This last weekend I read Zvi Bodie and Rachelle Taqqu’s recent book Risk Less and Prosper. One of the central points of the book is that, contrary to conventional wisdom, stocks do not become less risky over time.
We’ve been over this before, but I think the hullabaloo over such statements is mostly due to different people meaning different things when they say the word “risky.” As far as I can tell, most experts actually seem to agree that:
- The longer the time period in question, the less likely it is that stocks will lose money relative to their starting value (“stocks become less risky”);
- The longer the time period in question, the less predictable the ending value of a stock investment (“stocks become more risky”);
- The longer the time period in question, the more likely it is that stocks (and just about everything else, for that matter) will experience a catastrophic loss relative to their starting value due to a genuinely catastrophic economic event (“stocks become more risky”); and
- The longer the time period in question, the more likely it is that stocks will outperform safer investments.
The suggestion that young people should have stock-heavy allocations is often based on the idea that stocks become “less risky” over time. Bodie and Taqqu reject this idea, but they still make the case that younger investors can typically afford to have a larger portion of their portfolio invested in stocks than older investors can. Their reasoning is that, while stocks don’t get any less risky with time, investors become less risk tolerant over time.
Economic Risk Tolerance
Bodie and Taqqu argue that young investors can take on more risk because they have a greater degree of financial flexibility. (As you’ll see — next week, hopefully — this is very much in line with my explanation of risk tolerance in the 2012 edition of Investing Made Simple.) This increased flexibility is the result of a few factors, including:
- The more years you have left in the workforce, the more chance you have of being able to shift to a higher-paying position (or career), should it be necessary to increase your savings rate due to poor investment returns.
- The younger you are, the greater the impact of cutting your expenses by a given percentage. For example, bumping up your savings rate from 15% to 20% will have a huge impact if you make the change at age 30 but only a minor impact if you make the change just a few years before retirement.
- It’s much easier to stay in a job than it is to find a new job, so risk tolerance declines significantly immediately upon retirement.
Emotional Risk Tolerance
An investor’s emotional ability to take risk often declines over time as well, due to the simple fact that his/her portfolio is larger than it’s been in the past. For example, a 40% portfolio decline at age 25 might mean losing an amount of money equal to just a few months of wages. At age 55, it’s the equivalent of a few years of wages. Many people become understandably nervous when they see that their portfolio has lost more money in the last 6-12 months than they’ve earned in the last 4-5 years.
Hi. I'm Mike Piper, the author of this blog. I'm 
Why should asset allocation change over time? Because it can. Asset allocation isn’t the only risk management strategy people tend to use. Because of all the uncertainty involved in planning for the future. It’s in our nature to err on the side of caution, i.e. over-plan. Savings rates and withdrawal rates are chosen that would allow us to meet our goals in not only likely market scenerios, but in many unlikely ones as well, just to play it a little safe. We also choose an asset allocation that has a high potential for real returns because of the uncertainty of inflation and longevity. This means that there is a higher likelihood that we’re over-planning than under-planning. As that becomes apparent, we can afford to take less risk. It’s human nature to have less tolerance for risk that we don’t need to take.
This is not that different from the behaviors we may exhibit when going to the airport. We may leave early and drive fast because of the uncertainty of trafic or long lines at airport security. But as we get closer to the goal of making our flight, we usually start to slow down because we can. There is less need to risk a ticket or an accident because we’re more confident of getting to the gate on time. I hope that all makes sense.
I posted this morning from my iPhone just to share add a few thoughts on your insightful post on a topic I really enjoy, the link between risk taking and ages. Sorry if my comment came across as confusing or argumentative. I mean for it to be an expansion on the ideas shared in the post. 🙂
Nope, wasn’t confusing (at least not in my opinion), and I did not take it as argumentative. I just didn’t have much to add (except a paragraph break). 🙂
Mike, my only issue with the above is the characterization of declining risk tolerance as an emotional thing. For me, concern about a potential 40% drop at age 55+ is entirely a rational thing. It’s very different from being ruled by your emotions as might be the case with someone who panics at a drop in the market and sells everything.
I see though too that despite your title, you’re talking primarily about less exposure to stocks at 55+ without stating if you endorse a strategy like Bodie’s flag-waving for TIPS. This is becoming a real dilemma for me as I approach retirement in perhaps 3 years. I’m right now about 50/50 between stocks and bonds, and stocks have done well for me since 2009. This in itself raises a yellow flag since what comes up often comes down. But would it be wise – not on emotional grounds, but because it would be the most prudent strategy for my money – to lock in some of my gains and move closer to a 40/60 split at this point or go even more conservative yet? This would mean rebalancing my accounts even though I understand the arguments against unnecessary rebalancing, but should an age-related shift in allocation take precedence over any concerns about rebalancing?
