Are you investing as if you were just starting out in life? Many people are. For most of us, our first stock-market experience comes when we become eligible to participate in our employer’s 401(k) or 403(b) plans. These deferred arrangements condition us as youths to the idea of dollar-cost-averaging, where declines in the market allow us to buy more shares at lower prices, and where increases in share prices mean that we buy fewer shares when prices are high. This works because we are systematically investing and always adding money. High volatility is masked by small balances and steady contributions. Volatility is less important when we have a lot of time ahead of us.
When we have shorter time horizons, stop adding money, or begin spending a percentage of our savings, we are now doing the opposite of what we did when we were young. I shall call this dollar-sales-averaging. For those of us who rely on our savings to pay our bills, we can find ourselves selling more shares when the markets are down. When the market recovers, we no longer have as many shares and will not recover as much as we did when we dollar-cost-averaged. We may not have time to recover. The same is true of any lump-sum portfolio to which we will not be adding money. We should think about our investments differently and allocate our assets accordingly when our circumstances change. Investors who cannot add money will not be able to take advantage of bargains in the market if all their investments are down at the same time. Investors who systematically withdraw need to have some low-volatility assets and earn sufficient dividends and interest to avoid selling low. During prolonged bull markets, we may be tempted to ramp up our risk, and therefore our volatility, but since bears follow bulls like day follows night, we will eventually regret that risk.
There are exceptions to these rules. If we are certain that we will never use specific funds and intend them for our children or grandchildren, we can accept more risk. If we have dependable incomes outside of that provided by our portfolios, we can take more risk. All of this assumes that you will not be bothered by significant declines every few years. Many people whose systematic purchases masked the volatility of their investments believe that they can. Sometimes they find out that they cannot when big declines reinforce the reality that the money that remains to them is all that they will ever have.
We have incorporated these considerations into our Investment Management Agreement. Moderately aggressive investors “should have a long-term time horizon greater than 10 years, be comfortable with the significant volatility inherent in an equity portfolio and expect to periodically add funds.” Moderate investors “should have a time horizon of more than 5 years and be comfortable with the volatility expected of a portfolio containing a majority of equity investments.” Many people who will never add funds to a portfolio and have time horizons of less than 10 years still choose the riskier portfolio.
Feel free to choose the more volatile portfolio, but only after making a considered decision. Our experience tells us that long bull markets lead to complacency. During the long lead-up to Y2k, many people made the wrong choice from the belief that the world had changed forever. The same belief prevailed in the 1970s, right before OPEC and Watergate became household words. Some of the victims had to go back to work after retiring. Others took advantage of the high-interest rates that preceded the downturns and enjoyed long and prosperous retirements. Our office is ready and waiting to help you make the choice that is right for you.