The Hidden Risks Of Equities When Saving For Retirement – ValueWalk Premium
Hidden Risks Of Equities Retirement 1

The Hidden Risks Of Equities When Saving For Retirement

Should those further from retirement safely allocate more to stocks? I’ll use an example to challenge the popular notion that those with many years left until retirement can safely allocate heavily to stocks. I’ll then demonstrate that pre-retirement investment challenges are more difficult to deal with than generating income after retirement.

Q3 hedge fund letters, conference, scoops etc

The motivation for this article came from the recent stock market swoon, which predictably gave rise to a bevy of articles and posts with suggestions about how investors should react. A recurring theme was that those close to retirement had good reason to be nervous, while those with many years of work and investing ahead had less reason to worry. Of course, the important takeaway from such discussions is not whether to be nervous, but instead to focus on appropriate asset allocations at different stages in the retirement-savings lifecycle.

Time is not the great diversifier

I’ll use an example of a 45-year old who wishes to retire in 20 years with a savings target of $1 million (in 2018 dollars). I’ll assume that he or she currently has $340,000 in retirement savings and will be saving $15,000 per year increasing with inflation. This individual will maintain a 60/40 stock/bond portfolio.

I’ll use Monte Carlo simulations to project the range of possible outcomes. But, instead of generating random yearly returns, I’ll employ a technique called “bootstrapping.” This uses randomly selecting 20-year blocks of stock and bond returns from Ibbotson data that covers the years 1926-2017. The objective is to capture historical relationships between stock and bond returns and year-to-year correlations within each asset class. However, I believe that historical returns paint too rosy a picture going forward, so I will scale down the historical returns to produce an average annual arithmetic real return for stocks of 5% and 1% for bonds.

In the chart below I provide downside risk measures showing the 25th and 5th percentiles of amounts saved at retirement in 2018 dollars. For comparison, I also provide the results for a client five years from retirement with $770,000 in savings who is also saving an inflation-adjusted $15,000 per year with a retirement-age target of $1 million.

As for the question, “Who should be worried?” the answer turns out to be both.

Hidden Risks Of Equities Retirement 1

Conventional wisdom might decree that the client with 20 years remaining should not be worried because stock market ups and downs will balance out over time, and additional stability will be provided by 20 years of future savings contributions fixed at $15,000 per year in real dollars. (These future savings can be thought of as the “human capital” contribution to retirement.)

But that’s not what the results of this analysis indicate. There’s roughly a one-in-20 chance that savings at retirement will be less than half what is hoped for, and a one-in-four chance savings will be less than three-quarters of the desired amount. The amount of retirement income such savings can generate will be directly proportional to the amount of savings at retirement.

When we compare the client with 20 years remaining to the one with five years, we see that time and future fixed savings have not reduced risk, but instead increased it. So time is not the great diversifier. Although this challenges commonly held beliefs, it is by no means a new finding. In 1995 Professor Zvi Bodie wrote this article challenging the notion of “stocks for the long run,” and later wrote two books on retirement planning that reflected the same theme – Worry Free Investing and Risk Less and Prosper. However, the view (or perhaps hope) still persists that stocks are safe over long enough planning horizons.

Read the full article here by Joe Tomlinson, Advisor Perspectives


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