A REQUIRED RATE TALE: "HOW MUCH STOCK SHOULD INVESTORS HOLD?"

I have spent a disproportionate amount of my life over the two decades looking at financial websites and articles written by trained journalists posing as trained financial experts. One of my favorites is Yahoo! Finance and today I ran across an article with the heading “How Much Stock Should Older Investors Hold?” The writer interviews a number of financial planners and guess what they find? They find that fear is running throughout this “segment” of the population. I don’t mean to pick on the writer or Yahoo! Finance since an article like this is written on a daily basis in some reputed publication somewhere and has been written for the last 50 years and will be written for the next 50 years. But it is nonsense.

In summary the article tells us that older investors are holding less stock as a percent of their portfolio because they are fearful.  They have been burned in the past and of course they fear the past will repeat itself.  What I want to know is, are younger people not fearful?  Does fear increase with age?  What exactly defines someone as “old” when it comes to how much stock to include in their portfolio?  Here is what I know for certain, attention –grabbing subjective headlines like these are meant to capture eyeballs but they are very destructive to the psyche of the untrained reader.  The real question that should be asked is—How much stock should investors hold?  Old or young has nothing to do with it.  So, how much stock should investors hold?  The answer is—as much as required to earn the returns necessary to achieve your goals and is why I call this tale A Required Rate Tale.

Subjective, attention-grabbing articles need to be closely examined.  Articles that stress fear and encourage poor investment behavior are particularly dangerous because they encourage the reader to take an action or follow a “herd” instinct that may cause them to lower their allocation to stocks because “others” are fearful.  These articles are tempting and offer the false hope of “safety” without the compromise of lower returns.  Fear-based articles allude to the notion and encourage the reader to develop a mistaken belief that they can overcome the laws of simple mathematics.  The lesson of this tale is the following—stop fooling yourself with thinking you can have your cake and eat it too.  You can’t.  You can’t earn stock market returns owning bonds and you can’t have the stability of bonds by owning stocks.

This of course brings us back to the question, how much stock should investors own?  Once again the answer is whatever is required.  So how much is required?  That is the real question.  This tale does not answer that question because it is a matter of your particular set of circumstances.  But, it does frame the puzzle and it does tell you what is required based on two other factors, the inflation rate and the distribution rate.  We learned about both of these factors in An Inflationary Tale and in A Distributive Tale.  In summary those two tales teach us that the purpose of investing should be to at a minimum maintain your purchasing power and that in order to maintain purchasing power you need to make a higher rate of return on your investments than the inflation rate.  So whenever you read headlines like the ones that play on fear and offer the false hope of reward without risk make sure you understand–it is a behavioral trap.  Don’t fall for it.  You can’t have your cake and eat it too.

Here is a surprise and something you won’t hear a journalist tell you given our societal tendency to think we are in control of our destiny.  It really doesn’t matter what you as an older investor think, want, desire or perceive of the capital markets or the investment climate.  When you retire and your money must work for you instead of you working for it, you run the risk of running out of money.  The saying “You can run but you can’t hide” applies to your portfolio and the assets you select for inclusion in your portfolio.  You can try to “run” from stocks or the perceived “risk” they pose but you can’t “hide” from the fact that bonds, money markets or CDs interest rates are not just currently low but historically don’t provide the solution for a perpetual flow of income into your retirement.  So please understand that regardless of what you read or what others are doing, you are not immune to inflation or the amount of money you need in retirement or the allocation of stocks in your portfolio.  Read this tale with the understanding that you cannot escape your mortality.

Since the intention of these tales has been and will always be to educate and promote financial literacy, this can only be classified as A Retirement Tale.  However it has universal applicability.  If you find yourself sitting on some board or institution or on top of a pool of assets you have to manage and protect, it also applies.  This tale applies to anyone with a set amount of money they must grow in such a way as to achieve two goals.  The first goal would be to provide a steady stream of income that keeps pace with inflation and the second goal is for it to last for an extended period.  It doesn’t cover all of the factors in the decision-making process but it is the first step one must consider.  Why is it the first step?  Because it lets you easily see what the required rate of return must be on this pool of assets in order to achieve your goals.  It is then easy to select the ranges of risk vs. return strategies you can target.

