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  • Marius

What Long-Term Investors Got Wrong About Risk

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Everyone who saves for retirement faces a question that determines their financial fate: How should I invest? 

The ubiquitous advice:

  • Diversify across stocks and bonds.

  • Younger people should invest more heavily in stocks while older people should invest more in bonds because stocks are considered riskier than bonds.

You've seen it repeated countless times, but is this good advice?

After testing hundreds of retirement scenarios, we kept finding that many financial plans would benefit from higher allocations to stocks than would be traditionally recommended. In fact, we found that age hardly made a difference in the calculation.

Our Retirement Planning Process

We analyze retirement plans by building a model of all cash flows: income, expenses, investment returns, taxes, goals, and so on. Each scenario is tested 1000 times under a wide variety of market returns. The probability of success is the percentage of trials that were able to fully fund retirement. Once we understand our base rates, we further stress test by forcing various adverse scenarios on the plan, such as high inflation, market drops, weak investment returns. We also compare wealth levels at major milestones, such as retirement and bequest.

A financial plan benefits from adding stocks if it shows improvements in the base success rate, stress tests, or wealth levels, without a major trade-off along one of the different dimensions.

As an illustration, below is an example of what we may see when a plan benefits from a higher allocation to stocks. In this example, the perceived safety of a preservation portfolio fails to adequately protect against unexpected taxes, inflation. The preservation portfolio relies heavily on our estimate of long-term returns. Chances are any long-term estimate will be wrong. The consequences suggested by the stress test would be devastating. Meanwhile, the all-stock portfolio, traditionally perceived as high risk, results in better overall scores across the board.


Our findings defied traditional wisdom so often that we had to step back and ask ourselves, "What is going on?" Could there have been a flaw in our process? Were our estimates of stock returns too optimistic? We have to be careful not to blindly follow what the computer tells us, so we embarked on a research journey to discover the answer.

What we learned suggests that traditional advice is out of date at best, and puts many retirees at risk of running out of savings at worst.

Age is just a number

Our first clue comes from portfolio theory and the formula we use to decide how much to allocate toward stocks. The Merton formula tells us to how much to invest in any risky or uncertain investment, usually a portfolio of stocks. Any amount not invested would then be allocated to some "risk-free" asset, often government bonds.

a mathematical formula
This is a simplified version of the formula we use to determine how much to allocate toward stocks. Use of this formula requires forward looking assumptions of market conditions, an evaluation of so-called risk-free alternatives, and the degree of risk aversion of an individual. Risk-free is a standard industry term and does not imply zero chance of loss. No formula is perfect. All investments have risk and the potential for loss.

The formula uses forward looking assumptions of returns for both the risky and "risk-free" investment. It also relies on assumptions regarding the investment's risk and the individual's level of risk aversion, but not age. Age is absent from the equation.

Study Suggests Adding Stocks May Provide Better Outcomes

Anarkulova, Cederburg, and O'Doherty published an eye-opening study in 2023, Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice. The study agrees with our experience and challenges traditional investment advice. They modeled forward-looking investment returns using data from 1890 - 2019 for a wide variety of countries and used it to simulate the outcomes for savers with income uncertainty, Social Security risk, and longevity risk.

The authors found that a globally diversified, all-stock portfolio dominates target-date funds, which in turns dominate the results of a "safe" 100% government bills strategy. The all-stock strategy showed better outcomes in terms of generating more wealth at retirement, providing higher retirement consumption, and even capital preservation. They found that a household allocating half to domestic stocks, half to international stocks, and nothing to bonds to be less likely to exhaust their savings and more likely to leave a large inheritance.

This effect was only present under two conditions. First, the all-stock portfolio had to be internationally diversified. The reference stock portfolio was 50% domestic and 50% international, but the exact percentage didn't matter. Second, they had to use data analysis methods that reconstruct how stock returns vary over time. Older studies that recommend bond-heavy allocations to retirees assumed stock returns to be fixed or random and identically distributed; an assumption that has since been empirically invalidated.

