One of the most common pieces of advice that investors receive is that their current age and time to retirement are two of the most important factors when deciding how much of their money should be allocated to risky assets like stocks and safer assets like bonds.
The thinking goes like this if a young investor experiences a market crash today, it is no big deal because there are plenty of years for their investment to "recover." This line of thinking is dependent upon the concept of time diversification, which states that risky assets like stocks get less risky over time.
The stock market can be incredibly risky on a day-to-day basis or even on a weekly or yearly basis. But if you zoom out several decades, stocks become "less risky." This makes intuitive sense; if you've ever looked at a chart of the S&P 500 over the past 50 years, it appears to continue moving straight upwards.
So, do stocks get less risky over time?
No, stocks do not get less risky over time. Nobel prize-winning economist Paul Samuelson proved the concept of time diversification was a fallacy. If an asset is risky this year, it's just as risky 10, 20, or 50 years from now.
In this article, I discuss why young investors should be heavily invested in stocks even though time diversification makes no sense.
Why time diversification doesn't work
If you're a 35-year-old investor and you expect to live to 85, you have a 50-year investing time horizon.
In that kind of time frame, the odds of the stock market underperforming a risk-free asset like stocks or government bonds is low. But the likely hood of a major market crash, say a decline of 60% or more, is just as likely 50 years from now as it is today.
If an asset is risky, it will always be risky no matter the time frame.
So, does that fallacy of time diversification mean that young investors should invest less in risky assets?
No. In fact, young investors should be more heavily invested in stocks but investing time horizon has nothing to do with it.
To understand why it makes more sense for young investors to invest aggressively, we need to step back and look at the entire financial picture.
The two types of wealth
Two types of assets make up our total wealth.
Financial capital: Cash, Stocks, bonds, and other financial assets.
Human capital: The money we can make working or starting a business.
Total wealth= financial capital + human capital
When we are young, we have huge amounts of human capital but very little financial capital. Someone in their 20s might have 40+ years of paychecks to collect, so the present value of their human capital is worth millions.
Human capital, particularly for those with strong job security, often acts like a bond; it provides a stable and predictable source of income.
So, when you are young, you might be sitting on a bond-like asset (human capital) that's worth millions. To diversify your total wealth, it makes sense to invest your financial capital more heavily in stocks.
Here's how I plan on managing my money over the next 40 years, explained in 10 bullet points
When you're young, you have much more human capital than financial capital.
It makes sense to take a bit of the surplus from your human capital and invest it in financial capital.
To balance out your total wealth, which is skewed towards bond-like human capital, you may want to weigh your financial capital more heavily towards stocks.
You should be less concerned about a stock market crash when you're young because you're not living off your financial capital; you're living off your human capital.
As you get closer to retirement, your human capital begins to decline and eventually approaches $0 when you stop working.
As your bond-like human capital begins to decline, ideally, your financial capital should be accumulating a large balance that is initially heavily invested in stocks.
As your human capital declines, it makes sense to begin diversifying your financial capital into less risky assets like bonds.
By the time you retire, you may have some pension income or government benefits, but by, in large, you'll be living off your financial capital.
During retirement, if you're heavily invested in stocks, a market crash could be devastating. This reinforces the concept that time does not make the stock market less risky.
The stock market is always risky, so you constantly need to be diversifying with less risky assets so that you can continue funding your lifestyle in the event of a crash. When you're young, you rely on your human capital to manage that risk, and as you age, you allocate more of your financial capital to less risky assets.
That should note, that these are not my ideas or even new ideas of managing money. This is a summary and interpretation of economists that are much smarter and more accomplished than I am. Specifically, I would highly recommend the research done by Moshe Milevsky.
How much should you allocate between stocks and bonds, given your current age?
There are to approach this question.
The first is to use a blunt instrument like a rule of thumb. One such rule of thumb is the rule of 110 which states that the percentage of your financial capital allocated to stocks should be equal to 110 minus your age. So, if you're 30, you would have 80% of your financial capital allocated to stocks. If your 60, you would have 50% allocated to stocks, and so on.
Like all rules of thumb, this is a good tool to begin your research but should not be what you use to make financial decisions.
The second approach would be to use a mathematical model like the one Milevsky describes in his brilliant book "The 7 Most Important Equations For Your Retirement."
Here's the equation (it looks intimidating, but I'll explain it)
Ψ= 1/γ(HC + FC) (μ-R/ σ2)
Where
Ψ= The amount of dollars you should have invested in the stock market.
γ= Your level of risk aversion ( on a scale of 1-8)
HC= Human Capital= The present value of your net take-home pay between now and retirement.
FC= Your current amount of financial capital
μ= Expected return of the stock market
R=The expected rate of return on risk-free assets.
σ2= Expected volatility of the stock market.
Is it reasonable for anyone reading this to be able to accurately come up with the assumptions required to use this equation?
No.
But, if you're paying a financial advisor to help you manage your money, they damn well better be able to sit down with you and build an estimate using this framework.
For those without advisors, here are some general takeaways, all of which have the caveats of "all else being equal" and end with "vice versa."
The more squeamish you get about investment risk, you should invest less in stocks.
The more human capital you have left to collect, you should invest more in stocks.
The higher the expected return in the stock market, you should invest more in stocks.
The higher the rate of the risk-free asset, the less you should invest in stocks.
If you take one thing away from this article, let it be this
The stock market is a great way to build wealth, but it's always risky no matter your investing time horizon. The only way to manage investment risk is to have non-risky assets that you can fall back on. When you're young, that will be your ability to earn an income. As you approach retirement, that risk can be managed by shifting more of your financial capital away from risky assets like stocks and towards less risky assets like bonds.
Two parting thoughts
Let's end this discussion with two additional ways to manage the risk of the stock market.
If you're young, a market crash can't ruin you. Only a stock market crash AND losing your job at the same time can do that. That is why it is so critical to have a cash emergency fund set up as an insurance policy to act as a financial lifeline if you lose your job.
The best emergency fund is one you never have to use. That is why I have always diversified my human capital by having a 9-5 job and a side hustle. If you have two sources of income that can cover your basic living expenses, you minimize the odds of ever having to tap into your emergency fund or investment portfolio.
This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.