Investors should be wary about being too aggressive with the asset allocation early in their careers. As I wrote a few weeks back, many young investors think they can handle a bear market, only to have a rude awakening when the market drops.

In the comments section of that article about Mike Tyson and asset allocation, multiple physicians and non-physicians discussed their risk tolerance and how it affects their asset allocation. One surprising theme in the comments was that many readers have become more conservative with their investments as their net worth has risen. They were aggressive when they had a small investment portfolio, but added more bonds to their asset allocation as their portfolios have grown:

  • Dads, Dollars, and Debts: “I am still at 100% stocks…when I hit $500k in assets, I will start allocating into bonds”
  • A Good Life MD: “I was just a few years into my residency when 2008-2009 hit. I watched my 401(k) go from like 35K down to 20K or so. As the absolute amount was so small, it didn’t bother me at all. Now I’ve got real money and loathe to see it dwindle in the next downturn. I’ve been increasing my bonds to 20%.”
  • Amy @ Life Zemplified: “The higher our accounts get in value…the more I’m glad I started investing in bonds.”
  • Live Free MD: “I used to think I was pretty tough and could handle a big punch. Now, as my net worth increases, I’ve backed off to around 70% stocks.”

Why do investors become more conservative as their net worth rises?

There are many possible reasons why we see smart investors become more conservative (with their asset allocation, not necessarily politically) with their investments as their account values rise.

Risk-Aversion

When we put money at risk (such as in investing), the pain of losing is greater than the thrill of winning. In a poker game with your friends for $10, you might take all sorts of risk. Raise the stakes to tens of thousands of dollars, and you will play more conservatively.

If you treat investing like a high-stakes poker game that you are favored to win, then it makes sense that people will hold more bonds as their portfolio rises. When millions of dollars are at stake, holding some of your portfolio in bonds begins to make a lot of sense.

If investing were simply about maximizing your expected return, then 100% stocks (actually greater than 100% stocks) would be the optimal portfolio. However, you have to be willing to withstand the downturns, and a 60%+ drop in your portfolio (which happened to investors who held 100% stocks during the 2008 financial crisis) isn’t easy.

The absolute decline in your portfolio is scarier than the relative drop in your portfolio. If your portfolio value falls by 40%, but is only from $35,000 to $20,000, that doesn’t mean much to someone making a physician’s salary. You can recover that loss in a few months by saving diligently.

However, when you have a $2,500,000 portfolio which drops 40%, that $1,000,000 loss will keep almost anyone up at night. You can’t make up for that kind of investing loss with a few extra weekend shifts. That’s years of hard work that just vanished into thin air. For investors that have experienced a bear market before, the fear of losing hundreds of thousands or millions of dollars will cause them to hold a little bit of extra bonds.

More Investment Experience

With time, investors begin to have more experience with the markets. Even if you haven’t experienced a big market downturn, you’ve probably experienced a few minor scares in the market.

Even during long bull markets, there are some areas of turbulence along the way.

Older Age

Of course, your net worth grows over time, and as you get older, your bond allocation should slowly increase. Investors become more risk-averse as they get older, not only because they stop thinking they’re invincible, but also because they have fewer years of investing ahead of them.

Fear of the Next Downturn

I think one contributing factor, even if unconscious, is the fear of the next bear market. The current bull market is now 8.5 years long, and many investors think that a bear market is coming soon. There is a fear that we are “due” for a correction. And the case for an upcoming bear market is certainly plausible. Many investors don’t want to lose the investment gains they’ve made over the past 8 years. so they are moving some of their money to bonds.

Implications for Asset Allocation and Risk Tolerance

If having an 80-90% stock allocation (meaning that your portfolio could easily drop 40%) makes you squeamish when you have a large portfolio, then you should definitely increase your bond allocation as your net worth rises. You should never take more risk than you are comfortable with.

However, paring back on your stock allocation as your net worth rises has some implications.