This tale covers 3 of the factors you must consider in order to make your money last.  They are requiredrate of return, the inflation rate and the distribution rate.  Of these three it is clear you can’t actively control the inflation rate.  What about the other two?  While in theory it is possible to control your distribution rate or the amount of money that your pool or portfolio must periodically distribute, in practice this just isn’t the case.  You aren’t going to retire at age 65 or 70 expecting $50,000 a year from your portfolio and then magically only need $10,000 the next year.  Once you set a distribution rate I have seen people that can alter it a little but in practice it stays constant and even needs to increase with the inflation rate to maintain a standard of living.  So in practice, just like the inflation rate is beyond your control so is the distribution rate.  This brings us to the last factor–-required rate of return.  Guess what,required rate of return is also not under your control. The table that follows shows it is not under your control.  If you require an X% rate of return to not run out of money then there is no way to dispute the math.  What is under your control is the amount of stock you hold in your portfolio which is why I urge you to read An Asset Allocation Tale before proceeding.

This tale shows in unambiguous terms what the required rate of return you must earn on your portfolio so that it lasts for 30 years under different distribution and inflation rate combinations.  You might even want to read the long and laborious paper I co-authored in the February 2010 Journal of Financial Planning article entitled A Simple Dynamic Strategy for Portfolios Taking Withdrawals: Using a 12-Month Simple Moving Average to understand the not so intuitive notion that allocations of 60%-70% of your money to stocks vs. bonds have historically given you a better chance of your money lasting 30 years than the opposite allocation.  Lastly, the table assumes your annual distribution must keep pace with inflation—which is customary for analytical purposes.  However, please recognize it is a heroic assumption in my opinion since most people I have met when they retire have no need to actually keep pace with inflation.  They become what I call stealth savers.

Politically correct planners like to talk about designing portfolios where “you don’t outlive your assets” or “so you don’t exhaust your assets” but they are sugar coating things.  This tale is important because what I and everyone I know worries about is the phrase “so you don’t die broke.”  Once you understand the table you will be able to develop strategies to help you on your journey.  If you read too many articles about what others are doing you might think you can escape your destiny but once again—-you can’t.  I will provide you with some insights in A Preservation Tale to help you develop strategies to aid your journey.

When you look at the table you can see how difficult it is to have your money last for 30 years.  30 is the number many financial planners use as a goal for money to last.  It was derived from the concept that a person retired at age 65 and then might live to 95 so one should plan for 30 years of portfolio distributions.  Yet an examination of the table shows that in some cases even for people with the ideal low lifestyle requirements or low distribution rates and high rates of return on their portfolios they can run out of money before the Magic 30 is achieved.  Said differently at least some part of your portfolio strategy is beyond your control.  You simply must live in a country, society or time where the capital markets are conducive to your objectives.

Before reading any further please take a look at the table below.   I consider it the first place a person reading a fear-inspiring article should look if they are determining how much stock they should hold.  Remember fear-inspiring articles make people sell stocks.  You must determine if it is a good idea.  The table below will help you determine if your situation allows you to lower your allocation to stocks.

Let’s play a game called “Don’t Die Broke.”  There are all sorts of ways to play the game but you must play wisely or you will lose.  The way you start the game is to ask yourself the following question, how much money do I need on an annual basis in order to maintain the lifestyle to which I am accustomed?  This always comes out to be a dollar amount and let’s say you answered $50,000 per year.  The next step is to ask, how much money do I have?  The answer is also always a dollar amount.  Let’s say you answered $1,000,000.  You then divide $50,000 by $1,000,000 to get a 5% distribution rate.  You then look at the table and see the possibilities available to you.

What are the possibilities?  You can see if the inflation rate is 0% you are required to make an annual rate of return of 3% per year for your money to last 30 years or more.  But, if the inflation rate is 1% then you must make 4% per year.  If the inflation rate is 2% you must make 5% per year.  At 3% you must make 6% per year.  At 4% you must make 7%, at 5% you must make 8%, at 6% you must make 9%, at 7% you must make 10% and at 8% you must exceed 10% per year.

It’s important for the reader to recognize that these numbers are the same for anyone regardless of how much money they have, where they live, what articles they read or what others are doing.  This table is a universal table.  Once you determine a distribution rate then there is a required rate of return associated with a given inflation rate.  It is pure math and it is the same math for everyone.  Once you determine a distribution rate the only thing that you can still control is your asset allocation which is why this tale is so intertwined with An Asset Allocation Tale.  You cannot control the inflation rate.

How Many Years Will Your Money Last at Different

Distribution Rates, Inflation Rates and Rates of Return.

