Ultimately, investing in security proves to be more valuable than enduring several years of stock market volatility. There are more effective strategies to safeguard yourself from challenges.
My oldest son has just celebrated his 18th birthday. He got a bit of cash for his birthday, and now he’s looking to put it into the stock market. He aims to utilise it for his “gap year” – that period of exploration where recent high school graduates journey across the globe to uncover deep truths about existence, all while their parents anxiously await the next ambiguous WhatsApp update from afar.
I have some reservations about his decision to invest all his money in the stock market until that time. However, as he matured, he came to believe that the portfolio was just as secure as a savings account, but with significantly higher returns.
My friend Elisabeth, 63, has been eager to invest for years. However, due to concerns about the impending downturn, she chooses to keep her funds in the call money account, observing its diminishing value with each passing year. The risk assessments conducted by my son and my friend are strikingly divergent. This leads me to ponder: What should the appropriate level of risk-free assets in my portfolio be?
Too good experiences
It appears that many individuals tend to downplay risk during their younger years. This issue notably impacts young men, and there exists scientific research on the subject. As individuals age, they often have a tendency to exaggerate potential dangers. This could be attributed to the fact that younger generations, such as my son who was born in 2007, have not yet faced significant financial downturns.
The Corona crash occurred with remarkable speed, and the subsequent turmoil stemming from the Russian war of aggression has faded from memory, nearly three years after its onset. In contrast, older individuals, such as my friend Elisabeth, carry the weight of past experiences with Telekom shares, particularly the challenging decade marked by the stock market crashes of 2001 and again in 2008 during the financial crisis. By the close of the 2000s, stock markets remained beneath the levels seen at the dawn of the millennium.
Significant dangers
It is reasonable to conclude that losses impact us significantly more than the pleasure derived from gains, as demonstrated by the insights of psychologists Daniel Kahneman and Amos Tversky in their “Prospect Theory.” This clarifies why the risk-free segment in numerous portfolios tends to be more substantial than what would typically be deemed economically rational.
The strategy of balancing safe and risky investments finds its roots in the modern portfolio theory proposed by Harry Markowitz in 1952, which suggests that this combination yields the most favourable returns. A commonly accepted guideline that many seasoned readers may recall suggests that the percentage of stocks in one’s portfolio should be calculated as “100 minus age”. For instance, my 18-year-old son ought to hold 82 percent in stocks, whereas my 63-year-old girlfriend should limit her allocation to just 37 percent. Consensus has emerged that this guideline is overly cautious, leading investors to overlook potential opportunities.
The traditional 60-40 portfolio has thus remained dominant for many years, comprising 60 percent stocks and 40 percent bonds. In my opinion, this is just as antiquated as the guideline of “100 minus age”. Each offers an uncomplicated answer to a multifaceted issue. Conventional approaches such as these fail to provide adequate safeguards against price declines and do not capitalize on the potential for returns.
Investing with a cushion of security
The 60-40 portfolio is often regarded as an ideal blend of growth and stability. When stock prices decline, bonds provide a buffer against the losses; this is the guiding principle. Regrettably, that is precisely what has failed to yield results in recent years. Those who maintained a 60-40 portfolio in 2022 experienced a stark reality check, as the theoretical foundations of their strategy clashed with the harsh realities of the market: both stock and bond prices plummeted by double-digit percentages. In an environment characterised by low or even negative interest rates, bonds have provided minimal returns for an extended period.
As interest rates increased, prices plummeted. Individuals who depended on a traditional 60-40 portfolio were taken aback by experiencing a double-digit loss, even with what was thought to be a “safety net”. In 2022, bonds faced one of their most challenging years on record, yet indications suggest that a similar situation is unlikely to occur again. Nonetheless, there are several points of contention regarding the 60-40 portfolio: the alleged safety comes at a high cost over time, indeed, a very high cost. Historically, stock market prices have seen an average annual increase of eight percent, while the traditional 60-40 portfolio typically yields an average return of five to seven percent, varying by the specific timeframe analysed.
The subtle yet significant distinction
Do you really believe there’s not much of a difference? Stay tuned and observe! Individuals fully invested in stocks can expect to see their capital double approximately every nine years, given an average return of eight percent. Individuals maintaining a 60-40 portfolio require a span of twelve years to achieve a doubling of their investment at a six percent return. Now, let’s examine the long-term perspective: a fully invested stock portfolio of 100,000 euros is projected to grow to around one million euros over 30 years, whereas a 60-40 portfolio would yield just under 575,000 euros in the same timeframe. The slight variation in returns can translate to a significant sum over time, particularly when considering the lack of security experienced during genuine crises.
Upon reviewing the portfolios of my course participants, I consistently observe that the allocation towards low-risk investments is excessively high. This holds particularly true for individuals who continue to engage in work or possess alternative income streams. This could be attributed to the fact that numerous portfolios were established by advisors who either lack a comprehensive understanding of the overall situation or are prioritising their own security over more informed strategies. Regrettably, this incurs significant losses over time.
In “Pioneering Portfolio Management,” David Swensen, a prominent investment manager from Yale University, takes a critical stance on the traditional 60-40 portfolio, highlighting that low-risk investments inherently produce low returns. He supports raising the allocation to higher-risk assets (which at the Yale Foundation encompasses not just stocks but also alternative investments like private equity or venture capital, though this is typically not feasible for most individual investors) while maintaining safety reserves solely for immediate obligations.
One potential approach could involve allocating 90 percent of the portfolio to stocks while reserving 10 percent for liquidity or money market funds. These funds typically engage in short-term investments, including government bonds, bank deposits, or corporate bonds, serving as a viable alternative to overnight money. This approach provides a buffer for immediate financial responsibilities while also allowing for the agility to capitalise on lower prices during significant market downturns, rather than merely enduring the losses. The higher stock returns provide an advantage, while also maintaining a cushion for more turbulent periods.
Threats and protection
The appropriate size of this buffer is contingent upon your individual circumstances, including your income, additional sources of revenue, and importantly, your level of risk tolerance. For those nearing retirement with only a pension as their source of income, relying on a 10 percent safety buffer may be insufficient. Nonetheless, for those who are youthful and earning, potentially through real estate, it would be wise to seize the opportunities presented by the stock market. It is often overlooked that long-term poverty is not a result of taking risks, but rather of exercising excessive caution. A rigid focus on safety can lead to greater expenses over time compared to the temporary ups and downs of results experienced over a few years.
Nonetheless, I can’t shake off this unsettling feeling regarding my son. Initially, he possesses a brief investment timeline of merely six or seven months before his departure. Moreover, his supplementary earnings from tutoring are quite feasible. This all points to the need for a more balanced mix. What actions should I take? The young man has reached legal age and possesses his own portfolio. I will, however, have another conversation with my friend Elisabeth.
Author: Christiane von Hardenberg
+ There are no comments
Add yours