Should the amount of your wealth impact your AA Plan?

[InvestingMom]

I believe it should because the amount of wealth you have will impact how much you can afford to lose in a down market but I have seen conflicting advice on this, for example...

Argument to lower equity if wealthy-I have seen advice in earlier posts to lower the equity allocation in situations where the investor had a decent amount of money. Investor was in their 50s and did not intend on touching the money for several years. The reasoning was that there was not a "need to take on more risk" But why not if he/she has the ability to do so. If it were me I would look to my heirs and want to maximize return (within reason of course) for their sake.

Argument to increase equity if not so wealthy-I have read some magazines (believe me I take these with a grain of salt) that advised a more agressive portfolio with the reasoning that the investor needed to "catch up".

So both of the above pieces of advice seem completely wrong to me. Shouldn/t you be more agressive if you can be afford to be and less agressive if not? Of course for someone not so wealthly this can cause a dilema.

[bob90245]

For what it's worth, I agree with you. There are no hard and fast rules. Each person has to take into account their unique circumstances. Use the "abilty, willingness and need" criteria to take risk as guidelines (not rigid rules) when deciding on one's equity-fixed split.

[stratton]

Argument to lower equity if wealthy-I have seen advice in earlier posts to lower the equity allocation in situations where the investor had a decent amount of money. Investor was in their 50s and did not intend on touching the money for several years. The reasoning was that there was not a "need to take on more risk"

This is one of the main points Larry Swedroe tries to make. If you don't need to take risk then reduce it to the sleeping point. There's also the need to take less risk because of capital preservation such as a retiree might face. If someone wants to leave an inheritance then they may need to take more risk.

Paul

[ajbibi]

This is the part I don't completely understand. What utility model would make it so that a richer man would find the possibility of (let us hypothesize) a 25% drop in his portfolio more disastrous than for a poorer man?

If a rich man's portfolio has a sleeping point of 40% bonds, shouldn't a poorer man need a higher bond allocation to reach a comparable sleeping point? Certainly, either a risk neutral utility model or the standard model of diminishing utility in income should make it likely that a richer man would be better off/find it easier to have a diversified, yet stock heavy portfolio than the poor man.

Whatever allocation looks comfortable for a person when he's worth about $10K will be easier to achieve with higher returns and equivalent risk for him when he has a worth of $1M. Furthermore (all else being equal) the millionaire will be more able to ride out a 20% drop in a bad year than the poorer person. Right?

To assume otherwise is just to assume that people want a fixed dollar target regardless of net asset value. In that case I can see how a 50 yr old who wants (let us say) $1M at retirement will take less risk with a portfolio of $500k than with a portfolio of $100k, since he feels he **needs** only $1M. But as a general model of human behavior, I find that implausible, even perverse.

[Doc]

If a rich man's portfolio has a sleeping point of 40% bonds, shouldn't a poorer man need a higher bond allocation to reach a comparable sleeping point?

The poorer man may be more worried about the "starving point" and thus need to take more risk.

[statsguy]

I don't know about the richer man / poorer man argument. But I do think that having enough means you can take more risk.

We struggled with this for a long time. I know many suggest that once you satisfy your needs then there is no reason to take risk. After much thought we finally came to a different conclusion.

We are fortunately in a situation where our portfolio could drop by 40% and we would still be able to muddle through retirement without much hardship (mostly because our needs are small). It just does not make sense to us that we should basically invest 100% in TIPS or bonds etc.

Our solution was to choose a 60/40 (equity/bond) portfolio because that fits our risk tolerance. At some point we came to the realization that we are investing for our children's and our alma-mater's future.

Best
Stats

[larryswedroe]

The issue is very straight forward and goes like this

You need to determine your MARGINAL utility of wealth. The higher it is the more risk you should be willing to take (that doesn't impact your ability to need to, just willingness). Low marginal utility of wealth means upside worth little but downside very painful

So no right answer--just one right for you.

High net worth people have no need to take risk, certainly have ability, and may have willingness. But the issue for them should IMO revolve around the marginal value of wealth.

