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In the last two years, things seem to have only gotten more difficult when it comes to making choices about asset allocation. The S&P 500 (SPY) is essentially flat as we look back 2 years to date as of 10/17/23 (See Appendix A). To frustrate matters further, corporate bonds (AGG) are down over 17% over that same time. So many families are left with a bad sense of, “what now?”. In this article, we will examine a few ways to look at risk and allocation. I think consideration needs to be given to establishing healthy risk-taking as well as rethinking those choices appropriately. By the end, we hope that you either feel relief that you’ve done well or look to the horizon with a guide as to where to seek opportunities and the reasons behind them. CWA believes in long-term asset location and setting of patient trading structures. With that in mind, each family should be examining and checking their convictions during such times.
Fairweather friends?
Throughout life, most of us have encountered friends that we would describe as “fair-weather” They are always around when things are great, but scarce when things are tough. There is an old adage: “People don’t want you when you are lonely, they want you when they are lonely”. Should we treat our investments that way? Keep them in good times and dump them off in bad times? I don’t believe there is a universal truth there. I think that people are in a constant state of becoming. Some becoming is good, and some not so good. So naturally the facts and circumstances surrounding a person at the time of judgment about investments are critical to this “fair-weather friends” idea. I recently heard a wizened person say, “Beware of emotional attachments to inanimate objects”. Our own Lewis Johnson emphasizes, “Stocks don’t know you own them, so we have to treat them with that same dispassion”. The guiding principle in these thoughts is that investing decisions are a combination of emotional/rational, utilitarian, and expressive feelings. Consequently, holding investments forever is not the answer, yet hasty decisions made under sub-optimal conditions can bring undesired outcomes.
Portfolios generally are constructed to achieve just three goals:
- Growth (most common): Taxes, inflation, and undesired spending all make at least some growth needed to stave off that corrosion and defend spending power.
- To Create Income: Many growth portfolios become income portfolios as wage replacement becomes necessary in retirement.
- Protection: Many families need to buy time until either money is needed for them later, or to pass to heirs through an estate.
How does one determine the right timing for transitioning from a growth–oriented approach to taking a more defensive posture?
We have heard all kinds of things; One of the oldest ones we hear sounds like, “I should have one hundred minus my age as my stock percentage”. This means that at 40, you might be sixty percent in stocks and at 80 you would be reduced to twenty percent. I think the intention of this idiom is right. We should usually lower our stock percentage as we age. I’d argue that despite the good general intention this is a wildly imperfect rubric. So how do we judge? There is a sliding scale of factors to be considered by everyone. Each situation is unique, but at the core, we have to consider the three functions of portfolios: growth, income, and protection.
Let’s look at two examples:
| Example 1: Richard is 81 and his wife Janice is 53. He has children from a previous marriage. His goal is to take care of Janice for her remaining life expectancy and then to inherit his children. |
Which of the three goals fits here? Is there just one? The 19% stock that the idiom above would point to seems to lack the growth needed to accomplish the goals at hand. We also have to consider the expenses, debt, and income sources present in the family. This portfolio may need to be far riskier than one hundred minus his age. So, Janice may need income, and the heirs likely need growth.
| Example 2: Rachel is 63 and widowed. She was the breadwinner in the home, but she lost her spouse and never worked in a role that gave her a pension. The family incurred a lot of debt in the final years of her spouse’s life. She never handled the investing in their house, despite being totally in charge of income and budgeting. She can’t seem to really pull it together to go back to the stresses of the corporate banking industry she came out of. She desperately needs income from their savings. |
I would posit that this case should be far more conservative than one hundred minus my age. This case requires an income focus. Protecting her from aggressive market loss is likely a close second to Rachel. So even though there are only three goals for portfolios, they coalesce into an infinite number of combinations. At CWA we believe that communication and modeling are the real keys. Observation of prior markets and deep discussion can really help us set an investing policy that is very durable.
How do we know when to change allocations?
I think the answer resides in the soul and in the wallet. If we consider the wallet first, we have to look at changing priorities in our income streams. The requirement to produce additional income is a great reason to shift allocation away from high growth. We can look to investments that carry income components like bonds, annuities, and dividend-paying stocks. Turning down risk should decrease volatility and foster a much calmer portfolio. In turn, the payments we can expect should be much more stable. This shift can occur for many more reasons than simply retiring. We have clients who do not have children but have accumulated a tidy nest egg. Recently, I had to remind such a client that he only has so many years to enjoy his hard-earned wealth. He explained that austerity was so ingrained in him that he had a hard time accepting the idea of living more frivolously. I reminded him of the binary fact that either he will spend his money while living or someone else will once he is gone. It was an epiphany moment. He may not shift right away, but a critical discovery was made.
On the other hand, maybe the timelier for this discussion is about the soul. Making changes based on these inputs can be more challenging. Often changes that start here stem from deep thought and soul-searching questions. How do you feel about your family’s outlook? What are your greatest worries? If those greatest worries come true what are the negative consequences in your family? How does the news impact your thinking? How are you sleeping at night given the environment? These questions can and often should lead to actions. Sometimes these actions are a wholesale shift in thinking, and just as often they are situational compromises that address a specific time in the markets.
As humans we all make compromises. Everyone is sometimes forced to make tough choices and do the best we can in a moment to get through to better times. I was recently talking with another client of ours recently who was feeling threadbare about risk. He asked me, “Why am I in the stock market riding the rollover coaster, for two to four percent in dividends when I could buy a treasury bond and lock in a higher rate with lower risk?” This is a fantastic question. After some further discussion, nothing about this client’s situation points toward a shift to a utilitarian income need. What we have is an emotional concern about volatility. Just because the concern stems from how we feel doesn’t mean that it is invalid or going to cause a faulty biased decision. Our client is correct. As of this writing, the U.S. Treasury Dept does offer over 5% bonds. We discussed that if held to maturity that is all of the return available from these bonds. Could this security address the immediate concern about volatility? Yes. Should this person sell all of their stock to adopt a large-scale treasury ladder? I think not in this case. I did suggest that perhaps tilting the portfolio in a safer direction might be a great idea for him emotionally. I explained that if the markets should rocket northward from here he might miss out on some additional earnings and if the markets falter He might have a more stable portfolio during the volatility. In the end, our client did add treasuries based on the proceeds of some stock sales. While his portfolio is unlikely to be heavily impacted his ability to sleep at night is highly improved.
CONCLUSION
The overarching theme of this discussion is that communication about risk and the profile of a portfolio is critical. It is critical at conception and throughout time. There are a host of reasons to seek change, but they need to be rooted in calm rationale and good discussion. The markets seem to demand that we do things that feel counterintuitive. Selling our biggest winners and plowing the proceeds into things that may seem lifeless is a hard thing to do, especially under the duress of market stresses. So, I don’t think that we should be fair-weather friends, but I do think that all things have a season. A big part of that is about your family’s life and feelings, and the remainder is about market circumstances. If you feel concerned about your allocation or wonder if it has been too long since you discussed your views with someone, we’d love to schedule a discussion with you.