This is the 2nd post in a multi-post series walking through all the key financial decisions that led to financial independence in our 30’s along with a few mistakes along the way! Make sure you read them in order as each post builds on the last.
As discussed in the first post, I spent a substantial part of my 2nd year medical residency working out my fundamental investment belief system before investing a single dollar. I poured over financially blog sites and read numerous general investment books. I had formed the core personal finance beliefs that I have discussed in the About Me post. I was ready to save a significant portion of our earned income to allow compound growth to do its work.
Yet I kept reading one piece of investment advice that simply didn’t make rational sense to me after reading “Stocks For The Long Run” and similar books that discuss the historical returns of different assets. This post will give the background to a decision I made that is certainly not for every investor. Do not construe this as specific advice for you but I hope following my thought process may help give some insights for your basic asset allocation between stocks and bonds.
Conventional wisdom states that the asset allocation of a portfolio should always hold some bonds and this percentage should increase as you grow older. I was 26 years old and excited about the long investing growth run way I had in front of me. The traditional asset allocation suggested I should be at least 20% bonds and 80% stocks.
My wife and I had established a goal for Financial Independence (as discussed here) at a young age. This would require having a large nest egg to allow 3-4% capital withdrawals (The Safe Withdrawal Rate) yearly on a perpetual basis. The SWR only works when a portfolio can continue on in perpetuity by achieving 6-7% long term nominal returns to keep up with inflation. As referenced in the last post, this is the equivalent of 3-4% real returns after inflation.
As I compared the real returns of stocks at 6.6% and bonds at 3.6% based on a large data set of asset returns, a question kept recurring – WHY HOLD BONDS AT ALL? The empiric data from Stocks for the Long Run showed clearly that stocks would be short term volatile, but with my 30+ year time horizon it will be safer in fighting inflation to achieve my goal retirement portfolio. As long as I had no short term need for savings like buying a house, the empirical evidence pointed towards it being superior to allocate all my savings towards stocks.
The problem with empiric data is that it completely ignores normal investor behavior. An investor’s ability to withstand volatility is essential to allow stocks to outperform in the way an index would. I began viewing bonds as the necessary sub-optimal solution to prevent me from doing something stupid such as selling stocks at a market bottom. The next question was what percentage of bonds I personally needed to prevent stupid behavior?
Understanding Risk Tolerance – Poker
In the last post, I alluded to a personal experience that helped me gauge my risk tolerance before investing. In university, I found that certain analytical skills I developed from other interests during my teenage years translated well to Poker.
Poker for me began as local card games with friends for small amounts of money, but quickly the game became a sensation on the internet in the early 2000’s. I had more opportunity to play with inexperienced players online and it produced fairly consistent winnings over the next decade.
At my height of play, I would have played 10-14 hour sessions for many consecutive days (that immediately sounded very depressing to admit that!) In residency, a few attending physicians that knew me more personally joked about hooking me up with an IV, inserting a catheter and locking me in the call room to create Poker retirement portfolios for them instead of going to see patients!
Eventually, I found my skill edge narrowed and it was difficult to be consistently profitable near the end of the decade. My reduced ability to commit time to regular play, the increased skill of other players and the introduction of robo-analysis online all made the game harder to win. This coincided with my transition to professional work as a doctor which was a far more economical (and productive) use of my time, so I essentially quit playing except for home games here and there. My ego did make it quite hard to walk away and admit I wasn’t good enough anymore to consistently win the bigger games. I can still remember the emotional high I would get from occasionally beating professional players on the World Poker Tour.
A decade later, I recognize how so many skills I learned during my amateur poker career translated well to understanding the investment world. An additional benefit was being able to pay off all our student debt from poker winnings! My friends who did not play poker considered this outcome to be incredibly lucky and that a significant amount of risk must have been taken. Most people view gambling as luck and in the long run everyone loses. This is fairly accurate advice as it translates to casino gambling since the law of probabilities allow for consistent edges for the “House” to win in the long run over its patrons.
The difference with poker was that I was not gambling against the “House”, but against real life people sitting in front of me. I began to see that my analytical skills provided a reasonable edge compared to most players at the table. This edge would generally allow me to make profitable decisions overall, despite every single hand having an element of luck associated with it. The key to removing the luck element of poker was to play a huge amount of hands, thereby increasing the statistical sample set and reducing the variability in the overall outcome. It was also important to keep my process and decision making unaltered by emotion to keep my skill edge intact.
