Target date funds do it one way; simply systematically reducing equity content as time marches towards its funding horizon. Thoughtful investment advisers, on the other hand, think it through and customize an approach that factors in all investment considerations for the specific investor. We are talking about managing exposure to risky equity investments. Aside from tactical funds that make it their business to go “risk-on” or “risk-off” depending upon their current views of the markets, a long term strategic approach focuses in on your long term objectives and tolerance and/or capacity for risk.
The equity markets have been risky, but very beneficial to investors in stocks over the last 10 years. Certainly, if you could tolerate the risk, a 100% allocation to the S&P 500 index (IVV) has been a rewarding, if not nerve-wracking, experience generating a 14.32% annual total return and a risk level of 13.62% standard deviation of return over the last 10 years.
A first step to deciding on your risk tolerance is to understand the tradeoff between risk and return. Risky assets like stocks often need to be offset by less risky fixed income holdings. A good way to judge the relative attractiveness of risky portfolios is to compare portfolios with different broad equity weightings.
One of my favorite data sets includes the return profiles of the S&P Dow Jones Portfolio Indices. They include five separate modelled portfolios from Conservative to Aggressive with equity weightings ranging in 20% increments from 20% (for Conservative) to 100% (for Aggressive). Not surprisingly, the chart below shows the DJ Aggressive Portfolio (the aqua blue line on top) with a 100% equity content leading the pack over the last ten years!
But, what about the road it took to get there! This ten-year time frame does not include the Credit Crisis of 2008/09, but it does include other crises including the Pandemic crash of 2020. Looking at the chart you can observe that during 2020 the Aggressive portfolio actually lost so much return that it came close to the cumulative return value of the Conservative Portfolio (the darker blue line at the bottom); thus, negating almost all of the accumulated excess returns garnered over the previous nine years.
So, what lessons can we learn from this chart. At least four things, including:
1. No one knows when the next credit crisis or pandemic is going to hit and how long the crisis may last. Trying to manage equity risks based on a “gut” feeling will only work if you get “lucky”.
2. Over a long time horizon, the riskier portfolios with a larger equity content outperform the less risky portfolios with less equity content, but depending upon the selected time horizon, the less risky portfolio actually could outperform the more risky portfolio!
3. The return profiles for each of the DJ portfolios show an incremental pickup of about 1.5% of excess total return for each 20% increase of equity content. In other words, over the 10-year horizon the Moderately Aggressive portfolio with an 80% equity content generated total return of 9.02% compared to the Moderate portfolio with a 60% equity content that generated only a total return of 7.53%; an average annual give-up of 1.49% over 10 years, something that is very material. If you can tolerate the risk and have a long time horizon, it certainly paid off to accept more risk.
4. But nothing is forever, and we need to be cautious. Some forecasting models, like the one at Research Affiliates , have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!