How do you mitigate risk of investment loss?

lucija · 10-05-2007, 01:09 PM

In other words, how do young dreamers set their equity to bond/cash allocation? To put things in perspective: our retirement will be fully funded with our investments (no pensions, etc.).

In general, folks tend to list something like “your age in bonds”, “your age – 10 in bonds” etc. I find such rules of thumb are not very useful when one is planning for an early out. Similarly, one can cut exposure to equities based on “the number of working years left”. Again, this is somewhat useless in our case, since we’re not waiting for some magic age/tenure (for us, the range is 9-17 yrs to go).

So, anyone else run into this problem? How do you handle it? Do you simply follow your gut feeling? I would really appreciate to hear your thoughts and any feedback you may have on the following method!

I settled on using the percentage of current portfolio vs. final portfolio needed (in today’s $) as a trigger for asset allocation. For example, assuming you need $1MM (today’s dollars) to attain FIRE, then you could:

Be 100% equities up until $100K
Be 85% equities between $100K to $250K
Be 75% equities between $250K to $500K
Be 65% equities between $500K to $750K
Be 50% equities when you reach FIRE

A method like this would align risk based on portfolio's relative size vs. actual age or number of work years left.

Obviously, the actual percentages can/should be tweaked to reflect each individual’s situation and risk tolerance.

**Gumby** · 10-05-2007, 01:20 PM

Based on my reading and studying, I decided that 70-75% equities was on the efficient frontier, so that's what I did. I don't plan to change it even after retirement. I also ran Firecalc a few times and that was the range that gave me the greatest probability of success.

twaddle · 10-05-2007, 01:23 PM

The best risk mitigation is to keep working if the market blows up. Go balls out on risky investments until you're ready to pull the trigger on retirement, and then go conservative on that portion of your nest egg that is required to meet your basic expenses.

brewer12345 · 10-05-2007, 01:25 PM

I am gradually reducing equity exposure as I get closer, but it is nothing so scientific and I will and have dialled up equity exposure in response to buying opportunities. What I have done:

- Gradually start buying a few more bonds and other non-equity investments over time.
- Pay down more debt. This may sound unrelated, but paying down debt is effectively the same thing as buying a risk free bond. By the end of the year or shortly thereafter, I will be down to just a low rate mortgage and maybe a small, low rate student loan.
- Diversify more broadly. As I get closer to FIRE, I am monitoring sector and security concentrations much more carefuly than before.
- Keeping more liquid cash around. This varies according to buying opportunities.

FWIW, I think trending up to 50% bonds is too conservative/risking inflation problems if you intend to retire before age 55.

**Want2retire** · 10-05-2007, 01:29 PM

Quote:

Originally Posted by twaddle

The best risk mitigation is to keep working if the market blows up. Go balls out on risky investments until you're ready to pull the trigger on retirement, and then go conservative on that portion of your nest egg that is required to meet your basic expenses.

Wow! You're a brave guy, and I'd bet that you have done well with your investments.

Personally, I have decided that I'd almost rather jump off a cliff than continue working for more than two more years. My asset allocation is pretty conservative (only 60% equities) and I intend to continue LBYM in ER. That is the percentage that lets me sleep at night.

twaddle · 10-05-2007, 01:35 PM

Quote:

Originally Posted by Want2retire

Personally, I have decided that I'd almost rather jump off a cliff than continue working for more than two more years. My asset allocation is pretty conservative (only 60% equities) and I intend to continue LBYM in ER. That is the percentage that lets me sleep at night.

You have mentally pulled the trigger, so it makes sense for you to start preserving capital.

Bonds preserve wealth, but there's no one-size-fits-all allocation. It depends on your nest egg size (i.e., your need for high returns), and the term of your retirement more than it does on your psychological tolerance for short-term losses.

FinanceDude · 10-05-2007, 01:48 PM

Quote:

Originally Posted by twaddle

Bonds preserve wealth, but there's no one-size-fits-all allocation. It depends on your nest egg size (i.e., your need for high returns), and the term of your retirement more than it does on your psychological tolerance for short-term losses.

