Younger investors should be willing to take on the most investment risk.
This is due to the classic risk-return tradeoff from Investing 101. The greater the risk assumed, the higher the expected return over time.
However, young investors today are shying away from risk in their portfolios.
Why is this the case?
Is it because young investors were “recession babies”?
A good term, possibly coined by Bill Finnegan in this Wall Street Journal article.
“We had Depression babies,” says Bill Finnegan, a senior managing director with MFS Investment Management, a Boston-based asset manager. “Now I think we have recession babies.”
Given the tough economic conditions and volatile markets over the last decade plus, many young investors have no memory of bull markets and strong economic growth. All they see is high unemployment, a tough job market, and high student loans. Maybe their parents are out of work. Perhaps these young investors still live at home due to a lack of money.
Fully understandable that these “recession babies” are risk averse.
And for any aged investor, I normally recommend maintaining a 3 to 6 month emergency reserve in cash to protect against tough times and unforeseen circumstances.
Better to Earn Little in Safety, Than Nothing at All
Recent market history reinforces this low risk approach. As the article states,
A 27-year-old who started investing right out of college has seen a 0.5% annualized gain from a Standard & Poor’s 500-stock index mutual fund—less than the 1.85% returns of an ultrasafe money-market fund.
As a result of poor equity market returns, young investors have moved into very low risk assets.
According to a June MFS survey, investors in their 20s held 30% of their non-401(k) portfolios in cash—four percentage points higher than the average for all investors. The survey found that 40% of investors in their 20s agreed with the statement: “I will never feel comfortable investing in the stock market.”
An October MFS survey showed that young investors held 33% in cash, six points higher than the overall average, while 52% agreed that they would never feel comfortable investing in stocks.
So in mid to late 2011, young investors had 33% of their capital in cash equivalents. A much, much higher percentage allocation than any standard asset allocation model would recommend for investors in their 20s.
And roughly 50% of young investors “will never feel comfortable investing in stocks.” This compares with an average of 29% for all investors polled. A marked variance.
But is this Wise?
A hard one to explain, especially given the equity market returns over the last few years.
Modern portfolio theory is based in large part on the relationship between risk and expected return. Under the Capital Asset Pricing Model, expected return is a function of risk. Yes, there are times when it is not perfect but I think the principles hold.
I shall not get into the theory – the linked Investopedia article does a good job – but it should be intuitive to anyone reading this. When faced with two scenarios, you will require a higher return for the riskier venture.
Consider Nicole and Matt
For example, my niece and nephew come to me needing a $10,000 loan each.
Nicole will spend the money on a car to get to and from her new job. She has borrowed money from me before and always paid off her debt in full and on time. Further, she will use the car as signed collateral on the loan.
Matt, on the other hand, is like most Matts. He just lost his last job as a landscaper (who knew that sod did not go in grass side down?) and plans to use the money to finance a trip to Ibiza. His repayment history has been poor and the only collateral he has is a broken down ski-doo.
Now would you expect that I would charge each the same interest rate? Especially bearing in mind that they are my niece and nephew, so naturally I like neither.
No, I would desire a higher return to take a chance on the deadbeat, Matt. The probability is much higher that I will have difficulty collecting the debt from him versus Nicole.
You would do exactly the same.
In any aspect of life, the greater the risk you must assume, the greater the return you want.
This Holds For Investments
This risk-return relationship has held over time in the capital markets.
Cash pays less interest than investment grade bonds. And investment grade bonds pay less than riskier speculative (i.e., junk) bonds.
And the relationship between low risk cash, higher risk bonds, and highest risk (of the three asset classes) equities also holds over the long run.
If you take a quick look at the linked chart you will easily see that over the long run, higher risk assets (small and large company stocks) outperformed moderate risk assets (government bonds) which in turn outperformed risk-free assets (Treasury bills).
But note that in many short periods (1930s, 1970s, etc.) riskier assets underperformed the risk-free asset. So during shorter terms, risky assets may not always outperform. A crucial point to always bear in mind.
Perhaps an argument can be made as to whether this long-term risk-return tradeoff will continue. Even I have some concerns due primarily to demographic shifts (a topic for another day). But I think the majority of experienced investors do see the risk-return relationship holding into the future.
The Key is Youth
In the short term risky assets may underperform. But over the long run, the tradeoff works.
How does that impact investors?
The key to utilizing the risk-return relationship is the investment time horizon.
The longer the investment time frame, the more likely that the risk-return tradeoff will hold true. Investors with long time horizons can ride out short term volatility and still prosper.
If you are 30 years of age with a 40 year investment horizon, you can invest in riskier assets knowing that the long term trend is positive. But if you are 65 and only have a few years before needing your capital to live on, you cannot afford to be caught up in a shorter term bear market.
My Advice to Young and Middle Age Investors?
The 50% of young adults who “will never feel comfortable investing in stocks” need to reassess that viewpoint. Equities are not to be feared. And for the younger investor, stocks have proven to be the best of friends over time.
For most young and middle age investors, a 33% asset allocation to cash is probably excessive. I suspect a large portion of cash could easily be allocated to equities.
As for the exact asset allocation, creating a comprehensive Investor Profile will help determine the correct mix for each person. Part of this reflects an investor’s time horizon, personal risk tolerance, and phase in one’s life cycle.
Investors must take a more rational approach to their risk aversion. Take a long term perspective and tune out the short term hysteria and unpleasantness. Young and middle age investors have the time to ride out the periodic ups and downs. Use time to your advantage.
The phase in one’s life cycle plays a significant role in the asset allocation of common stock. Make certain you understand where you are in life. Then take an investment approach that takes advantage of your personal situation.
One comment that I may expand on in a subsequent post. When I refer to risky assets, I refer to them in a traditional investment sense. Shorting stocks, playing the futures’ markets, writing naked call options, are all high risk investment tactics. But I would never recommend their use by non-expert investors even though I believe high risk assets outperform lower risk assets over time. The potential exposure is great enough that a short term negative movement could cause irreparable harm.
And be aware that even within traditional investments, there may be different risk-return profiles within asset subclasses.
Use some common sense when investing to reduce portfolio risk. Focus on mutual and exchange traded funds (bearing in mind that risk-return can also fluctuate within these groups). Employ proper investment techniques including adequate diversification, long term buy and hold strategies, and dollar cost averaging to create strong portfolios.