My last article, The glide from youth into life after work, prompted a response from Peter Thornhill (PT hereafter) who “noticed with sadness” the support for 'lifecycle' investing. When someone distinguished says that about a piece you’ve written, it takes you aback. On reading his piece, I gather (this is a guess on my part) he thinks I’m endorsing volatility as the risk measure that leads to a glide path. I neither said nor implied it.
In keeping my article short, I focused on the human-interest aspect. Let me get to grips with risk in this piece. And you’ll find I agree with PT in many ways, and yet I still advocate a glide path.
PT’s approach is straightforward: over the long term, equities invariably outperform fixed income, so they are the obvious choice for accumulation. I agree with both parts of that statement, but there’s more to it than that.
Here, I’ll define risk and then apply that definition to investing. Then I’ll show how it works in the accumulation and decumulation phases of retirement planning (quite differently, it turns out).
And you’ll be glad to know that it takes no expertise to understand this stuff.
What is risk?
Risk is the chance of an adverse outcome. As simple as that.
What is adverse depends on the situation and on how the risk-taker defines the goal and the difference between acceptable and adverse outcomes. So, what’s adverse to one person may be acceptable or even favorable to another. Risk is necessarily subjective.
What is investment risk?
This is the chance of an adverse outcome in an investment context. As simple as that.
I have never found a better framework for analysing risk than that of William Bernstein, in his little gem of a book called Deep Risk. He distinguishes between ‘shallow risk’ and ‘deep risk’. Shallow risk is the risk that we’re forced to interact with the market at a bad time. We’re forced to buy right after the market has gone up, or to sell right after it’s gone down. It makes sense for volatility to be a good measure of shallow risk. Much of what’s called Modern Portfolio Theory is based on this concept. In many circumstances, it’s an avoidable and therefore irrelevant risk, as I’ll show.
Deep risk is much more serious. It’s the risk that the economy, and therefore the stock market, doesn’t perform over the long term. This is what places us all in retirement jeopardy. And sadly, it’s unavoidable.
I won’t get into Bernstein’s complete analysis, I’ll just go with PT’s flow, that equities give the average investor by far the best chance of achieving long-term growth.
The impact of shallow risk on an individual’s retirement finances
How can you escape shallow risk?
In the accumulation phase, you don’t really need to. It has little effect because you’re investing regularly. Volatility just means that sometimes you’ll buy high and sometimes low. This is often called ‘dollar cost averaging’. As long as it’s just volatility around a long-term upward path, in fact volatility is your friend, as a buyer.
Suppose, for example, you invest $100 per period. Suppose the price at which you buy is a constant $100. Then each period you buy 1 unit. After two periods you have bought 2 units. But suppose the price isn’t a constant $100. Suppose it alternates, sometimes $90 and sometimes $110. Then, in two periods, you buy 2.02 units. What if it alternates between $80 and $120? Then in two periods you buy 2.08 units. The more volatility, the more units you own. Far from being a risk, (pure) volatility in the accumulation phase is your friend.
In the decumulation phase, exactly the opposite holds true. Now you’re selling, to generate the cash you need for spending. And to generate $100 per period in those scenarios, you need to sell 2 units, or 2.02 units, or 2.08 units. The more (pure) volatility there is, the more units you sacrifice and the worse off you are. Now volatility becomes your enemy, and it becomes a form of risk, as the outcome is adverse for you, relative to the absence of volatility.
Can you avoid it? Yes, but at a cost.
If you need $100 a period, you can arrange your assets to generate exactly $100 when needed. This requires investments with explicit, certain outcomes. Typically, these investments have a low return, with no long-term growth potential, so you have a trade-off. The more you seek long-term growth, the smaller the portion of your portfolio available to generate exact amounts when you need them. The more predictability, the less available to seek long-term growth.
Fortunately, the need for predictability doesn’t occur, in a retirement context, until decumulation.
The lifecycle rationale
What’s the rationale for reducing exposure to growth-seeking assets over the accumulation lifetime?
The theory is simple. You have two kinds of assets. One is human capital: the ability to earn income through work, which in turn creates the ability to save for retirement. The other is financial capital: the value of what you’ve saved. At any time, your personal asset portfolio is the sum of the two. (Google “Bodie Merton Samuelson 1992” if you want details.)
An essential assumption in the theory is that your tolerance for (or aversion to) a large one-shot decline in your portfolio is constant over your lifetime (aka ‘constant relative risk aversion’ or CRRA).
Your human capital is (in this theory) viewed as a form of reasonably predictable inflation-linked fixed income, rather than a risky/growthy asset such as equities. The theory argues that growthy assets have far greater uncertainty than your human capital. In particular, as far as risk (in this context, a significant permanent decline in value) is concerned, growthy assets are far more susceptible than human capital.
Let’s suppose you invest all your savings in growthy assets. Over time, your savings get bigger and your human capital declines. That means that your total personal portfolio has an increasing proportion in growthy assets. Your exposure to risk increases over time. The way to keep it constant (remember CRRA) is to replace growthy assets with assets that look more like human capital (essentially, inflation-linked fixed income with a time horizon that ends at retirement).
That’s what a glide path is meant to do.
Actually, it’s more complicated than that, because right at the start you have no growthy assets at all, so you actually have too little risk exposure. What you need to do, at least in principle, is borrow against your human capital and invest the borrowed amount in growthy assets. In most countries you can’t do this explicitly with your retirement savings, but you can achieve the right direction to some extent if you buy a property financed by a mortgage.
How does this relate to the discussion on risk?
It relates purely to deep risk, not shallow risk.
The glide path’s rationale is based on a constant tolerance of exposure to risk of a significant one-shot decline. That’s a form of deep risk. It has to be a decline that isn’t recovered later; if it’s recovered, that’s just volatility, and remember, volatility is your friend in the accumulation phase.
What about later, during retirement decumulation? PT says that in retirement he’s interested in the income from the equities, and volatility in value is a non-issue. Not so! If PT doesn’t need to touch the capital, then financing retirement isn’t his focus; he has ample wealth. Fair enough, in that case. But the average person doesn’t have that luxury, and needs to sell regularly to generate spending money. And therefore volatility is indeed a potentially big issue after retirement, for the average person.
If we have to sell right after a big decline, those units have gone forever. They aren’t there to claw back anything from mean reversion. This is the danger often called ‘sequencing risk’.
I partially avoid shallow risk personally by having five years of spending in savings bonds or fixed-term deposit accounts. This is my ‘spending ladder’. Each year, the ladder naturally shortens by one year. If markets have been good, I’ll extend it by a year, back to five. If markets have fallen, I’ll wait for a recovery. My risk, of course, is that there’ll be five years without a recovery. Then I’ll be in trouble, but so will we all, and that’s my unavoidable exposure to deep risk. I wish I could afford a 15-year ladder. But holding that amount in fixed income wouldn’t give me as much exposure to the long-term growth I still hope for. It’s my trade-off.
Conclusion
I’ve tried to show that risk is subjective, that shallow risk is your friend in accumulation and your enemy in decumulation, and that even in decumulation it’s potentially avoidable for some time, giving growthy assets a chance to work for you. Deep risk is always with us. The glide path is a sensible way to keep our exposure to deep risk relatively constant throughout the accumulation period.
Don Ezra has an extensive background in investing and consulting and is also a widely-published author. His current writing project, blog posts at www.donezra.com, is focused on helping people prepare for a happy, financially secure life after they finish full-time work.