Measure for Measure

Jonathan Clements  |  August 12, 2017

THIS BULL MARKET is more than eight years old, U.S. stocks are undoubtedly expensive and there’s even talk of war. Tempted to sell? Problem is, there was also ample reason to be worried three years ago and yet here we are, with shares both higher and more richly valued.

What to do? I fall back on my standard advice: Forget trying to forecast the market’s short-term direction and instead focus on taking the right amount of risk. That brings me to two quick-and-easy ways to analyze your portfolio.

First, think about your current split between stocks and more conservative investments. But when you add up your conservative investments, include all future savings. This allows you to factor your human capital—your income-earning ability—into your asset allocation.

Let’s say you’re age 45 and plan to retire in 20 years, at age 65. You have $300,000 saved, with $240,000 in stocks and $60,000 in bonds and cash investments—a mix of 80% stocks and 20% conservative investments.

But let’s also assume your annual salary is $100,000 and you save 10%, or $10,000, each year toward retirement. At $10,000 a year for 20 years, that’s $200,000 that is effectively in cash and still to be invested. Factor in that $200,000 of future cash, and your portfolio is 48% stocks and 52% conservative investments.

To be sure, there is a risk you’ll never collect that future cash because you lose your job or earn less you than you had hoped. Those with weaker job security or widely fluctuating incomes might adjust for that risk by trimming their estimate of future savings by, say, 20% or 25%.

Even with a haircut like that, it can be comforting to factor future savings into your asset allocation—assuming you have many years of savings ahead of you. Indeed, if you’re in that camp, a stock market decline is a potential bonanza, because you’ll be able to scoop up shares at bargain prices.

But this formulation isn’t so comforting for those of us who are retired or close to it, because we have little or no future savings. Yes, we could take advantage of a market decline by rebalancing into stocks or even overweighting them if valuations seemed especially compelling. But let’s be realistic: Only the bravest retirees will be that aggressive.

What does all this mean for your portfolio? Here’s a possible rule of thumb: You never want more than 60% of your portfolio in stocks—with your portfolio defined as its current value plus future savings.

No future savings? You should have a maximum 60% in stocks. Just entered the work world? Even if your hold 100% stocks, your current investments plus future savings might be at less than 10% stocks. This highlights how irrational it is for young adults to worry about a market decline. In fact, you could likely hold a 100% stock portfolio into your early 40s and still be below 60% stocks, once you figure in future savings.

Is 60% the right benchmark for you? Here’s a gut check: my second quick-and-easy way to analyze your portfolio’s risk level. Pick a value for your portfolio, below which you wouldn’t want it to fall. Let’s say you currently have $600,000 saved and you’d be distraught if your nest egg dropped more than $100,000, to below $500,000. Experts in behavioral finance say that we get far more pain from losses than pleasure from gains. This is your chance to put a number on just how much financial pain you’re willing to endure.

Now, imagine stocks fell 35%. True, we’ve already seen two market declines of roughly 50% in the current century. But historically, 50% declines have been relatively rare. If you look at times when U.S. stocks have tumbled 20% or more—the standard definition of a bear market—the average decline has been around 35%.

To avoid a loss greater than $100,000 during a 35% stock market decline, you would want to limit your stock holdings to $286,000, or 48% of your $600,000 portfolio.

Want to try this with your own portfolio? This math is easy enough: Just figure out the maximum dollar loss you’re willing to suffer and then divide that number by 0.35. Not only will that tell you the amount you should have in stocks, but also it’ll get you mentally prepared, should it turn out that bad times do indeed lie ahead.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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