[ataloss]

Larry is right, of course. I think allocation matters less as net worth increases relative to spending. For example, if you live comfortably on 1% withdrawals, you should do fine with any allocation from 100% equity to 100% fixed. If you need a 4% withdrawal you might want to follow allocation from the Trinity study. If you need a 10% withdrawal rate you either need to accumulate more resources (ie keep working) or develop a belief that you have unusual skill at investing or market timing.

[Gekko]

"You only need to get rich once."

"You're either in the 'get rich' business or in the 'stay rich' business."

I think if you're already rich, you should look to preserve capital. Why take excessive risk?

[ajbibi]

Please help me by citing a relevant academic paper I can look up. I don't see how having a low marginal utility of wealth leads to more concern about the downside. (Assuming the same person would have a higher marginal utility of wealth when poorer). All the relevant literature I know says that all else being equal, the wealthier person should be less risk averse. In the extreme case, he can self-insure against all catastrophes and hence should asymptotically approach risk-neutral behavior since there will be little need to give up expected return to reduce variance.

Similarly, someone who is poor and worries about starving will be even less likely to accept downside risk.

I would expect that in relatively poor countries, people would be more likely to hold more of their assets in low risk, low reward investments. Only in richer countries would you be more likely to see people with larger exposure to equities and higher average returns. [Of course, correcting for different institutional environments would be tricky but the general pattern is indeed what you observe.] This is true cross-sectionally and across time.

[academic footnote: This seems to be true historically for farming behavior as well. Economists such as McCloskey argued that farmers scattered their fields and hence lowered their overall returns to reduce their risks in medieval times. As technology improved, property rights became secure, and people got richer, they could shift to "riskier" farm practices that had much higher expected value.]

[ramsfan]

Please help me by citing a relevant academic paper I can look up. I don't see how having a low marginal utility of wealth leads to more concern about the downside. (Assuming the same person would have a higher marginal utility of wealth when poorer). All the relevant literature I know says that all else being equal, the wealthier person should be less risk averse. In the extreme case, he can self-insure against all catastrophes and hence should asymptotically approach risk-neutral behavior since there will be little need to give up expected return to reduce variance.

Similarly, someone who is poor and worries about starving will be even less likely to accept downside risk.

I can give a real world example. I know for sure, that if my portfolio was enough to generate enough income forever to not have to work, then the marginal utility of wealth for me would be almost nil, yet the downside risk of the portfolio value dropping to the point where I had to go back to work, would be a bad downside risk.....

Seems really straightforward, but again it is personal.

[ajbibi]

Now that I think about it, I may have come up with a model that might reconcile Larry's view with the academic lit.

The relevant point is that one is holding a person's job and human capital constant. In that case, assume the following:

A person who is middle-aged, earning a guaranteed $50K per year (inflation adjusted).

In one case he has a portfolio worth $100K, in another, he has $2M.

If we treat his job as equal to an annuity worth $1M, then we see that in the first case, his investments are a small part of his true total net worth.
In the latter, his portfolio is the dominant portion so it makes sense to take less risk.

In contrast, imagine someone at 60 who's retired with no salary and no chance of earning a salary. [Leave out SS.]

If he has a portfolio worth $1M that he's living on, he should be taking less risk than someone with a portfolio of $10M because of the downside risk. The former might have a 30/70 stock/bond AA. The latter could easily go 50/50 and be very comfortable even in a bad year.

Does this make sense?

[Wagnerjb]

Argument to increase equity if not so wealthy-I have read some magazines (believe me I take these with a grain of salt) that advised a more agressive portfolio with the reasoning that the investor needed to "catch up".

I see this argument all the time, and it is very disappointing to me. It is simply "the poor getting poorer". These people made poor financial decisions, ending up behind as retirement gets near. What do they do? They make another poor financial decision and ramp up the risk. Then 2000 happens and we hear these people complain about how undiversified active funds ruined their retirement and caused them to continue working.

Why can't these people learn to live on what they have saved?

Best wishes.

[InvestingMom]

Thanks so much for all of your opinions and advice. Larry you brought it home and many of you said the same thing in so many words.

I realize that as I am helping my mom with her asset allocation I need to sit down with her and convince her to lower her equity allocation or at least make sure she understands the ramifications.

I wish I could work some magic for her but the bottom line is that she does okay with her current withdrawal rate and so we need to maintain her investments (keeping up with inflation) and not risk a reduction in that withdrawal rate.