Conventional investing wisdom says that the older you get, the less of your financial assets should be in the stock market. One frequently heard justification is that stocks rise reliably in the long run but can fluctuate a lot in the short run and that if you’re old, you don’t have time to recover from a bear market.
Both parts of that formula are problematic. For most retirees, it actually makes sense to increase their exposure to the stock market as they age and spend down their assets. That’s because more of their remaining wealth is in the form of Social Security, which is super safe, so they can afford to take a little more risk in their remaining portfolio of stocks and bonds.
And as for stocks rising reliably in the long run — not necessarily. True, the likelihood of coming out ahead goes up the longer you’re invested. But the risk of a very bad outcome also rises. Think of investing like driving a car: Statistically speaking, the chance you’ll have a serious accident over the next five years is greater than the chance you’ll have one over the next five months.
The bigger point is that the truisms you hear from financial advisers don’t always stand up to scrutiny. Laurence Kotlikoff, an economics professor at Boston University, argues that investors and their advisers should pay more attention to the findings of economists, including greats such as Paul Samuelson.
“Either we economists have it wrong, rendering a century of research on saving, insurance and portfolio choice pointless, and the Nobel committee has awarded a slew of prizes in economics by mistake, or the financial planning industry needs to fundamentally rethink what it’s teaching and doing,” Kotlikoff writes in a book published this week, “Money Magic: An Economist’s Secrets to More Money, Less Risk, and a Better Life.” (The book got a favorable blurb from Robert Merton, a Nobel laureate in economics who was once described by Samuelson as the Isaac Newton of finance.)
For most people, Kotlikoff argues, the ideal path for allocation to stocks is high when they’re young, low in the years just before and after retirement and then higher again in the last stage of retirement.
The economic justification for being heavy into stocks in one’s youth is not that stocks will surely rise over time, because they might not. It’s that most of young people’s wealth is human capital — that is, their own earning power. For people with steady jobs, that human capital is like a bond: It produces a reliable income, and for most professions, it’s not highly correlated with stocks. So it makes sense to offset that bondlike human capital with a financial portfolio tilted toward stocks. Plus, if their stocks do badly, young people have time to make up for it by intensifying their work effort and earning more money.
The investment industry offers funds that gradually reduce the allocation to stocks over the investor’s working life, based on one’s target date for retirement. Target-date funds accounted for 27 percent of assets in 401(k) accounts at the end of 2018, up from 7 percent a decade earlier, according to the Investment Company Institute.
But many target-date funds leave people with too much of their money in stocks in their final years of working and the early years of retirement, Kotlikoff argues. Some investors make matters worse by putting only some of their money into a target-date fund and leaving the rest in more aggressive stock mutual funds, which makes their overall portfolios overexposed to the stock market.
Many financial advisers recommend a fairly high allocation to stocks even for people in their 50s and 60s on the grounds that stocks protect against inflation and bonds don’t. But that’s a weak argument. First, stocks don’t reliably protect against inflation. Second, there are bonds that do guarantee that your asset won’t be eroded by inflation — namely, Treasury inflation-indexed securities and Series I savings bonds sold by the Treasury Department. Kotlikoff recommends putting some of one’s wealth into inflation-protected securities and holding them to maturity, “laddering” them so they pay off on a regular schedule when the money is needed in retirement.
Dimensional Fund Advisors, which manages about $66 billion in defined-contribution plans, is one company that has embraced the economic approach to retirement investing. Mathieu Pellerin, a senior researcher there, says its research has found that 50 percent of assets — which some target-date funds aim for — is too much for most near-retirees to have in the stock market and that for many people, something closer to 25 percent is a better choice. (For people whose target retirement date was 2020, the average allocation to stocks in target-date mutual funds as of late 2021 was 43 percent, according to Morningstar, an investment research firm.)
Dimensional aims to use inflation-protected securities along with other assets to generate a stream of income that matches retirees’ spending needs year by year, says Tim Kohn, the head of Dimensional’s retirement distribution group. That’s kind of like how pension funds work.
One reason that economists and financial advisers seem to operate in different worlds is that academic economists aren’t rewarded for applying their theories to real people, which can involve a lot of bothersome detail. “Nobody wants to worry about Idaho taxes,” Kotlikoff says. His often iconoclastic book has chapters on saving for college, home buying, marriage and divorce, among other topics.
Another worthy book in the small genre of economists doing personal finance is “Risk Less and Prosper: Your Guide to Safer Investing,” by Zvi Bodie and Rachelle Taqqu, from 2011. Like Kotlikoff, the authors say investors should focus on what living standards they can maintain rather than the size of their nest eggs. They also lean hard against the idea that stocks are a sure thing. “At no time will we argue that your risk in the stock market goes away or even diminishes over time,” they write. “This popular and rather seductive belief is a fabrication based on misconception, illusion and confusion.”
Wade Pfau, who has a doctorate in economics from Princeton, has spent his career in financial planning. He teaches at the American College of Financial Services. He agrees with Kotlikoff that many retirees would be wise to gradually increase their allocation to stocks as they run down their assets and Social Security looms larger as a source of wealth. That’s something that not many target-date funds do. In fact, some target-date funds continue to decrease the allocation to stocks throughout an investor’s retirement.
Pfau and Michael Kitces wrote an article advocating a “glide path” of increasing stock exposure during retirement that was published by the Journal of Financial Planning in 2014. “It did seem to resonate with a lot of consumers and readers,” Pfau said. “People said, ‘That’s really interesting. I’d like to apply that to my own retirement.’”
The surprising bottom line: Stocks are riskier than you think. And old age is an excellent time to tilt toward them.
Hat tip to the investor Barry Ritholtz for pointing out this remarkable coincidence to me. (He wrote about it on his website on Monday.) The official Standard & Poor’s 500 stock index is weighted by capitalization, namely the market value of stocks; the most valuable companies, like Apple, matter most. An alternative version gives each stock equal weight.
You might worry that stocks are headed for a fall if a handful of companies have been disproportionately responsible for the market’s advance. It’s true that since April, the cap-weighted index has outperformed the equally weighted index, thanks, in particular, to gains by Alphabet (parent of Google), Apple, Microsoft, Nvidia and Tesla. But for 2021 as a whole, there’s no difference. The stock market doesn’t look more top-heavy than usual. (Whether it’s fairly valued is a separate question.)
Quote of the day
“The trouble is that we have a bad habit, encouraged by pedants and sophisticates, of considering happiness as something rather stupid.”
— Ursula K. Le Guin, “The Ones Who Walk Away From Omelas” (1973)
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