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ISSUE 31: TIME PART TWO - LESS TIME EQUAL LESS RISK?

Does Less Time Equal Less Risk?

The theory states that if you have more time, you can and should accept more risk. You might hear phrases like… “time is on your side” or “you have plenty of time to recover.”

While explaining sequence risk, an “expert” once told me that “returns are different in retirement.” Huh? The return for the asset class in that period is the same no matter whether you are close to retirement, just entering the workforce or somewhere in the middle. Returns aren’t different.

 
Why Would I Accept a Lower Return?

 
I was helping a couple (one spouse) review her financial plan to determine many of the questions spouses consider (or should consider) as they navigate the financial side of divorce. The other spouse attended one of our meetings. We discussed probability of success, return and risk. Given that I had already run a plan for her, I had a rough idea of what the other would look like.

As I shared the projected allocation, he (not the current client) questioned why we would accept a lower projected return than he had achieved over the past few years. Isn’t a higher return better? The dreaded answer… “it depends.”

I explained that as they got closer to retirement (he plans to work another five years), he will start spending the assets rather than accumulating them. He agreed, but wouldn’t it be better to have more assets to spend when he got there? Maybe, but had he considered the additional risk of the higher allocation to stocks?

He shared he was “OK” with risk. He weathered the 2008 market and maintained course. He was planning to work another 5 years so he felt he could recover from another storm if one came and again, why accept a projected lower return?

 
How much is enough?

 
I asked if he felt five years was enough time to recover if the “storm” hit today? What if it hit next year or perhaps even worse…four years from now? Time becomes a factor but not simply because there is less of it. The reason is the projected need for cash flow from the portfolio. So, although time is the easiest way to explain it; focusing on the real issue (cash flow) will help us build a better plan.

Next, I asked if his plan projected success with lower risk; what is the benefit of having more? Or as the saying from the movie Wall Street states…how much is enough? If your goal is to maintain your lifestyle (measured by dollars spent), what would you do if you had more at “the end.”

In our planning software, having more at the end is reflected as a projected “safety margin.” This is the amount you have remaining after you fund your goals. In this case, the couple have no children and therefore have limited worry about leaving assets to the next generation, but they still wanted to have a “safety margin” … just in case.

The spouse’s plan projected a greater than 80% probability of success based on the expected return (and risk) of a diversified 50% stock/50% bond (50/50) allocation. When using a consistent average real return of 2.96% (5.46% nominal with 2.5% inflation); the program projected 100% of all goals were funded WITH over a million-dollar safety margin. This achieves the desired goals, so I questioned “what would you do with a bigger safety margin?”

 
Your story is different, but not really

 
Before I go further, I want to share an important point. This scenario created a high “nominal safety margin.” Some may look at the number and say this doesn’t fit my situation. Before you do, I recommend considering your safety margin as a number of years’ worth of expenses. In other words, if you plan to spend $50,000 a year from your portfolio, is a $500,000 safety margin equal to a $1,000,000 safety margin for someone spending over $100,000 a year? Maybe…of course some expenses are fixed no matter your income (long term care is an example). The media likes to say you need a certain number to retire. Based on my experience, this is wrong (and defeating to those who won’t have that number).

I have written plans for people who have less than $500,000 saved and project a high probability of success. I have written plans for people with $2,000,000 in assets who will likely run out of money within the first 10 years of retirement. Your success is not based on a number only. Your decisions have a greater impact than your account balance.

 
Risk is a factor

 
If increasing your safety margin above your current goal isn’t important, should you take additional risk? In this case, the probability of success was marginally impacted by adding more stock (risk). In fact, as we added more stock the probability of success fell (because of the added risk). Many are surprised when they first see this result. They assumed more stock equaled more return. That would be true if risk always paid, but then it wouldn’t be risk.

So, I posed the question… “if the probability fell with more stocks, why would you accept more risk, especially given your goals (not leaving a large inheritance)?” His goal was to beat the market (or maybe his peers). This is a different goal than the desire to maintain the current lifestyle. This is important and worth repeating…people without a clearly constructed plan often default to the goal of beating the market or to simply have more. This is their measurement of investing success. This goal often fails to consider the “cost” of risk.

With this goal, it made sense (I suppose) to keep a higher amount of stocks in the portfolio. The current portfolio was closer to 70% stocks with a high amount of US Large Cap. As he looked at the projected returns, he pointed out that he did better so why change? I reminded him of the return in 2008. He said that didn’t matter. He would recover if that happened again…in other words, he has time.

