I read Dr. William Bernstein’s Kindle eBook The Ages of the Investor again. This book is worth reading and re-reading a few times.
One nugget I learned from this book that I haven’t seen emphasized quite enough in other books is the difference between investing a lump sum and investing a stream of savings over time.
There’s a big difference. I wish I had learned this difference years ago.
Traditional investment advice primarily comes from investing a lump sum: a pension fund has a pot of money to invest; money coming into and going out of the pot are small relative to the size of the pot. These investors care about the consistency in returns, thus the use of standard deviation, multi-year annualized returns, Sharpe ratio, efficient frontier, and all those good stuff.
An individual doesn’t invest that way. You start from nothing. Money comes in for many years. Then you start to withdraw for many years. An an individual investor, the more important things to me are (a) when I will accumulate enough to retire and (b) how I can make sure the money lasts a lifetime. I don’t care about standard deviation or Sharpe ratio.
If investing a big lump sum 100% in stocks is risky, it doesn’t mean it’s as risky when you are investing a stream of savings 100% in stocks, at least not in the beginning. So what if you lose 50% of your investment in the first year or in the fifth year? Your savings next year and the many years after next aren’t invested yet.
If you get a quick rebound, great, you are back to where you were before the crash. If the market stays low for years, even better. As Dr. Bernstein wrote in his book Investor’s Manifesto:
A 25-year-old who is actively saving for retirement should get down on his knees and pray for a decades-long, brutal bear market so that he can accumulate stocks cheaply.
Let those who already have a large amount of money invested worry about market crashes. Before you get there, investing 100% in stocks for retirement would be just fine.
What about risk tolerance?
Nobody likes losing money. One can learn and overcome the irrational fear though. Think about the money that you will invest in the future. Is it more or less than you invested so far? Will it buy at higher or lower prices? If the answers are more and higher, would you rather buy at lower prices now?
Once our young investors truly understand the difference between investing a lump sum and investing a stream of savings, they will stop focusing on what little they already invested and start looking ahead toward what they will invest in the future. Knowledge is power.
[Photo credit: Flickr user Anne G]
Say No To Management Fees
If you are paying an advisor a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.
David Wilcox says
This goes along a bit with lifestyle investing. If you consider your job as fixed income, then it makes sense to treat it as a bond. You can then find the present value of the bond and consider that as part of your portfolio.
For a lot of young people starting out, they probably have millions of dollars in this bond. What I think you are saying is you should be considering the entire portfolio of someone (including the bond which is their life / job) instead of just what is in the market.
Harry says
It’s not so much as considering your job as fixed income, but simply recognizing that if you are going to be a saver, you will have a future stream of savings to invest. That stream is not as reliable as fixed income. The size of the stream may very well have a positive correlation with the stock market. Nonetheless, you still have a stream that you most likely will invest at a higher price in the future.
The White Coat Investor says
The underlying assumption of your argument, that stocks will return more than bonds over your investing lifetime, is just that. Although likely, it is certainly not guaranteed. I also find that no one really knows their risk tolerance until they’ve gone through a bear market. I think 100% stocks is great for a young person with a tiny portfolio IN THEORY, but in practice, I think adding a dollop of fixed income is probably a good idea, even for a tiny portfolio owned by a 20 year old.
Harry says
That’s where education comes in. It makes one understand the theory and then put it into practice.
How much is a dollop? If it’s a token amount such as 10% as harry @ 4HWD commented below, or as Vanguard puts in its Target Retirement 2050 fund, we are just kidding ourselves. How much does 10% in bonds really help anyway in terms of making our young investor not panic? TR 2050 dropped 35.1% in 2008. A 70:30 mix of Total US and Total International funds dropped 39.6% in 2008. To see some real dampening effect, you need at least 30% in bonds (TR 2025 fund dropped 30% in 2008).
harry @ 4HWD says
I posed a similar question on BH forum a long time ago and everyone brought up the efficient frontier bla bla bla. I ended up deciding on 90/10 for the same reason WCI mentions above and because I don’t think the 10% difference(90 stocks vs 100 stocks) is a good trade-off for the risk.
I know you need to pick AA based on risk tolerance but you can really lose out on a lot of money by investing with your heart and not your brain.
john says
Harry,
My philosophy is to have (120-age) % in stocks. The rest in bonds.
Considering the sequence of returns risk it is always difficult to know when to actually convert to bonds before retirement
1) Every year this helps me gradually move towards bonds
2) Also helps with rebalancing annually.
Any downsides to this strategy?
Harry says
Vanguard shows the glide path for its Target Retirement funds in this video:
https://personal.vanguard.com/us/insights/video/1856-TDNEP02
You see it has a flat top at 90% stocks to age 40. I like it better than straight line down from the very beginning. Where you peg the flat top (90% stocks vs 100%) and how long you hold the flat top are for discussion: early starter vs late starter, aggressive saver vs average saver, good returns in early years vs bad returns, and so on.
Dennis says
When discussing the topic of whether to diversify or not, are bonds always the goto investment? What about real estate? Historically, real estate has better yields than bonds with similarly low volatility. Additionally, real estate follows the population cycles and not the economic cycles which allows for better diversification and economic cycle insulation.