The possibility of an all-stock portfolio being a better choice for long-term investors was hinted long ago by John Campbell in his paper, Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. He mentioned that the stock market may be safer than bonds for long-term investors if the stock market exhibits mean reversion. Mean reversion essentially means that we expect low future returns after a drastic run-up in price. Similarly, we would expect higher future returns after a drastic decline in price. This is exactly what valuation theory suggests, so there is good reason to believe mean reversion exists. The Anarkulova et. al. paper from 2023 gives us more confidence in this fact as their results only appeared when reconstructing returns with observed long-term characteristics.

Are Stocks Just Sheep In Wolves' Clothing?

What are your goals as an investor? Is it simply to make the number go up? To achieve a "high score" on the leaderboard in the sky? Or is it to reliably fund your future consumption during non-working years?

If it's the latter that you're after, then we need to redefine risk.

In an earlier paper, Campbell set out to answer Who Should Buy Long-Term Bonds? Campbell demonstrated that long-term bonds, despite often being considered a higher risk investment, are a better fit for long-term investors than short-term bonds and cash. According to Campbell, if your goal is to fund long-term consumption, purchasing power matters more than stability of value. Since consumption is the goal, it's the stream of income that you'd be looking for. The ideal risk-free asset would be something that pays a dividend or interest payment forever and is adjusted for inflation. Although this asset would be considered risk free, it would fluctuate widely in price as interest rates change.

Consider what happened with my first homeownership experience. I finished grad school in 2006, immediately entered the workforce, and started saving. Thanks to softness in the housing market toward the end of 2007, I found that I was able to make a downpayment on a condo. I was dissatisfied with my rental unit, and a break in the home buying frenzy felt like buying a home was a good deal at the time. I closed on the last day of November in 2007. Talk about terrible market timing. The housing market crashed almost right after I took possession of the property. Prices on exact comps were down roughly 30%. Peers left their keys on their kitchen counters and walked away in despair.

From a practical perspective, nothing had changed. Despite what real estate websites wanted me to believe about the "value of my home," everything about the home was still the same. The home still provided warm, dry, and comfortable living. It was still a great community. The location was convenient to all that was important to me. I continued living there happily for the next 12 years, for the price that I agreed to pay in 2007.

Similarly, long-term investors, who draw only a small fraction from their portfolio each year, are like the long-term homeowner. All this should be familiar to income and dividend investors, who care about cash flow and not about the stated value.

In some ways, a well-diversified stock portfolio can look like Campbell's idealized risk-free portfolio. Such a portfolio has no definite end date. Businesses keep going, and the ones that close are replaced by new ones. While stock prices get hit by bad inflation news in the short run, most businesses are able to adjust their prices for inflation and increase their payouts to investors over time. Of course, stocks in the real world still have plenty of economic risk and uncertainty, but certainly not as much as price fluctuations would have you think.

In many ways, stable value and stable income are mutually exclusive. You cannot get both at the same time. When we sign on new clients, we ask the question:

Which are you more worried about?

  • That my investments don't earn enough for my needs.

  • That my investments might temporarily take a dive.

It turns out that the safer an investment appears in the present, the riskier it is in the long-term future. No investment is truly free of all risk. Selecting a seemingly safe investment pushes risk into the future where you cannot perceive it.

Why don't more advisors think this way?

Portfolios for Long-Term Investors, published in 2022 by John Cochrane, might as well be the ultimate rant in academic finance, although it wasn't meant to be harsh. It criticizes finance theory and industry for failing to solve the important problems faced by real investors, as demonstrated by a wide split between what is done in theory and in practice. One reason has been an obsession to generate alpha, unsustainable wealth at the expense of others.

Perhaps more strongly, the entire financial system seems to be geared toward the needs of short-term investors. Finance research has largely ignored the behavior and relationship of returns across stocks and across time. These relationships are necessary to draw conclusions about the long-term. Meanwhile, industry focuses on point-in-time balances and monthly, quarterly, and year-to-date returns. All of these are meaningless to the long-term investor. Nowhere can you find an account statement that gives you projected future earnings in terms of your long-term annual income based on total returns. Even regulation has cemented traditional advice based on antiquated research by giving employers safe harbor when offering target date funds in their pensions.

What sets Left Coast ahead is the drive to continuously push our knowledge and service beyond what's commonly available. We leave no stone unturned in our quest to give clients the best possible advice we can offer. Managing risk to fit every client's unique profile is our top priority above all others.

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