No matter how young you are, chances are that you are too heavily invested in equities.
I say this not because I think a bear market is imminent—though, of course, a major decline could begin at any time. Instead, I base this declaration on new research that takes a fresh look at the so-called glide path—the gradual reduction in equity exposure as you approach retirement and then live in retirement.
The new research finds that, in some cases, workers as young as 35 should have no more than 70% in equities. That’s a lot lower than previously thought; the target-date retirement funds at both Fidelity and Vanguard that cater to investors this young currently have 90% or more currently allocated to equities.
The new research comes from GMO, the well-known Boston-based money management firm whose quarterly letters have almost become as widely read as Warren Buffett’s BRK.A, +1.42% BRK.B, +1.53% annual shareholder letters. In GMO’s latest missive, Ben Inker, head of the firm’s asset allocation team, argues that glide paths up until now have too often been determined in a vacuum—with little regard for the assets and liabilities that you might have outside your portfolio.
This poses a particular challenge when the risks you face outside your retirement portfolio are correlated with the securities held by that portfolio. What if, for example, the very factors that would cause losses for your retirement portfolio’s equity investments—think severe recession—also could lead you to lose your job? In that event, a holistic focus on your situation would conclude that you’re probably too exposed to equities.
As Inker puts it: “Performance of one’s investment portfolio is not the only determinant of success, and it is almost certain that investors would achieve better overall outcomes if they recognized the risks outside of their portfolios that really mattered and invested accordingly.”
To calculate the appropriate equity allocation in a retirement portfolio, Inker assumed that a worker needed, at retirement, to have accumulated 10 times his or her final preretirement salary. He also assumed that, in each preretirement year, the worker invests 10% in a retirement portfolio, and that his/her salary grows at an inflation-adjusted annual rate of 1%. You can quibble with these assumptions, of course, though it’s not clear that different assumptions would have led to major differences in the bottom line.
That’s because the far more impactful variable that Inker introduced was that an economic downturn would simultaneously hurt the equity holdings in workers’ retirement portfolios and, due to job loss, their ability to continue investing in those portfolios.
Inker focused on three hypothetical workers who all had the same risk preferences, each wanting to enter into retirement with a 60% stock/40% bond portfolio. The three differed only in the likelihood that a recession would lead them to lose their jobs. The one with the highest such probability was someone employed in the financial services industry, while the one with the lowest was a teacher (on the theory that jobs in education are far less likely to be cut in a downturn). In the middle was a worker in a manufacturing industry.
(Inker uses these three industries as illustrations only. No doubt there are other industries whose workers face a heightened risk of job loss during recessions. He also acknowledges that teachers also lose their jobs in a downturn.)
The accompanying chart shows the glide paths that Inker calculated for each of these hypothetical workers. Notice that for the financial service employee, for whom a recession has the greatest likelihood of leading to job loss, the glide path drops precipitously starting at ages less than 30. The teacher’s glide path, in contrast, is closest to what is more traditionally recommended.
Inker’s broader point is that advisers too often fall back on what can easily be quantified, and in the process come up with the right answer to the wrong question. “Whether or not you use quantitative tools to help guide your portfolio construction,” he writes, “the act of trying to determine the nature of the true problem you should be solving for is likely to lead to insights that otherwise wouldn’t occur to you.”
Inker’s argument brings to mind a comment made many decades ago by Benjamin Graham, the father of fundamental analysis and author of the investment classic “The Intelligent Investor”: “The best way to measure your investing success is not by whether you’re beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.