Sally’s next door neighbor and good friend Robert Rischi is the typical stock junky. He, like Sally, is also 60 years old and has been investing $1,000 per month for retirement for the last 15 years, ever since his 45th birthday. However, in stark contrast to Sally, he surrendered to the siren call of the mutual fund and investment industry and has been allocating all of his savings to the equity market. Mind you, to maintain a diversified equity portfolio, he has allocated 75% to a broad collection of Canadian equity funds, with the remaining 25% going into broadly diversified U.S. equity funds. In the language of financial planning 101, he has been dollar-cost averaging into the stock market, buying more units when prices are low and less when prices where high. He has been careful to stay away from the high-cost mutual funds and concentrated bets on particular industries. After all, his RRSP isn’t meant for gambling.
Oh yes, Robert has endured some sleepless nights and restless days over the last few years, and especially the last 18 months; but he has been steadfast in his belief that over the long run the extra market volatility and financial stress will pay off with a handsome nest egg. In the language of financial economists, he is riding the equity premium. In fact, he periodically teases his neighbor Sally about her overly cautious retirement account, and has promised to invite her to his paradise retirement home in the Caribbean.
And, after 15 years of investing his portfolio is worth $221,150 at the end of March 2009.
Yes, you read that correctly, for all the risk Sally shunned, the equity premium she missed and the teasing she endured, she is actually ahead and has approximately $17,000 more money than Robert, after 15 years of investing. Oh, and if Robert had allocated 100% of his portfolio to Canadian stocks, he would have had $243,200 which is more than his cross border 25/75 portfolio. So much for international diversification.
Now, wait a minute, you might cry: “What exactly was Robert holding all these years? You are cherry picking!” Well, I assumed Robert was holding typical funds linked to Canadian and US Equity indices, on which he was paying (only) 100 basis points of expenses each year. If Robert was paying closer to 200 basis points in annual fees, his nest egg would be worth $202,000, which is $37,850 less than Sally. And, if you believe that the end of March/2009 isn’t a fair ending point, consider the end-of-December/2008 values: Sally has $234,500 while “Buy and Hold” Robert has $226,500.
So, what exactly went wrong?
It seems an entire generation of Canadians has been unlucky, or perhaps confused by the buy-and-hold mantra. Over the long run all this stress was supposed to pay-off with handsome rewards. Sally was supposed to look back with regret, at retirement, since Robert would be so far ahead. This has clearly not been the case and only time will tell – perhaps when Robert is 70 or 80 – if indeed his nest egg will ever surpass Sally’s by a wide enough margin to make it all worth his while.
Take Away
I am quite sure that most Canadian financial planners would never advise Robert to allocate 100% of his RRSP to equities, Canadian or international. Perhaps the portfolio would have been tempered with some asset allocation to bonds and other classes. The possibilities are endless and indeed, some alternative Roberts might be ahead of Sally. However, many others who have been buying and selling for the last 20 years have ended with much worse account values than all of the above-mentioned scenarios. They bet on performance that never materialized. And honestly now, beating Sally isn’t much of an achievement when you consider the little skill that requires.
Indeed, I believe that your equity allocation should depend much less on your so-called time horizon, hard-to-measure risk aversion or fickle confidence in the stock market, and much more on the composition and structure of your personal balance sheet. If your job is reasonably secure, your pension is protected and you income is predictable, then go ahead and take some stock market risk with the non-essential funds. Thus, I personally am still very heavily allocated to equities/stocks because I have a secure job with a Defined Benefit (DB) pension from the University. Economists call this general asset class human capital, which is likely more valuable than financial capital.
So, here is the bottom line. The long-run can be very long indeed. The financial planning theories we have used to quantify the “probability of regret” from equity investing must be revised after the new statistical evidence we have uncovered during the past year. The potential rewards must be tempered. To loosely paraphrase one of the greatest economists of our time, Professor Paul Samuelson, the long-run case for equities shouldn’t be oversold.
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As global markets remain frustratingly volatile -- and highs of a few years ago remain a distant memory -- now is a good time to remember that your 401(k) plan was never meant to be a pension plan. Retirement is more than just a number, it’s what you do with that number that counts.
A traditional pension, often called a Defined Benefit (DB) plan promised a guaranteed paycheck during your golden years. The size of your pension check depended on the number of years you worked for the company as well as your salary near retirement. A typical DB plan replaced 60% to 80% of your final salary, guaranteed. But, in recent years an increasing number of companies have frozen or eliminated their traditional pensions and replaced them with 401(k) plans. In other words, most companies are shifting the responsibility of retirement income directly to their employees. The risk and possible reward sits squarely on the shoulders of individuals. If markets don’t live up to their expectations -- and especially if stocks decline around the time people are supposed to retire -- the nest egg will be woefully inadequate.
So, what can you do about this turmoil? Unfortunately, in the short-run the answer is nothing. Selling all your investments now and moving to cash is futile. On any given market day, it’s virtually impossible to predict how markets will perform. Moreover, market timers have to get two things right: exiting prior to further declines, and entering again prior to the inevitable rebound. Some might get the first one right, but the odds of hitting both nails on the head are exponentially smaller.
Yet, for your long-run financial health and sanity I do have some economic aspirin. Now is the time to take a very close look at your job, profession and career and ask yourself an odd-sounding question: Are You a Stock or a Bond?
Let me explain. From an economic perspective your personal balance sheet – which is a concise statement of your total net worth – consists of two distinct categories of capital or assets. They are (i) financial capital and (ii) human capital. Your financial capital is relatively easy to visualize. You don’t need special glasses or measuring cups. It is the market the value of anything you can auction on eBay or sell for cash. That includes your investment portfolio, your retirement plan, your house, your car and perhaps even the family pet. The other type of capital on your economic balance sheet is your human capital. That is invisible to the naked eye, but is also an asset. It can be quantified as the present value of future wages, salary and income you will earn during your working life. Human capital is the oil in the well or gold in the mine called You Inc.
We now reach my main point. Make sure you manage your human capital and financial capital, jointly and together. The old maxim that counsels to keep your eggs in different baskets is just as relevant on the macro (jobs and portfolio) level as on the micro (stocks and bonds) level. Make sure your retirement plan’s financial capital and your job’s human capital are in completely different buckets. Indeed, the majority of hard working folks at Bear Stearns, Sprint, General Motors and Dell Computers, not to mention Enron, learned this lesson only after it was too late.
So, for example, if you work in the financial services industry, your retirement plan investments should be tilted towards consumer staples, healthcare or information technology. And, if you work in the airline industry, your portfolio should overweight energy and natural resources, etc. If you manage a hedge fund, I suggest your financial capital be entirely in treasury bills and bonds. If you are a teacher, fireman or policeman with a steady and reliable income that will convert to a lifetime DB pension when you retire, then your financial capital can be entirely invested in broadly diversified stocks.
The bottom line again is as follows. Make sure your human capital (i.e. your job) and your financial capital (i.e. your money) are in completely different sectors. This way, when one zigs the other zags and the true value of all the assets on your balance sheet won’t fluctuate as much.
At the very least, next time you check the value of your investment portfolio and feel the urge to jump from the highest window, remember that your human capital is still the most valuable asset class on your personal balance sheet for most of your working life. Jumping will exhaust that one too.
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