Many of us started getting interest in investing by being interested in making money from individual stocks.
Due to that, we seldom pay enough attention on the portfolio perspective. The proper asset allocation or such higher level considerations.
The problem here is that to be successful in building wealth over the long time frame, it requires you to survive until you are able to see that all these mambo jumbo you read in books and blogs do work.
This means you need to address some psychological worries.
And some of the biggest psychological worries that we often have is “What will happen if we invest all our money before the market falls by 30-50%?”
That is a scary thought.
However, my interaction with others shows that the fear is mixed. Some relish for that opportunity. For good reasons because in those situation they would be able to buy some assets at likely deeply undervalued prices.
So who are those that worry more?
Of course the first group are those that are more risk adverse. They tend to be risk adverse because they are new to investing. So my solution for them is, learn more, get to know more of the subject, understand deeply.
In this way you will build conviction. No one can give you real conviction other then yourself (read my article here).
The second group tends to be people that are older.
Their money is more dear to them. They are afraid to lose it.
I don’t blame them. If I were to put half of what I own in crab farms that tells me I can earn 20% per year, I will be afraid to lose it and not sleep well as well.
We worked hard for our money all our lives and we tend to want positive risk events to happen to our money (a stock X that we own suddenly did something great and went up 140%) but don’t want negative risk events to happen.
If I were to re-label this fear it is: We do not wish to lose a large amount of our net worth, which we think we cannot get back.
For most people, if you are worth $100,000, you dare to risk $2,000 in high stakes, high risk bets, because if you lose the entire amount, you could probably earn that amount back with 1 month of your salary.
If you make a lot of money, you will brag to others you made 500% on it.
However, people get anxious if the bulk of their net worth is in their HDB flat, and the government and the news paper articles tell them that, the land lease is really limited and once it runs out, you have a HDB flat that is worth $0.
We all do not wish to lose large part of our net worth, unless, you think what you are doing is as safe as fixed deposits. Some of the people I know have confidence in their investing strategies that they think they are putting their money in safe fixed deposits.
How Traditional Portfolio Allocation Strategies Can Alleviate These Fear
Going back to the first point, if we do not read up, we might not be aware that traditional portfolio construction can some what alleviate the fear of losing a large part of our net worth.
Even if we have read up, we might not understand the magnitude of the impact of how these portfolio allocation strategies.
Ben Carlson, at A Wealth of Common Sense, have a great article called that showed me some of these simple portfolio allocation stuff is no bullshit.
Ben was exploring how painful bear markets is. And usually, the next one becomes more painful than the previous one (we will explain why later)
He explores 3 different profile of investors and how their wealth will be affected by going through a -50% stock market draw down as the one we experienced in 2007 to 2009.
Each of us start with a different set of competency, life situation, starting wealth, salary, and lifestyles.
Some of the main variables:
- The starting size of our wealth
- Our time horizon or how long this money needs to be ready for use. This affects the bond to equities asset allocation
- How much capital injection we can funnel into our wealth machines every year
In traditional portfolio allocation:
- we allocate the starting amount of wealth into a percentage of bonds and percent age equities. Bonds are lower in volatility and lower returns. Equities have higher volatility but might be compensated with higher returns.
- this can be implemented with individual stocks and bonds, unit trusts, or low cost exchange traded bond and equity funds (ETF). For most active stock investors, it is a decision between a number of individual stocks and cash (instead of or in conjunction of bonds)
- once we fixed this allocation, we inject capital to our portfolio with a fixed amount from our salary annually. We will add on either in equal amounts, or based on re-balancing requirements
- once a year, we re-balance the portfolio back to our desired allocation. For example, our plan tells us to have a 50% stocks to 50% bonds allocation. When the stocks allocation is 60% versus 40% in bonds, we sell some of the stocks to buy bonds. This is how buy low sell high is systematically achieved
- once a year, we evaluate against our needs, and the time horizon we have to invest and whether this allocation fits us. We also evaluate if we should increase the amount of capital injection into our wealth machine.
This is how passive ETF investing is carried out (explained simplistically on a high level) and the annual maintenance actions that is required.
We can pigeonhole ourselves into 3 different profiles. These profiles are segregated by age group:
- Starting wealth: Small
- Future human capital: Large
- Investing time horizon: Long (30-40 years away)
- Capital injection: Small annual amount but gradually growing
- Starting wealth: Medium
- Future human capital: Medium
- Investing time horizon: Medium (20-25 years away)
- Capital injection: Higher
- Starting wealth: Large
- Future human capital: Small
- Investing time horizon: Short (5-10 years away)
- Capital injection: Highest
Where would you fit in?