I don't think bonds preserve wealth, maybe TIPS do............

Lusitan · 10-05-2007, 02:02 PM

Interesting phased approach you have come up with there, lucija. It'll probably follow something similar, although the percentage of my portfolio in bonds will be lower than in your example.

Since I'm planning on an early retirement (age 45 would be nice) I don't expect my bond holdings will make up more than 25% of my portfolio when I reach FIRE.

I'm holding 15% bonds right now and I'm still over 10 years away; I should probably consider reducing this to 10% at some point, but I'll probably do that by increasing my equity contributions going forward in the near future as opposed to rebalancing.

lucija · 10-05-2007, 02:46 PM

Thanks for the perspective and some of the suggestions… the numbers, themselves, are illustrative only.

We are and will continue to take on more risk than outlined in the example. Currently, we have about ¼ of the assets and hover around 10% bonds/cash. However, in my heart I know, if we continue to see the recent returns over the next 3-5 years (wishful thinking, right) and continue contributing at the current rate, I will be cutting the equity exposure to max 70%. I guess, as someone mentioned, I have mentally checked out already. My ultimate safety net is the fact that (at this time at least) my husband is not opposed to working till 50-55 (or later is the %$#^ really hits the fan).

Personally, our plan is to have an option to quit by age 45 (earlier, would be better), so I seriously doubt we’ll FIRE with less than 65% equities. It would be nice, though, to limit SWR to less than 3.5%.

Lusitan · 10-05-2007, 03:21 PM

Quote:

Originally Posted by lucija

My ultimate safety net is the fact that (at this time at least) my husband is not opposed to working till 50-55 (or later is the %$#^ really hits the fan).

Good idea, I gotta talk to my wife about that one ...

maddythebeagle · 10-05-2007, 03:25 PM

Thanks, OP...something to think about...and have been thinking about as my portfolio gets larger and nearing FIRE..

SecondCor521 · 10-05-2007, 04:31 PM

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement.

2Cor521

Milton · 10-05-2007, 04:36 PM

Quote:

Originally Posted by twaddle

Bonds preserve wealth

Can't agree with you there.

twaddle · 10-05-2007, 04:51 PM

If I hold a bond to maturity, I get my original principal back + interest. As long as the interest rate exceeds inflation for the period, my wealth has been preserved, right? And if we're talking about TIPS, the risk of inflation exceeding interest has been removed.

Are there any such guarantees for stocks? Let's ask the Japanese:

Nope, no such guarantee for stocks. Of course, the probabilities favor stocks over the long term, but that's not a guarantee of wealth preservation.

When bonds really help is when short-term losses in the stock market aren't so short-term and you need to sell off assets to pay the bills. That's why older folks are advised to have a higher allocation in bonds -- they can't afford to ride out potential losses over their remaining lifespan.

maddythebeagle · 10-05-2007, 05:57 PM

Quote:

Originally Posted by SecondCor521

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

2Cor521

I believe that the "gurus" (Paul Merriman and Bogle) talk about a 10-20% bond allocation and dont give up much in return....

**Gumby** · 10-05-2007, 06:36 PM

Quote:

Originally Posted by SecondCor521

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement.

2Cor521

I don't know where you were at in the Spring of 2000, but I was 100% equities. It was painful. I learned then that it is worthwhile to put a small drag on performance to decrease volatility.

zebageba · 10-06-2007, 09:08 AM

I'm 40 and have set my 401k to 80/20. Two Roths, one an index fund the other domestic growth. Taxable account maybe 5% bonds and a REIT, Large blend, small cap, Mid-cap and Intl. I'm more aggressive in the taxable. I probably won't touch my allocation until I'm 50. I've tried to cover all my bases.

Milton · 10-06-2007, 11:16 AM

Quote:

Originally Posted by twaddle

As long as the interest rate exceeds inflation for the period ...

Is that guaranteed?

Quote:

Originally Posted by twaddle

Of course, the probabilities favor stocks over the long term, but that's not a guarantee of wealth preservation.