 
Return is…

 
Returns aren’t different in retirement; cash flow needs are. Semantics? Maybe…but a lot easier to say you should have less stock because you have less time than to ask about your cash flow needs, your financial goals and your sources of income in retirement.

But, if the return is the same, should we consider how returns affect investors with more “time?”

I struggled with this comment about time and portfolios since I first heard it. A 50% loss is a 50% loss no matter whether you have 25 years to retirement or 5 years. Yes, you do have more “time” to recover, but that is because you have fewer upcoming cash flow needs. At this point, I would ask the same questions to the person with 25 years until retirement that I would the person with 5 years…if you take additional risk and are rewarded for taking that risk, what would you do differently? My follow up question would be…if you saw your portfolio halved, how would you react? What would you change? Most are affected more by the second question than the first.

 I find that a significant loss in a portfolio is damaging to both people from a psychological standpoint. Knowing you have time to save more and hope the market recovers helps in theory, but some can’t stay the course. If that is the case, time had little to do with the portfolio decision. Bottom line…it takes a 100% return to get back to even after a 50% loss.

Stephanie chose to spend her time…

This past week was Spring Break for Stephanie. This is one of the reasons this week’s post is being delivered later than usual. Like usual, her time with Patty was very different than with me.

Steph began her Spring Break with a trip to Disneyland and California Adventure (with Patty). Sounds like a normal Spring Break. Then she came back and it was my turn. Thursday morning, Rick (the set guy from the theater) let me know he could use some help prepping for The Producers. I asked her if she wanted to help. She jumped at the chance…I am serious…don’t call protective services…I am not promoting child labor!

So, for her second half of Spring Break, she helped paint and build a theater set. If you asked her which was more fun, I am not sure what she would tell you, but I can guess…

I enjoy watching people question why Steph would do this when she could be doing other things during Spring Break. First, I think she likes to be able to say she helped out at the theater. She gets to say, I painted that or I built that. Second, she likes to try new things. I love that she will try new things. Third, maybe she is looking to grow up a little too quickly and wants to do what adults do.

Rick needed a wall “washed” (color added to a base coat that brings out highlights – in this case a soft brush with a sponge). How is she on a ladder? I am fine. I didn’t ask you…I asked your father. She is good up to a certain height. She knows her limitations…and has just enough fear to keep her safe.

So much better than sitting in front of a computer screen…watching YouTube.

As I watched her paint, I thought about how empowering this was. She gained experience with tools and paint and hopefully will continue to have confidence to try new things. She also learned new words (hopefully new) as dad swore at the birdcage he was building…” Hey Rick…I think my dad needs your help!”

 Although different, I think she enjoyed both parts of her break.

Looking Forward

Time is a consideration in most investment or financial planning choices. But, it is not the only factor and maybe not even the most important one. Like most advice, beware of the one size fits all approach. Having more time does allow you the ability to recover, but that doesn’t mean you should ignore your true goals.

Return and risk are correlated. That is a rule you should always consider. To gain a higher return, you will accept a greater amount of risk. The correlation seems to disappear at times…it hasn’t…it is just dormant. Perhaps like a Grizzly Bear after hibernation. Risk looks peaceful while it sleeps…then it wakes and needs to fill its empty stomach.

Measuring risk before the fact can be difficult. After the event, risk is easy to second guess. I don’t use risk questionnaires when building allocations because they are skewed by recent information. When things are going well, investors are often willing to take lots of risk. When things turn south, they want no risk. Instead of risk questionnaires, I share what a similar portfolio did in a bear market. Then I listen to the answer and more importantly watch the body language.

 Not just for retirees…

Time is not simply a retirement concern. I focused on retirement because it is the most common. But, I could have just as easily inserted a major purchase (house, college, helping parents, medical) or surprise expense (lay off or medical). In other words, any significant cash need.

The point of this post is to remind you that you will hear “expert” advice that sounds logical. It will sound logical because for the most part it is. But, I hope you will take a few extra minutes to think a little deeper about the answer. In this case, time is important when considering your portfolio allocation as you enter retirement and before, but for me, time represents the need for cash from the portfolio. When you understand the difference, you’ll make better decisions.

 Next week…how we address expected and unexpected cash flow needs in your portfolio.