Monday, 3 March 2008

An All-Equity Portfolio? .. further thoughts

The admonition that we should all think of ourselves and our investments in a very broad fashion including our own ability to make money (termed human capital) and how we do it is one idea I am finding to be extremely helpful. Not long ago, blogger Michael James had been trying to answer the very good question, "why not have an all-equity portfolio?" since equities outperform fixed income in the long run.

One answer comes in the form of this article For Long Term Investors, the Focus Should Be on Risk by the same Zvi Bodie and Paul Hogan (though it is not part of the book). The answer there boils down to the fact that investment returns are not evenly distributed through time so that an 8% compounded return can have enormously and perhaps disastrously different end values for the investor who puts in (pre-retirement phase) or withdraws (retirement) money each year.

The second answer comes from consideration of one's other sources of income in life. If your job is highly correlated with the stock market, then an all-equity portfolio is extremely dangerous since everything will implode at once. I learned this the hard way by having four and a half years of retirement savings wiped out at the same time I got laid off by Nortel since I had invested the voluntary retirement plan contributions in Nortel stock. On the other hand, someone like my relatives who are in education (job security and completely unrelated to the stock market) with an inflation-indexed, generous defined benefit pension plan should not put a penny into fixed income investments and should put it all in equities. Mind you, then we face the other issue of personal financial planning - the teachers are totally risk averse and don't want to go into equities at all and many of the tech industry workers I know are too keen on equities!


Michael James said...

Although I don't agree with Bodie's conclusions, his advice may be good for most people. I say this because many people take big chances with their finances. Rather than having emergency savings, most people have various debts: credit cards, car loans, lines of credit, etc. Rather than investing in low-cost indexes, most people either own very expensive mutual funds or engage in momentum investing in individual stocks buying high and selling low. Given the big mistakes most people make, they could do well to put some money away in a safe place that gives only modest returns.

I still maintain that if you have adequate cash reserves to cover job loss, and you have safe investments for any money you will need for the next 3 years, all the rest is best put in low-cost stock index funds. The main purpose of the 3-year buffer is to provide adequate planning time if stocks go through a bad period. It simply makes no sense to have a large portion of your savings languishing in bonds for decades.

Unknown said...

Hi Michael, I think the point the gurus are trying to make is that someone's "portfolio" includes everything they own, all their assets, not just their financial assets. That means emergency funds, cottage, land, their jewelry, their car, insurance policies and their pension rights, which Sherry Cooper painstakingly showed in her recent book, in a DB plan can dwarf other financial investments, and finally, their brains and capability to earn income. Viewed that way, there are many non-equity asset classes that people own.

Consumer debt amounts to leveraging one's life and as you say, it increases the risk of future failure/hard times. Since I have zero debt, I feel more able to withstand bad equity markets as more of my total spending is discretionary and I can compress my discretionary spending more easily.

Michael James said...

I agree with you. However, this means that the proportion of your savings that should be in fixed income is highly dependent on your individual circumstances. Gurus often offer some fixed ratio like 70% stocks and 30% bonds that I think is meaningless. Some people I know who have too much debt shouldn't be in stocks at all. I have a couple of Aunts and Uncles who have foregone millions over the last 40 years because they are debt-free and have put all their savings into GICs. In each case, they could have safely put almost all of their money into a broad range of stocks.

Anonymous said...

Great discussion. I personally have a bit of short bonds (20%) to dampen the volatility of our portfolios. Though I'm giving up a smidgen of the return (lower return from bonds offset by gains from rebalancing) I could expect from an all-stock portfolio, I feel it is worthwhile given that bonds lower overall risk.

Though I am personally mostly invested in stocks and feel that currently stocks are a better bargain, it's not always true. There are times when bonds are a better buy and bonds should be purchased at that time.

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