Assessing Equity Exposures
Back in 2002, I was spending my time full-time educating myself as to the academic underpinnings of markets. I was uncomfortable investing with alleged financial experts without having a basic understanding of the language of and the basis for their investment ideas and techniques.
One of the very first things I learned was that according to academic research, over 95% of all investment returns was determined by your asset allocation. It should not surprise that a portfolio of 80% stocks and 20% bonds has a greater *EXPECTED* return over time than a portfolio constructed of 60% stocks and 40% bonds, yet this simple illustration eludes many.
Of course, because the 80/20 portfolio has higher EXPECTED returns, (by most commonly used risk measures) it is also more “risky” than the 60/40 portfolio. One can slice and dice these portfolios (US vs. International Stock, Large vs. Small Stock, Growth vs. Value Oriented), but that is not the subject for today.
What I wanted to share was some insight and assistance in choosing an equity percentage from some of the finest academic-oriented financial authors, both of which I have listed in the Reading Room.
Authors William Bernstein (WB) and Larry Swedroe (LS) have published some guidelines relating to this issue. Both agree on two major points:
- Determine your maximum tolerable percentage loss from the following tables,
- Use the LESSER of the amounts shown to determine your maximum equity exposure.
Maximum Maximum
Tolerable Equity
Loss Exposure
———- …… ———-
5% …………….. 20%
10% …………… 30%
15% …………… 40%
20% …………… 50%
25% …………… 60%
30% …………… 70%
35% …………… 80%
This first table deals with a “stomach acid test“. If your heart starts palpitating at a 10% stock market loss, according to the first table, your maximum equity exposure should be no more than 30%. However, the “stomach acid test” is only the first gauge- we need to think in terms of time.
Accordingly, a person needs to consider the time horizon as to when funds placed in the stock market need to be “repatriated back” for use as originally intended. Both authors have a slightly different take on this issue as shown in the following table:
. Max Equity
Investment Allocation
Horizon WB … LS
———- ………. —– … ——
1 year ………. 10% .. 0%
2 years ……… 20% .. 0%
3 years ……… 30% .. 0%
4 years ……… 40% . 10%
5 years ……… 50% . 20%
6 years ……… 60% . 30%
7 years ……… 70% . 40%
So, if you need the money that you’ve invested in the stock market in four years, William Bernstein recommends no more 40% allocated to the stock market. Larry Swedroe is much more conservative, advising no more than a 10% stock allocation.
My personal belief is that Swedroe is right, as four years is simply not enough time for the stock market to recover ground in the event of a severe downturn. You may need to sell at a most inopportune time (like today), negating the market’s historical long-term benefits. Of course, you would lose the opportunity for gain if the market trends higher over that hypothetical four year period.
So when you hear/read about those people “soon to retire” who now have to postpone retirement due to the state of the U.S. stock market today, ask yourself: Were these people getting the “right” advice on asset allocation?
It appears they were not.