William Bernstein is beginning an experiment of sorts. He is writing a series of low-cost e-books called Investing for Adults. The first of these is now available: The Ages of the Investor: A Critical Look at Life-cycle Investing (Investing for Adults).
As he notes, these books are not for beginners. They are for adults who have outgrown their beliefs in stock-picking fairies, market-timing fairies, and risk fairies. I think the first two are clear. The risk fairy tells you that the risks of holding stocks decline with time. Despite the name “expected returns,” you cannot simply expect greater returns for having loaded more funds into volatile assets.
The book is relatively short and is fully of interesting insights. I think it is definitely worthwhile. He divides investing life into three phases: the beginning, middle, and end.
For the beginning phase, the overwhelming consideration is that one’s human capital (the present value of future earnings) will likely dwarf in size one’s portfolio of stocks and bonds. This is a justification for allocating more assets to stocks when young. As well, he discusses in detail the interesting issue of lump-sum investing versus period contributions. Young people are generally forced to contribute new funds as they age (they can’t borrow their human capital at the start) and this reduces volatility and allows them to take advantage of market dips.
Bernstein discusses age-in-bonds, the Ayres/Nalesbuff strategy of leveraging to 2:1 in stocks when young in order to better balance stock holdings with human capital, call options on a stock index as another way to leverage assets, and also the Fama-French approach to focusing on risk factors related to small-capitalization and value stocks.
Despite the fact that young people can take much greater financial risk, Bernstein argues that young people are actually quite risk averse and should probably start with no more than 50% stocks. Then, they should gauge their reaction after experiencing their first big market drop to decide whether their appropriate stock allocation might be more or less than 50%.
As for the retirement phase, Bernstein describes the goals-based approach to retirement income flooring. The objective becomes to secure lifestyle needs and take as little risk as possible. Retirees should build two separate portfolios in retirement: a “liability matching portfolio” (LMP) structured to support desired lifestyle spending with inflation-protected and secure assets, and a “risk portfolio” with any remaining assets which can be used for luxuries and bequests. As RIIA says: first build a floor, then expose to upside.
He describes various options for the LMP portfolio, including inflation-adjusted single premium immediate annuities, a ladder of TIPS, delaying Social Security to 70, and a mix of TIPS and deferred annuities. He also discusses part-time work and a portfolio of stocks and bonds. He notes that about half of the dividend yield on stock holdings could be treated as part of the LMP.
He indicates that it is tough to know which risk is greater: running out of funds because you live longer than the end date for your bond ladder, or running the risk of a systematic financial crisis that wipes out the ability of the insurance company and the state guarantor to provide you with your annuities payments.
He does look at several examples of people with different spending needs. A rule of thumb he provides is that by age 70, people should have enough safe assets to fund at least 20 years of spending needs after accounting for Social Security and other pensions. Of course that is very tough to do, especially in today’s low interest rate environment.
This period is saved for the end because it is about shifting from the aggressive early part of life to the defensive latter part of life. There’s lots of interesting tidbits here, including the idea of waterfalls which get at the heart of intergenerational risk. Those born just a few years apart may have very different lifetime investing experiences. To me, this suggests a need for intergenerational risk sharing as we enjoy with programs such as Social Security. Relying solely on defined-contribution pensions means relying much more on luck.