Retirement: Investing When You’re Young And Time’s On Your Side by Anne Bucciarelli, Ashley E. Velategui – Alliance Bernstein

You’ve made a commitment to sock away money for your retirement. But how should you allocate the funds? Here are some trade-offs to consider.

Stock-heavy allocations typically generate higher returns than bond-heavy allocations over the long-term. You can see this in the left side of the Display, which shows how much annual sustainable spending a 401(k) retirement account invested in various asset mixes might support after 35 years of diligent saving; it assumes typical markets.

But stock-heavy allocations also pose a much greater risk of large, if temporary, drops in portfolio value along the way. You can see that in the right side of the Display, which shows our estimate of the probability of a 20% peak-to-trough drop in account value at some point within the next 20 years, for the same asset mixes. In our experience, most investors can tolerate a peak-to-trough loss of some size, but there’s a threshold loss—often 20%—that prompts them to consider selling at a market bottom.

Retirement Investing

Retirement Investing

Risk tolerance is a highly individual matter that may reflect your personality and the source of your funds. The better you understand your own risk tolerance, the more likely you are to establish a financial plan that will not expose you to more (or less) risk than you could stand. The last thing you want to do is adopt an asset allocation that is riskier than you can tolerate, incur a large loss, and then sell at the bottom to establish a lower-risk portfolio that is highly unlikely to generate the returns needed to recoup the loss.

That said, there are a few objective factors to consider when setting your asset allocation, which suggest that younger people, as a rule, can take more risk than older people—because time is on the younger investor’s side:

Your human capital. If you have a steady job, your future ability to save can be thought of as a relatively safe, bond-like asset, which increases your ability to take risk with your financial assets. All else equal, the more years of work you have ahead of you, the greater your human capital is likely to be, relative to your financial capital, and the more investment risk you can take, as explained here.

Your financial capital. If you have very little financial capital but expect to have significantly more in the future from years of work and saving, an inheritance, or the sale of the company you’ve built, you can generally take more risk. If you expect to have $5 million in 20 years, it really won’t make much difference to your long-term wealth if you lose the $5,000 you now have. (Of course, it also won’t make much difference to your long-term wealth if you get terrific returns on that $5,000 in the next year or two.)

As your financial capital accumulates, you benefit more from strong returns—but have more to lose, too. If you have $5 million now, and you don’t expect to obtain any more capital aside from portfolio returns, a 20% portfolio return would increase your capital to $6 million—and a (20)% return would reduce it to $4 million. At $6 million, the portfolio would support a lot more spending!

Your time horizon. Up to a point, it generally makes sense to seek more return and take more risk with money you won’t need for many years or decades to come than for money you’ll need in a few months or years. If you’re not going to start spending from the portfolio for 30 years, you can take more risk than if you’re going to start spending from it in two years.

Are you accumulating capital or withdrawing it? Generally speaking, you can take more risk when you’re accumulating capital in a portfolio than when you are withdrawing from it. When you are accumulating capital, you can benefit from market drops by investing more at low prices. By contrast, money you withdraw for spending at market bottoms won’t be there to participate in a subsequent rebound. Withdrawals during a deep, sustained rebound can significantly erode principal.

In sum, most younger investors in a retirement fund would benefit from a stock-heavy allocation—if they can stomach the risk it would bring.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.