There are essentially no guarantees in investing (or life!), and there are pros and cons to all asset classes. IMHO, it is better to play the (historically-proven) odds, especially if one has sufficient capital to ride out any downturns.

SecondCor521 · 10-06-2007, 05:24 PM

Quote:

Originally Posted by Gumby

I don't know where you were at in the Spring of 2000, but I was 100% equities. It was painful. I learned then that it is worthwhile to put a small drag on performance to decrease volatility.

In the spring of 2000, I had a chunk in my employer stock and the rest was 100% equities; in fact 100% S&P 500 index equities.

I sold off a chunk of my employer stock near their all time high in order to buy a minivan. This call, however, was my ex-wife's, not mine. I wanted to take out a low-interest rate loan at the local credit union and play arbitrage. (Credit where credit is due.)

I remained with a smaller chunk in my employer's stock and 100% S&P 500 index between then and now. The employer stock went to my ex in the divorce.

It was somewhat painful but with the increasing equity in my home and my additions to savings, we basically went sideways net-worth wise from about 2000 through 2002 or so.

Then in 2003 it looks like the index went up 28% or so. That year was good to me.

Many people talk about the 2000-2002 slide. If you were in dot-coms or sold on the way down, yes, you didn't do well. If you stayed reasonably diversified, held on, DCA'd into it, and waited for the rebound, you did OK.

But like I said, the heartburn for me the next time may be too much.

2Cor521

10-05-2007, 01:09 PM	#1
lucija Recycles dryer sheets Join Date: Dec 2006 Posts: 124	How do you mitigate risk of investment loss? In other words, how do young dreamers set their equity to bond/cash allocation? To put things in perspective: our retirement will be fully funded with our investments (no pensions, etc.). In general, folks tend to list something like “your age in bonds”, “your age – 10 in bonds” etc. I find such rules of thumb are not very useful when one is planning for an early out. Similarly, one can cut exposure to equities based on “the number of working years left”. Again, this is somewhat useless in our case, since we’re not waiting for some magic age/tenure (for us, the range is 9-17 yrs to go). So, anyone else run into this problem? How do you handle it? Do you simply follow your gut feeling? I would really appreciate to hear your thoughts and any feedback you may have on the following method! I settled on using the percentage of current portfolio vs. final portfolio needed (in today’s $) as a trigger for asset allocation. For example, assuming you need $1MM (today’s dollars) to attain FIRE, then you could: Be 100% equities up until $100K Be 85% equities between $100K to $250K Be 75% equities between $250K to $500K Be 65% equities between $500K to $750K Be 50% equities when you reach FIRE A method like this would align risk based on portfolio's relative size vs. actual age or number of work years left. Obviously, the actual percentages can/should be tweaked to reflect each individual’s situation and risk tolerance.

10-05-2007, 01:20 PM	#2
Gumby Moderator Join Date: Apr 2006 Posts: 1,774	Based on my reading and studying, I decided that 70-75% equities was on the efficient frontier, so that's what I did. I don't plan to change it even after retirement. I also ran Firecalc a few times and that was the range that gave me the greatest probability of success. __________________ You should not assume that I have a clue about anything I post. If you need a lawyer, go get your own.

10-05-2007, 01:23 PM	#3
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	The best risk mitigation is to keep working if the market blows up. Go balls out on risky investments until you're ready to pull the trigger on retirement, and then go conservative on that portion of your nest egg that is required to meet your basic expenses. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

10-05-2007, 01:25 PM	#4
brewer12345 Give me a museum and I'll fill it. (Picasso) Give me a forum ... Join Date: Mar 2003 Posts: 9,226	I am gradually reducing equity exposure as I get closer, but it is nothing so scientific and I will and have dialled up equity exposure in response to buying opportunities. What I have done: - Gradually start buying a few more bonds and other non-equity investments over time. - Pay down more debt. This may sound unrelated, but paying down debt is effectively the same thing as buying a risk free bond. By the end of the year or shortly thereafter, I will be down to just a low rate mortgage and maybe a small, low rate student loan. - Diversify more broadly. As I get closer to FIRE, I am monitoring sector and security concentrations much more carefuly than before. - Keeping more liquid cash around. This varies according to buying opportunities. FWIW, I think trending up to 50% bonds is too conservative/risking inflation problems if you intend to retire before age 55. __________________ “When you realize that you are one of the rare few who observe moral principles in their relationships with others, there is a temptation to sink into amorality, not out of conviction or pleasure but simply to avoid further pain, because there is no greater suffering than being an angel in hell, whereas a devil feels at home wherever he goes.” – Martin Page, How I Became Stupid

