With Age and Investing, Resist Generic Formulas and Shortcuts
“Let’s talk about time. I’m not sure how much I’ve got left, ok? I’m 70. Longevity does not run in my family. So, how much should a guy like me have in the stock market?”
That’s what a client asked during a recent meeting. Great question.
Time horizon is an important subject that repeatedly surfaces in my interactions with investors. Several issues from this meeting may help other investors think more clearly about their own time horizon.
Time horizon is not always linked to your age
Conventional thinking is the older you are the less investing risk you should assume. That’s true in some cases, but not all. A better proxy for gauging time horizon is the longevity of the assets.
Start by asking: What’s the money for?
For example, a 45-year old with a kid getting ready to go to college probably has a short time horizon for a portion of their money.
My client, on the other hand, actually has a long time horizon, despite being 70. We arrived at that determination by following the money trail.
Unless you plan to have your financial accounts liquidated upon your demise, and the cash stuffed alongside you wherever your final resting place happens to be, the money lives on. This became apparent when I asked my client what happens to the money after he passes? In his case, his wife maintains it. She’s younger, and her family’s genes are biased to longer longevity. Maybe she lives another 20-30 years?
Most people underestimate how long they’ll live. That’s because each generation is hanging around a little longer than previous generations.
According to Laura Carstensen, director of the Stanford Center on Longevity, life expectancy increases about 3 months with each year that passes. Today, there is a 50% chance at least one half of a 65-year old couple will live to the age of 94. Pretty amazing, considering the average life expectancy in 1900 was 47 years!
It doesn’t stop there though. After my clients both eventually pass, their money transfers to children. That makes the next generation the time horizon proxy.
So while my client presumed his time horizon may be short given his age, in reality, it could be 50 or more years. That means plenty of market cycles and a lot of flexibility in terms of asset allocation choices.
Tip: A long time horizon is a significant investing advantage. Make sure you don’t short change yours.
Covering health care costs
Even though my clients comfortably fund their current living expenses, they worry about health care costs. What if they rise enough to strain their budget?
After housing, health care is likely to be most peoples’ second largest expense during retirement. According to Fidelity Benefits Consulting, a 65-year old couple retiring this year probably needs close to $280,000 in today’s dollars (after-tax) to full cover estimated medical expenses in retirement.
Big number. And a big deal, considering approximately 40% of pre-retirees are not currently factoring health care costs into their retirement savings plans.
Yes, Medicare begins at age 65. But it’s not likely cover everything! The average retiree should expect to pay around $5,000 per year in extra costs for supplemental insurance and out of pocket expenses. Health care utilization increases with age, so it’s important to factor this expense into your planning.
Tip: If you’re still working, you can get ahead of the curve on these costs by contributing to an HSA (Health Savings Account). These plans allow you to stash away more pretax dollars which you can grow and withdraw tax free, for federal tax purposes, if you use the funds for qualified medical expenses.
Finding the right volatility profile
Since my clients are in good shape to fund their financial goals, there’s no need to press for higher returns beyond their comfort threshold. Some call this: “The Sleep-at-Night-Factor.” Independent of time horizon, comfort matters, because even the best strategy in the world is worthless if somebody can’t stomach the ride and stick with it.
My clients monitor relative performance. But we’ve had enough discussions to clearly delineate that their objectives revolve around absolute risk/return parameters.
Thus, even though I could be comfortable allocating this clients’ portfolio 100% to equities, we know that’s not the right allocation. They aren’t just trying to maximize returns relative to how long they have to invest. There are psychological constraints to consider.
The way to configure asset allocation strategy in this type of scenario is to identify a maximum volatility threshold, which I call a “Risk Budget.” This could take the form of an annualized volatility target or max drawdown threshold relating to stress test scenarios.
People work hard for their money. They justifiably want their money to work hard for them. So stuffing money under mattresses usually isn’t the answer.
Once a risk budget is delineated, the goal becomes maximizing returns within a customized risk boundary. That’s ultimately how my clients and I arrived at the ideal asset allocation for them. Time horizon actually had little to do with the proportion of stocks versus bonds.
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In conclusion, try to resist generic formulas or heuristic shortcuts when it comes to time horizon. Some number minus your age will not tell you the best stock allocation for your portfolio. Investing is a highly individualized sport. There are many nuances to consider.