  • Lower expected return — your expected investment returns will be lower with a higher bond allocation. Therefore, you may need to work longer or save more in order to achieve your retirement goals.
  • May need to save more for retirement — the standard investment advice of saving 25x your annual retirement spending for retirement assumes that you hold at least 50% stocks during retirement. If you cannot tolerate a 50% stock allocation when you have a multi-million dollar retirement portfolio, then you will need to save more before retiring (e.g. 33x your annual spending if you only want to hold 25% in stocks during retirement)
  • Think about changes in your allocation in advance — you should plan out what your asset allocation will be when you reach certain net worth milestones (e.g. $500,000, $1,000,000, $3,000,000, etc.). This can be done as part of your investor policy statement. It is not optimal to change your portfolio on a whim when the market is down 5-10% and you see your portfolio drop by hundreds of thousands of dollars.

Conclusion

When the stakes rise, it’s fine to be more conservative with your asset allocation. However, understand the implications of this decision and plan accordingly so you are making asset allocation changes as you reach financial milestones instead of in reaction to stock market gyrations.

What do you think? Have you become more conservative with your investments as your portfolio has grown?

11 COMMENTS

  1. I struggle with this more than deciding whether to intubate somebody or not—haha doctor humor.
    In 2007-2009 my wife and I had about $1 million net worth and were about 80/20 stocks to bonds. Kept plowing more money into equities mostly and now we sit at 3 million net worth not including our paid off house. Anyway it sure is tempting to let it ride as is, but seeing 3 million go to 1.5 million sure would hurt—alot. My plan is for this week to add some bonds to our portfolio.

    Thanks for all the great articles WSP!!

    • I hope the article didn’t scare you away from your asset allocation, but if it helped you better understand your risk tolerance (which may be correlated to the size of your investment portfolio), then I’m happy it helped.

  2. We’re currently at 75 x 25 in favor of stocks. That’s always been my allocation but I do find myself monitoring more closely that my allocation stays at 25. Where as before every few years I’d check my AA across accounts , these days I rebalance once a quarter or half by changing how new money invests. The 25 percent helps me sleep at night which is what counts.

  3. As you mentioned, it’s important to find a balance between risk aversion and the need to outpace inflation.

    100% stocks is too risky for most people, and 0% stocks has no chance at outpacing inflation.

    Personally, I think a reasonable asset allocation would be 90% stocks for those who have a long (>20year) working career ahead of them, and 60% stocks for those who are nearing or in retirement, with gradations in between as net worth rises.

  4. Great article and completely reflects my own practice, which was done without nearly as much foresight and planning as you describe.

    I came out of training in 1996 and was 100% in stocks when the 2000-02 tech bubble crash hit. I did not sell my equity position, but moved toward a 75:25 split thereafter, which is where I was when the 2008 real estate crash bubble burst. Again, I did not sell into the crash, but repositioned my portfolio over the last few years to a 60:40 split, where it is today.

    In the process, I have created a 10% cash cushion, in savings and CDs (all in taxable accounts), which serves as my bond tent, or first bucket, or emergency fund, or whatever you call it when you start living off your savings, which is what I plan to be doing in the next few years.

    I like the idea of having breakpoints to change your allocation, but they might need to be somehow tied to your level of wealth, your expected income and the intended length of your career. For example, $500,000 at age 40 as an FP making $200k per year and intending to work 20 years might be invested differently than the same figure in an FP at age 60 with 10 years to work vs. the same figure in an orthopedist at age 35 with 30 years to work, etc. (This might be an interesting project for Big ERN or the Actuary on FIRE, to fit the ideal curve for the income, wealth, and expected length of career.)

    • It also depends on what your goals are. If you are trying to maximize the probability of meeting the 4% rule by your target retirement age, you might allocate your money differently than if you’re simply trying to maximize the amount of money you have in retirement.

  5. I am 100% equities. When I get 7 yrs retirement I will keep 5 yrs living n expenses liquid. 2 cash 3 ladder cd. I will always keep this allocation during draw down. Bear market hits and it will I can pull from the liquid funds leaving the equities 5yr recovery period. Bonds would not of helped you much in 08. They went down also.

  6. Great article. I like the fact that you are thinking of cooling off the AA in response to financial milestones rather than simply by age as target date funds do. We can’t control what the markets do, but we do know where we are relative to retirement, how much we have, how much we need. Makes much more sense to me to customize one’s personal glide path than to blindly stick to one determined only by age. Given the recent long (longest ever?) bull, current valuations, future expected returns, I think it makes strong sense for people within a 5-10 years of retirement to make pretty big moves towards cooling off the AA.

    Dave

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