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.
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.
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.
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?