Back in the days, you may hear about the sizzling returns of a stock whose company you’ve loved for years, or the gambler mentally in you urges you to try buying a few speculators. It could have started even when you learnt of your best friend’s massive profits from the stock market just a few short weeks ago. Whatever the case may be, it’s safe to say that buying stocks is how many people are introduced to investing.
When we are young with relatively few assets, investing in stocks is fun. Even if we fail to make money, it could set ourselves up for success. But like many people, they approach their thirties and sometimes even forties with only stocks in their portfolios. A quick check with wildly accepted wealth management theory says that this is no big deal though, because we want to have most of our assets in stocks when we are young to capture the greatest long term appreciation. But stocks bring volatility, and…
Volatility Can Wreak Havoc
We are all well aware of the emotional toll of suddenly losing 10, 30%, even 50% of our wealth and how it affects our immediate savings and investment strategies, but volatility affects us even if our investment disciplines are rock solid.
You may feel that you are willing to ride out a 50% lost, but what if you need to take money out at the depths of the downturn? Let’s say you have a cool $1 million dollar in stocks. If it goes down 50%, you might still feel confident that it will bounce back eventually, but what if you lose your job too and need to withdraw $100,000 to cover a prolonged period of unemployment? As if a 100% increase to break even isn’t high enough, you now need your $400,000 to increase by 150% just to go back to what it was previously.
When the stock market is down, the economy is probably not at its best either. If that day comes, is your stock allocation still right for you?
But there is a place for being aggressive in stocks…
Even with all the volatility, being young is a great time to be invested in the stock market. Not only is your portfolio relatively small and your time horizon long, but you likely have much less of a need to withdraw from your taxable accounts, giving the investments time to recover.
In fact, sustained investments through the good and bad times can be even better than continually investing in a bull market. As long as the investment ultimately recovers, you are better off with prices jumping around because you will have plenty of chances to buy low.
And let’s not forget: stocks as an asset class is still ultimately the best performing asset class long term.
So what’s the takeaway?
For most folks who have decades until they call it quits and decades more in retirement, their wealth will still potentially increase the most if they put most of their assets in stocks. But in order for this strategy to work well, we all need to figure out a way to get money fast just in case without tapping into our stock holdings. Whether we put some money in a safe, setup an online savings account or a line of credit from a family member is irrelevant as long as it’s dependable.
Instead of following the general guideline of asset allocation based on age alone, we should think of how much money we will need to withdraw versus the total value of our nest egg. The more we need in the near term (within 5 years) and the immediate term (5 – 10 years), the more we will need to shift away from volatile asset classes like stocks and into bonds and liquid savings.
For example, a young government employee might have a rock solid position. For him, it might be wise to allocate a much higher stock allocation to maximize his returns. On the other hand, a freelancer who has fluctuating income may want to set aside a relatively high emergency fund, as well as setup a more conservative portfolio to hedge against the event that her income may decrease for years at a time while the stock market takes time to recover from a crash.
It’s true that you will want to move more towards safer assets as you age, but this is based on your own circumstances and how much money you might possibly need to withdraw from your nest egg, not just because you are, say, 55 years old. If you are 45 and could lose your income any day, your allocation towards stocks should be low because you might be forced to retire at a moment’s notice. If you are 65 but have tons of passive income, there is really no need to become more conservative as long as you can rely on those income streams.
How much money you should put into the stock market will depend first and foremost on how comfortable you are with the inherit volatility of your allocation. But assuming that you are perfectly capable of accepting high risk, you should figure out how much is needed in the near and immediate term first. The rest is free to be allocated into stocks.
How much do you allocate your holdings in stocks? How did you come up with the figure?
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They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it's free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.