Larry,
You wrote, “my only issue with the above is the characterization of declining risk tolerance as an emotional thing.”
I’m not saying that it’s only an emotional thing. I’m saying it’s both emotional and economic/financial. I think investors have a certain level of risk they can financially tolerate (based on their flexibility with goals and so on) and a certain level of risk they can emotionally tolerate.
Depending on the person, one such risk limit could be significantly lower than the other. (And I think in most cases investors should invest according to the lower of the two.)
As to your question, while Bodie is a flag waver for TIPS, I’d say that, if anything, I’m a flag waiver for annuitizing (especially via delaying Social Security, as we’ve discussed before). In other words, if I personally were in a situation in which I was in or nearing retirement and I wasn’t quite sure that my portfolio would sustain the level of income that I desired, my response would probably be to shift more toward lifetime inflation-adjusted annuities rather than toward bonds.
The last paragraph confuses me a bit. Delaying SS makes perfect sense to me. My SSA estimates show a significantly larger monthly amount if I were to wait until 70 to start. But you write also, “if I was nearing retirement, I would probably shift more toward lifetime inflation-adjusted annuities rather than bonds.” Are you suggesting then buying an SPIA in the pre-retirement period? That puzzles me as you otherwise seem to advocate delaying annuitizing.
Forgive me if I’m sounding at all dense on this point. But one sees so many opposing recommendations – everywhere from “age in bonds,” which for me would mean 37s/63b, to 110 or even 120 minus age in stocks, to Bodie’s 100% TIPS, to Robert Kessler’s all in Treasuries, to the Trinity Study’s apparent implication that withdrawal rate matters more than allocation – that the average investor may be pardoned for not knowing what to think anymore.
Larry,
With the exception of Social Security (which is unique because the only way to buy more of the “annuity” is to delay taking it), I don’t think I generally advocate delaying annuitizing.
This bogleheads post from dpbsmith (author of the annuities chapter in the Bogleheads Guide to Retirement) reaches the same conclusion that I’ve reached whenever running hypothetical quote scenarios. That is, if:
A) Interest rates don’t change, and
B) In the “delay annuitizing” scenario, you invest the money as conservatively as the insurance company would…
…then you’re better off annuitizing as early as possible to get any mortality credits (however small they might be at early ages).
That said, my assumptions A and B are both big assumptions. And many people would view assumption A as positively stupid right now. (Personally, while I do agree that rates are going to rise at some point, I don’t see any reason to assume that has to happen soon.)
And, I don’t think you’re being at all dense. These are not easy decisions.
I took a look at that Bogleheads link and should read the chapter by dpbsmith more thoroughly. But for now my question is: it is worthwhile to purchase an SPIA before retirement, and with tax-deferred funds? And if not, I return to my original question, which is: for someone about 3 years from retirement (and considering that right now I can probably fund about 10 years of retirement without SS, and about 20 with), would a 50/50 allocation seem too risky to you, or am I better moving more into relatively non-risk areas like cash, short-term bonds, and/or TIPS at this point?
I’ve been pondering that exact question recently for my own purposes. Frankly, I don’t have a fully-formed answer yet.
I’m sure most people would say that buying an annuity before needing the income is nonsense. But I think most people have a far greater aversion to lifetime annuities in the first place, because they care a great deal more about leaving behind money to heirs than I do.
I think that:
1) If interest rates were at higher levels, I’d go ahead and annuitize even prior to retirement, but
2) Because they’re currently quite low, I’d be tempted to wait to see if rates go up between now and the time the income was actually needed.
Note, I have no reason to necessarily think rates will go up in the next few years, but the mortality credits given up from years prior to age 70 or so aren’t super high, so it’s not a terribly high price to pay. (Of course, there is the chance that rates could go even lower…)
In the event that you decide that you do want to annuitize part of your portfolio, but not just yet, I would go ahead and make the move now to allocate that portion of your portfolio to something low risk.
I don’t myself understand why to take an annuity before retirement, because to me that would be using money earmarked for retirement and reducing my IRA/401(k) balances at a time when I was still drawing an income. As for myself, right now I have about 30% of my portolio in cash, TIPS, and short-term bonds, which I trust you’ll agree qualify as low-risk, and I may move more money into such assets in the next few months since I think my portfolio is a little stock-heavy.