These avatar are based on society norms, but your situation might be slightly different.
Based on age group, I would fit closer to Gen X. However, based on my needs (investing time horizon), wealth and future human capital, I would fit more towards the Boomer. Your mileage might vary.
Our profiles, or these variables will affect our allocation:
- If we need money faster: More bonds versus more equities
- Our investing horizon is longer: More equities versus bonds
- In all cases, the portfolio needs consistent capital injection
- You stay consistently invested
In Ben’s simulation, the allocation is more stock heavy if you are younger, have less starting capital. The profiles where you are closer to the point where you need the money, the allocation to stocks is reduced.
In Ben’s simulation, he also assume the bond returns to be 0%, which will be more conservative because bonds still contribute some returns. The returns would be purely driven by stocks/equities.
So how did they react to a -50% shave in equity/stocks?
The young person was largely unaffected. This is because the person didn’t have much money in the first place. A lot of his wealth came from the monthly contributions and the growth in the market subsequently.
If you look at it the other way, he also do not have much money to take advantage of a 30% plunge.
Even if he did, I wonder how much of a difference it makes, versus his subsequent capital injection.
The middle aged guy probably felt some pain because he would have built up more starting wealth than the young guy.
However, the graph look almost the same if we zoomed out probably because:
- his capital injection is larger
- traditional portfolio rules would have start or have tweak his portfolio to a lower stock allocation versus the younger guy
- the stock market generally end up higher
The guy nearest to the time he needs the money probably felt the most pain because he has the most money in the market.
The amount of unrealized losses or draw down from the peak felt would be the highest.
However, everything worked out because:
- traditional portfolio rules would have start or have tweak his portfolio to a lower stock allocation versus the other 2 guys
- the stock market generally end up higher
I would contend that why this worked out is because the USA stock market have done well in these past 10-11 years. It would be more interesting if we carry this out in the local context.
The Singapore Straits Times Index didn’t do so well and even today, after 11 years, it is still below the peak.
As a summary, Ben shows the level of portfolio draw down. The Boomer, or someone near the retiree definitely felt more pain, but I contend that its much more livable to be down 300k then 500k of your net worth.
The more you lose, the more likely you might not stay in the game.
Thus, you might missed out on the recovery. It is not selling that kills you, it is not getting back in after you sold that is the big issue.
Ben goes a step further, by exploring the title of his article, of a subsequent -30% fall in the market.
The next plunge, after this, is more painful, simply because you have more wealth then.
So its like the more wealth you have, the more then market tempts you to exit the game.
The table above shows a further -30% bear market. The portfolio draw down in percentage is smaller for the Gen X and Boomer, and larger for the Millennial.
He has more skin in the game now!
The percentage, as Ben says is not the issue. The issue is that we tend to look at the actual dollar figure. And that is a scary amount.
Scary enough that we usually do stupid things.
The old man would have suffered a bigger paper loss, but he would still be better off because his wealth has grown substantially compared to 10 years ago. They all have.
Reducing the stocks allocation over time makes things more livable and that we are able to stay in the game.
However, at the end of the day, to invest, you have to have enough optimism in equity markets.
Majority of the grunt work is done by a stock market that eventually ended higher. It might be a totally different story if the market went nowhere for 10 years.
If you are doing active stock investing, you got to have enough conviction in your process to be optimistic that if you stay in the game, you will do well.
Ben also raised some good points:
- It’s difficult to sit through a drawdown and not do stupid things
- There is a difference when looking at the absolute amount of drawdown versus percentage. The absolute will hit you hardest because it is the most realistic. It let’s you know you are losing some real money there
- Our perception of risk is always changing whether you know or do not know. When your wealth is much more impactful, much more functional to fulfill your dreams you might become more risk adverse to risk seeking
- Because you have more wealth over time, a draw down in your wealth will always be more painful than the last
Here are the things to remember:
- Understand how much of your wealth is in what you own now versus how much is in your future wealth from your career. It may make you more risk seeking and less fearful
- Capital injection from your annual salary is an important part of the system to achieve the targeted level of wealth. For that you need to understand the wealthy formula
- When you are near the targeted amount of wealth that is functional, reduce the volatility accordingly. A lot do not respect the strategic plan and choose to be risk seeking excessively, as a sport, to beat the index, for bragging rights, or totally ignorant of the portfolio aspect. It might reduce your stress.
- Re-read the additional points Ben Carlson brought up above
- For those who are interested to see the performance if you dollar cost average into the STI ETF 2 months before the GFC, you can read this article here.