What’s obvious from this is that the higher the distribution rate and the inflation rate the higher the required rate of return.  The higher the required rate of return the higher the risk a portfolio needs to take.  The higher the risk a portfolio needs to take the higher the percentage of stocks a portfolio must hold.  So the answer to the question How much stock should older investors hold is a function of their situation.  However, there are some facts that are not preferences but subject to the laws of nature or mathematics.  Do not delude yourself.  Lastly, let’s recognize what we learned from A Distributive Talewhich is that the Distribution Rate is more important than the Inflation Rate when it comes to portfolio management so that you don’t die broke.  This table is crucial to anyone that is embarking on the 30 year journey.  It’s the road map.  While a person can’t control the Inflation Rate they can control their lifestyle or Distribution Rate and they can control their portfolio allocation.  Here is where the tradeoffs and conversations begin and portfolio management for this phase of life gets complicated and must factor other aspects into the equation.  Let’s take some examples as how you might use this table.

Mr. and Mrs. Jones are 65 and have $1,000,000 when they walk into an advisor’s office and want their portfolio to last 30 years.  They need $50,000 per year they tell the advisor.  Let’s take a leap of faith and assume the advisor is a competent one.  The first thing a competent advisor would do is to pull out the table above and make an assumption about a future inflation rate.  Please recognize that your advisor is making a guess since neither they nor I nor anyone has a clue as to the accuracy of the forecast.  Nevertheless since you can’t escape this need to forecast, let’s assume there will be an inflation rate of 3%.  The advisor also recognizes that their services are not free so he or she adds their approximate 1% annual fee on top of the table calculation and determines The Jones’ must earn a 7% rate of return in order to not run out of money in 30 years.  The advisor then informs them that the only way to earn this type of return is to take some risk with their portfolio.  This means they must own stocks.  He tells them there is no way they can earn 7% in a guaranteed account.  If you refer to An Asset Allocation Tale I provide a chart that tells you approximately what level of risk as defined by how much money you need to allocate to the stock market in order to achieve a 7% rate of return.  As we can see the historical average number is 40%.  This becomes a guide because what we also see from the chart in An Asset Allocation Tale is if the Jones embark on a 7% targeted rate of return journey for the next 30 years and they start their trip at the wrong time they could lose as much as 26% in their first year.  This would probably blow up their retirement plan, depending on the portfolio composition, due to the mathematics of recovery which we can learn about in A Tale of Recovery.  Like I said earlier, there are tradeoffs and this is where conversations must begin when making decisions such as this.

The choices a competent planner might present is to lower the allocation from 40% stocks to some number that is more comfortable though based on averages less likely to succeed.  Or perhaps convince the Jones to live on less than the $50,000 so that the required rate of return is lower which would then require a lower stock allocation.  It could be a combination of the two and usually is in most cases.  In many cases the solution might be to keep earning income for a few more years and not retire.

A final point about this tale is the other factors that need to be considered.  The reality is that making money last for 30 years is a complex problem with no correct answers since a number of factors are beyond the investor’s control or the advisor’s control.  I use the word complex not as a synonym for complicated.  Complicated problems are deterministic and are solvable.  Complex problems are not.  If making money last for 30 years were an easy problem to solve, I and others would have solved it.  However there are too many moving parts to the equation.  The factors that matter are well known, they are the distribution rate, the inflation rate, the initial starting point or timing, the required rate of return and the volatility of the portfolio you choose.  I urge the reader to also refer to A Tricky Tale so that they can see how portfolio timing and volatility play a factor in determining the appropriate strategy.

So is it a hopeless situation trying to make your money last?  Must you have an uncomfortable allocation to stocks in your portfolio?  The answer is as always—it depends.  What I have seen in real practice is what I call The Just in Case Effect.  This effect is characterized by the investor over-estimating the initial required distribution and then not increasing the distribution to keep up with inflation.  Every table you will ever see such as the one I show above makes 2 heroic assumptions.  The first is that the investor knows what their distribution rate should be.  The second is that they want to keep up with the inflation rate.  The reality is that people have a tendency to over-distribute from their portfolio and then save money from this over-distribution.  This has two consequences.  The first is that over time the investor starts accumulating cash that they either eventually re-invest in the portfolio or use it as a piggy bank so that they don’t have to take ever higher distributions to keep up with inflation.  It is not unusual for investors that started out at age 65 for example receiving $3000 per month to still be receiving $3000 per month 5-10 years later.  This self-imposed and stealth lowering of the distribution rate effectively means they are theoretically lowering their life-style and thus extending the time frame their money will last.

I have been unsuccessful trying to model this effect but recognize it is the way real people actually behave—-Just in Case.  When making your plans you should recognize this is how you will also more than likely behave.  This means that you can reduce your exposure to stocks if this is the way you will operate.  By how much can you reduce it?  It depends on your situation.  I hope this tale helps.