Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
If I divide the stock part by two, which makes no sense, I still have a huge pile of money.
You do understand that older folks shouldn’t have a huge percentage of stocks?
I’m happy for you that you have a huge pile of money, Laugh. I wish that you could take some joy in it and calm down about things a bit. There are lots of other people in the world who would like to have more money and permitting honest posting on the last 36 years of peer-reviewed research at every discussion board and blog would help them to make that dream a reality. That’s what this is all about.
Most Buy-and-Holders recommend that investors lower their stock allocation as they get closer to retirement. This is certainly a good idea for those following a Buy-and-Hold strategy. Following a Buy-and-Hold strategy sends the risk of stock investing off the charts. It would be dangerous for a Buy-and-Holder to go with the same stock allocation that he used when he was young at a time when, if he suffered huge losses, he would not be able to make up for them. So this bit of conventional advice makes sense in the context in which it is usually delivered.
However, it is not entirely necessary for Valuation-Informed Indexers to lower their stock allocations as they get close to retirement. The peer-reviewed research that I co-authored with Wade Pfau shows that an investor who switches from Buy-and-Hold to Valuation-Informed Indexing thereby reduces his risk by nearly 70 percent. The Valuation-Informed Indexer who does not lower his stock allocation when he nears retirement in most cases is facing less risk than his Buy-and-Hold counterpart who does so. The research shows that failing to take valuations into consideration when setting one’s stock allocation is BY FAR the primary contributor to risk. The other factors (like age) are small factors in relative terms.
Say that an investor has turned 60 and the P/E10 level has dropped to 8, half of fair value. The most likely return is 15 percent real. The investor should be trying to tap into as much of those juicy returns as he possibly can while they remain available. By going with a high stock allocation while the returns offered are so great, he can in a short amount of time amass enough capital to not need to invest in stocks at all when prices go higher (Personally, I would remain in stocks at all times, but not everyone feels this way). So an argument could be made that an investor of age 60 might consider a stock allocation of as high as 90 percent when the P/E10 level is 8.
Does that sound too risky? Yes and no. If he loses lots of money, he is in trouble. But how much lower can stock prices go when stocks are already priced at one-half of fair-value? It is certainly possible that the P/E10 level could remain at 8 or thereabouts for a long time. So the investor should not form expectations that prices are going to jump upward anytime soon. But the return is 6.5 percent real when prices remain steady. The investor does not need to see any price jumps at all to enjoy a very good return on his money.
The price level once fell to 5. That would be a big drop. But the P/E10 level did not remain at that insanely low level for long. If the investor cannot psychologically handle a drop to 5, he needs to go with a lower stock allocation for sure. And of course he needs to be careful that he is not fooling himself. But if he truly believes that he can handle a drop to 5 that only remains in place for a few years, he is probably in good shape. If we were to see a drop to 5 that remained in place for over 10 years, we would be seeing something that we have never experienced before. No one can say with certainty that it will not happen. But the likelihood of such an event is very low. It doesn’t make sense to give up the option to tap into years of huge returns because of a possible outcome that is a very low-probability event.
My take is that investors should lower their stock allocations a small bit when they get close to retirement. Even if it does not make logical sense to do so, the reality is that we are humans, not machines, and there is an added psychological fear that is going to arise when losses are suffered close to retirement age. But I don’t think that Valuation-Informed Indexers need to lower their stock allocations as much as Buy-and-Holders in these circumstances given that they have addressed the far bigger risk factor through their willingness to take the last 36 years of peer-reviewed research into consideration.
Please note the tone in your post. The attitude that comes through suggests that an investor who does not accept that he needs to lower his stock allocation when he nears retirement is a fool. But I have never heard you call those investors who do not accept the need to take valuations into consideration when setting their stock allocations fools. It is the Buy-and-Holders who are the bigger fools, Laugh. The peer-reviewed research shows that failing to take valuations into consideration sends investing risk into the stratosphere. Why do something like that? Why not just invest in the sensible, low-risk, high-return way that works best in the long run?
The answer to that one is that the Get Rich Quick urge that resides within all of us causes our brains to go haywire. Buy-and-Holders like counting the cotton-candy returns generated by bull markets as real. Any suggestion that they consider a research-based strategy makes them go mad because acknowledging what the research says means acknowledging that the cotton-candy returns always get blown away in the wind in the long term.
Valuation-Informed Indexing is a new paradigm. It is the first TRUE research-nased investing strategy. We didn’t have the last 36 years of peer-reviewed research available to us when Buy-and-Hold was developed and Bogle’s unwillingness to say the word “I” and “Was” And :Wrong” has held back the Buy-and-Holders from incorporating the most important research into their model for over three decades now. Drop the resistance to looking at what the research says and everything changes. Even in the Valuation-Informed Indexing era it will make sense for investors to lower their stock allocations a bit when they approach retirement. But this is not nearly as big a consideration in an environment in which investors have opened themselves to taking advantage of the power of the “revolutionary” (Shiller’s word) insights developed (but kept hidden from most investors) over the past 36 years.
I hope that helps a bit, my good friend.