell, that 5% yield nicely cushioned the loss in share prices. Over the decades, that yield has fallen to well below two cents, which is a much thinner cushion.
Almost a century ago, economist John Maynard Keynes said this about owning stocks: “It is from time to time the duty of the serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself.” (Italics added.) Think you can time the market and avoid these drawdowns? Guess again. There is now almost a century of academic research demonstrating that no one has consistently done so, and the boneyard of Wall Street is littered with the remains of those who gained fame with one lucky call and then made spectacularly lousy forecasts for decades thereafter.
Now, let’s see what this all means for the young investor and for the retiree.
Theoretically, even if the young investor puts 100% of his savings into stocks, those savings are so small relative to his bond-like human capital that his overall stock allocation is still quite small. Even knowing all that, our young investor with 100% stocks in his 401(k) plan may not be able to emotionally handle half of it disappearing for some years. Our young investor, then, needs to discover his real-world risk tolerance. Start with, say, a 50% stock-50% bond retirement portfolio, and see how you respond during a bear market. Were you able to buy more and up your stock allocation to, say, 75% stocks-25% bonds? If so, then great. Wait until the next time, rinse and repeat. Did you just barely hang on? Then 50-50 is probably about right. Did you panic and sell? Then even 50-50 is too aggressive.
For older investors like me, things are a bit more complex. Let’s start with the simplest, and most felicitous, case. There are likely millions of retirees who have won the retirement trifecta with income from Social Security and an old-style corporate pension whose monthly payments meet or even exceed their living expenses and taxes. Their investment portfolio, then, really doesn’t belong to them. Rather, it’s destined for their heirs, charities and maybe even Uncle Sam. (Which applies, as well, to the essence of estate planning: You can piss the money away, your heirs can piss the money away or the government can piss the money away. Your job is to pick the pisser.) The stock allocation of these fortunate individuals really doesn’t matter at all to them and, by the time they’re retired, they should have a good idea of their risk tolerance. If they’ve hung on in the past with 100% in stocks, then God bless.
The same is also true of retirees who need, say, less than 2% of their portfolio to meet living expenses. Since the dividend flow on their stocks should provide this, and since dividends do not decline very much for very long even in severe bear markets, then even a nearly 100% stock allocation with a small sliver of cash for emergencies, if tolerated emotionally, is fine, too.
Below that level of assets, things are a little dicier. For the retiree, holding 10 years of living expenses in safe assets is barely acceptable, 15 years is better and 20 years’ worth is optimal. Once you’ve filled your retirement safe-asset bucket, you can begin filling and growing your risk-and-aspirational bucket. Never forget, if you’re going to survive retirement, your portfolio first has to survive. If you play portfolio Russian Roulette, by taking more risk than you can handle during a frightening economic and investment crunch, you’ll inevitably pay the price.
Thirty-five years after my 1987 baptism by fire, this is how I’ve come to view the great lifetime financial endeavor of amassing and then spending money. I often tell people that, when you’ve won the game, stop playing with the money you really need. Perhaps all would be fine if I kept 100% in stocks. But I’m now in my 70s and more interested in financial survival, which is why today I keep at least 20 years of living expenses in bonds and cash investments. That won’t make me rich. Instead, I’ve done something more important: minimize my odds of dying poor.
HERE ARE THE SIX other articles published by HumbleDollar this week:
Also be sure to check out the past week’s blog posts, including Mike Zaccardi on covered calls, Sanjib Saha on returning to learning, Ron Wayne on getting organized, Mike Flack on the cost of internet service, Kyle McIntosh on fixing his finances and John Lim on the Federal Reserve.
Bill Bernstein is a recovering neurologist, author and co-founder of Efficient Frontier Advisors. He’s contributed to peer-reviewed finance journals and has written for national publications, including Money magazine and The Wall Street Journal. Bill has produced several finance books, including The Four Pillars of Investing, and also four volumes of history, the latest of which is The Delusions of Crowds. His life’s goal is to convey a suitcase full of books and a laptop to Provence for six months—and call it “work.” Bill’s previous article was When Cash Is King.