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Stock Market Investing Risk versus Financial Condition and Financial Stage of Life

InvestorEducation / Learning to Invest Mar 20, 2009 - 03:04 PM GMT

By: Richard_Shaw

InvestorEducation Best Financial Markets Analysis ArticleHere are several archetypal situations that illustrate the differences in appropriate risk taking with respect to stocks depending on the financial condition and financial life stage of the investor — there are, of course, more profiles, but these cross a wide spectrum:


  1. You are 25 years old, don't have a house and are saving for a down payment.
  2. You are 35 years old, own a house and are saving for long-term college for your 1-year old child and for your retirement in 20 to 30 years
  3. You are 45 years old, sold your business for many millions of dollars, are living entirely on investment income and have substantial excess interest and dividend income over and above your lifestyle requirements
  4. You are 55 years old, plan to retire in a few years and expect to rely heavily on your life savings to support your lifestyle — continuing to work is a possibility if your investment portfolio and its performance becomes inadequate to meet your financial needs
  5. You are 65 or more years old, retired, living on a combination of social security, some pension and your investments, but your income and budget are tight such that any material reduction in investment values or income would force you to reduce your standard of living.
  6. You are 65 or more years old, have ample investment income such that a material investment loss or reduction in investment income would be regrettable, but would not force you to alter your lifestyle, or threaten that you may outlive your assets.

It should be obvious on the face of it, that the advice to those six different hypothetical investors should be different.

“Young” and “Mature” Portfolios:

#1 and #2 are “young” portfolios. #3, #4, #5 and #6 are “mature” portfolios. Youth and maturity in this frame of reference are not a chronological concepts (see our article on suitability determination ).

“Young” portfolios are small relative to future additional savings, and small relative to the ability to replace investment losses with future wages or business profits.

“Mature” portfolios are large relative to future additional savings, and large relative to the ability to replace investment losses with future wages or business profits (see our approach to mature portfolios ).

Don't follow rules of thumb about your physical age. Follow logic about your financial condition and portfolio development stage. That's what we are talking about in this article.

Our clients, whether individuals or non-profits, virtually all have “mature” portfolios. Therefore, most of our writing is targeted to and appropriate for that category, but this article touches on “young” portfolios too.

Generic Risk-Based Advice:

Note: Nothing in this article is individual personal investment advice to any specific person for any specific purpose. This advice is impersonal and merely a general discussion of issues. No one should make any investment decision based solely on the content of this article. All investors should carefully consider their own situation, perform appropriate research and/or consult with their own adviser(s) before making important investment decisions.

Each answer below is in relation to the corresponding hypothetical investor listed above:

1. The hypothetical 25 year-old would probably be best served by saving in a bank account or money market fund until the amount needed for a house purchase down payment is achieved. The price volatility of stocks and the near-term fixed amount savings goal for house purchase are incompatible.

2. The hypothetical 35 year-old would probably be best served by investing all assets in stocks now and to be fully invested at all times in highly diversified funds until the child reaches age 8 (10 years to go before college). At that time the portion of assets for tuition would be best converted gradually over the next 10 years to bonds and then money market assets, so that at the time the college tuition is due, the cash is ready — gradually moving away form the volatility risk of stocks toward the lower volatility of bonds and the expected zero volatility of money market assets.

However, that portion of savings in excess of, or separate from, college savings would probably be best maintained fully exposed to equity opportunity, volatility and absolute risk. While today's stock prices may not be the lowest, this investor's low asset base relative to periodic savings amounts and ultimate savings amounts strongly favor full equity exposure and the benefits of dollar-cost-averaging over a long period.

3. The hypothetical 45 year old entrepreneur in early retirement with redundantly sufficient assets should probably also be fully invested in his/her stock allocation, although bonds should probably be in the portfolio as well. A more cautious version of that investor might create two conceptual portfolio buckets. One bucket would be just sufficient to support life style, and be managed very conservatively. The other bucket would contain the excess assets which could be managed conservatively or aggressively to suit the personality, and the perhaps this investor's degree of stock market attention, interest and risk appetite. In that split portfolio approach, the investor would manage the needed base in the same way as the 65 year-old retiree with just adequate resources (#5) and manage the excess assets either conservatively or aggressively according to preference.

A conservative approach would not be in stocks at this moment, because the balance of forces is unclear at best, and a clear trend reversal from bear to bull is not yet established. An aggressive approach could be invested in stocks now, either on the basis that it will all likely work out well in the long-term, or that the investor believes that the bull train is currently leaving the station. However, an alternate aggressive management approach would holding cash while seeking an ideal market bottom.