10-05-2007, 02:46 PM	#9
lucija Recycles dryer sheets Join Date: Dec 2006 Posts: 124	Thanks for the perspective and some of the suggestions… the numbers, themselves, are illustrative only. We are and will continue to take on more risk than outlined in the example. Currently, we have about ¼ of the assets and hover around 10% bonds/cash. However, in my heart I know, if we continue to see the recent returns over the next 3-5 years (wishful thinking, right) and continue contributing at the current rate, I will be cutting the equity exposure to max 70%. I guess, as someone mentioned, I have mentally checked out already. My ultimate safety net is the fact that (at this time at least) my husband is not opposed to working till 50-55 (or later is the %$#^ really hits the fan). Personally, our plan is to have an option to quit by age 45 (earlier, would be better), so I seriously doubt we’ll FIRE with less than 65% equities. It would be nice, though, to limit SWR to less than 3.5%. Last edited by lucija; 10-05-2007 at 03:31 PM. Reason: added clause about continuing saving at the same rate

10-05-2007, 02:02 PM	#8
Lusitan Recycles dryer sheets Join Date: Jan 2006 Posts: 351	Interesting phased approach you have come up with there, lucija. It'll probably follow something similar, although the percentage of my portfolio in bonds will be lower than in your example. Since I'm planning on an early retirement (age 45 would be nice) I don't expect my bond holdings will make up more than 25% of my portfolio when I reach FIRE. I'm holding 15% bonds right now and I'm still over 10 years away; I should probably consider reducing this to 10% at some point, but I'll probably do that by increasing my equity contributions going forward in the near future as opposed to rebalancing.

10-05-2007, 03:25 PM	#11
maddythebeagle Thinks s/he gets paid by the post Join Date: Jun 2005 Posts: 2,439	Thanks, OP...something to think about...and have been thinking about as my portfolio gets larger and nearing FIRE..

10-05-2007, 04:31 PM	#12
SecondCor521 Thinks s/he gets paid by the post Join Date: Jun 2006 Location: Boise Posts: 1,331	I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15. My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off. So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement. 2Cor521 __________________ "At times the world can seem an unfriendly and sinister place, but believe us when we say there is much more good in it than bad. All you have to do is look hard enough, and what might seem to be a series of unfortunate events, may in fact be the first steps of a journey." Violet Baudelaire.

10-05-2007, 04:51 PM	#14
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	If I hold a bond to maturity, I get my original principal back + interest. As long as the interest rate exceeds inflation for the period, my wealth has been preserved, right? And if we're talking about TIPS, the risk of inflation exceeding interest has been removed. Are there any such guarantees for stocks? Let's ask the Japanese: Nope, no such guarantee for stocks. Of course, the probabilities favor stocks over the long term, but that's not a guarantee of wealth preservation. When bonds really help is when short-term losses in the stock market aren't so short-term and you need to sell off assets to pay the bills. That's why older folks are advised to have a higher allocation in bonds -- they can't afford to ride out potential losses over their remaining lifespan. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

10-06-2007, 09:08 AM	#17
zebageba Confused about dryer sheets Join Date: Oct 2006 Posts: 5	I'm 40 and have set my 401k to 80/20. Two Roths, one an index fund the other domestic growth. Taxable account maybe 5% bonds and a REIT, Large blend, small cap, Mid-cap and Intl. I'm more aggressive in the taxable. I probably won't touch my allocation until I'm 50. I've tried to cover all my bases.