4. The hypothetical 55 year-old pre-retiree would probably be best served by having a substantial portion of assets in bonds (perhaps 30% to 50%, maybe even 60% “depending”), and a substantial portion of the long-term stock allocation in cash, waiting for clear signs of a trend reversal from a bear to bull stock market (leaving the early stage of the next multi-year bull on the table for the more adventurous and risk tolerant investors, in the belief that there will still be plenty of upside remaining after the trend reversal is clear).

If this investor were to commit cash designated for equity now, he/she would possibly be betting in a game where the outcome could be either (a) more wealth in retirement and possibly slightly earlier retirement; or (b) more years of working for a wage to make up for investment losses, and possibly less retirement income even if more years are worked.

This investor is most likely best served by “being from Missouri” and waiting for proof that the market has turned before adding to US stock exposure. This investor should probably leave bottom seeking to others, and hop on board when a sustainable bull trend is evident.

5. The hypothetical 65 year-old with a tight income-to-budget situation cannot afford to take the risk that the US stock market has bottomed, or is near a bottom, and that it will not decline 20% to 30% from its current level, and perhaps remain below current levels for several to many years ( see our article at Index Universe on the frequency of annual negative stock returns, and the probability of multi-year losses over periods of various lengths). Presuming this investor found a time and way to take some assets off the table before the US stock market reached its recent lows, as some have done, this investor would probably be best served to wait for a clear trend change to a bull market before committing to more equity risk exposure.

6. The hypothetical 65 year-old with ample, redundant investment assets has the same basic situation as the 45 year-old entrepreneur retiree, except that the number of years over which assets must sustain lifestyle are fewer. In our experience, most such investors would rather have amply redundant peace of mind, more than they would rather have aggressive growth of assets that already exceed their lifestyle needs.

If this investor has a passion for investing and a desire to grow assets, for whatever reason (e.g. the fun of it, the challenge of it, or the desire to leave the largest possible inheritance to beneficiaries), then this investor would be best served by bifurcating the portfolio into two buckets. One bucket would be run the way the tight budget 65 year-old would do (#5), and the remainder could be managed aggressively, perhaps as the 35 year-old (#2) might do, or even more aggressively with illiquid private investments, futures, options or exotics according to knowledge, skills and preferences. Most, however, we would expect, would be best served not straying too far afield, and remaining conservative to moderately aggressive.

Conclusion:

What is good for the goose may not be good for the gander. One size does not fit all. With respect to risk, there is no disputing of taste. The facts and circumstances of each individual investor vary.

It is dangerous to your financial and perhaps your psychological and physical well being to take generalized advice from this article or from the financial press without putting that advice into the perspective of who you are, what you have, what you need, how you would cope with possible losses, what financial capacity you have to take risk, and so on.

Recognize your uniqueness and act accordingly. Think for yourself, and take only those risks you are reasonably able to take. Don't bet the farm.

Remember, it takes a lot more percentage gain to replace a loss than the percentage loss itself — a 50% loss requires a 100% gain to break even, or a 50% gain to replace a 33% loss. Too many investors are in exactly one of those two situations today.

Pursuit of gain trumps risk management for those at the beginning of life's asset accumulations. Risk management trumps pursuit of gain for those at the end of life's asset accumulation, and the beginning of reliance on investments to live.

Hope is not a plan. “Should”, “ought to” and “might” are not as safe as “is” when evaluating major trends. Risk management is serious business for serious investors with mature portfolios.

If you have a “mature” portfolio and the current rally is beckoning you to join it, one question is whether this is a bear market rally or a change to a sustainable bull trend. However, the more fundamental question is; “Can you afford to be wrong?” If the answer is Yes, now may be an OK time to take more equity risk. If the answer is NO, then now is probably not the right time to take more equity risk.

Safe journey.

By Richard Shaw 
http://www.qvmgroup.com

Richard Shaw leads the QVM team as President of QVM Group. Richard has extensive investment industry experience including serving on the board of directors of two large investment management companies, including Aberdeen Asset Management (listed London Stock Exchange) and as a charter investor and director of Lending Tree ( download short professional profile ). He provides portfolio design and management services to individual and corporate clients. He also edits the QVM investment blog. His writings are generally republished by SeekingAlpha and Reuters and are linked to sites such as Kiplinger and Yahoo Finance and other sites. He is a 1970 graduate of Dartmouth College.

Copyright 2006-2009 by QVM Group LLC All rights reserved.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Do your own due diligence.

Richard Shaw Archive

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