I can’t pretend there were no behavioral mistakes during my poker playing days. It was a learning process that isn’t just innate to the person, although certain personality types are more adept than others to handle volatility. I can recall at least 5 sessions where I lost my rational framework and let my ego get the better of me against a certain player. This is known as going “on tilt” in poker, which essentially refers to an emotional gambler who loses rational thinking. It was easy to lose large sums of money in these sessions if there was no “stop” mechanism to ensure you lived to play another day.
If I kept my behavior in check to not risk a significant percentage of my poker bank roll on any given individual poker session, every next game would provide more poker hands to allow my edge to win more often than I lost. By the end of my poker career the absolute amount of dollars lost or won on any given day grew into the thousands, but always only represented a few percent of my overall poker bank roll. Losing or winning $5000 in a day seemed obscene to many friends around me, but I had learned to view the dollars as tokens in a long game being played over many years. As long as my edge remained, the long game would play out in my favor.
Poker Risk vs Investing Risk
The beauty of the poker analogy to investing is that you do not require an analytical skill edge over other investors to achieve your retirement goal. Investing in assets for the long run has proven to consistently produce gains over inflation given a long enough period of time. The only “edge” you need is time to allow for compound growth to occur. Adequate time in investing is the equivalent of playing a huge number of hands to reduce the luck variable in poker. The ups and downs of the stock market do level out to a steady upward slope in the long run.
The behavioral part of investing is the primary cause of mistakes that interrupt the magic of compounding. The investor is easily drawn in by the seduction of elusive market beating returns. In a normal stock market environment, everyone thinks they are a rational investor. A speculative bull stock market is another matter. It can producing eye-popping juicy returns and speculators seem to making money hand over first. The fear of missing out (FOMO) is strong and very real. Remember this graphic and implant it in your brain.
The equivalent of going “on tilt” in investing is allowing emotions to take over to buy riskier assets in the good times and selling when the herd is fearful. Everyone thinks they can avoid this trap, but the herd is the majority of people for a reason. The only way the contrarian investor can fight these urges is by creating a plan that they fundamentally believe in and sticking to it.
Ways To Individualize Your Optimal Asset Allocation and Risk Profile
As I finished residency, I felt strongly that my risk tolerance would allow me to stay rational during times of distress and volatility. I underwent real world volatility of daily swings of +/- 300% of the amount I brought to a poker table on any given day. The absolute amount won or lost on any given day could be more than one month’s salary as a resident.
To reduce the noise of volatility and luck, I had created a poker bankroll management system to ensure I never risked too large a portion of my assets in one poker session. My belief in the plan allowed me to remove emotion and I felt I could be the rare contrarian when it came to investing.
I recognize that many readers will have no real world experience of significant volatility outside of the 2000 Internet bubble or the 2007-2008 Great Financial Crises depending on their age. How should you actually judge your risk profile accurately without real word experience?
The wide variety of personality types and individual life experiences create inherent preferences towards conservatism or optimism when thinking about money and risk. It is imperative to not fight your gut instincts aggressively. Building a financial belief system and a long term plan will help battle your emotional core values. Market volatility will invoke the rawest form of your emotional core in times of distress. If the volatility is far outside your comfort zone, the downside of making a behavioral mistake from having too much stock allocation far outweighs the benefit of its theoretically superiority to bonds.
Multiple questionnaires like this one from Vanguard will help gauge your risk tolerance, but I believe it falls short of a true informed risk assessment. My belief is your initial emotional instinct should be modified by variables that independently influence your risk profile. Here are a few examples that should be factored into your acceptable risk tolerance.
The single biggest variable in asset allocation should be age. Stocks clearly have short term volatility and an adequate time frame to allow its volatility to smooth out into superior returns is needed. The single biggest “mistake” I see is that young people have too little stock allocation. The emotional scale risk tolerance can be adjusted when an individual truly understands why stocks are long term safer than typical conservative investments.
Stability Of Income
The greater job stability an individual has, the larger the stock allocation they should be comfortable with. A basic emergency fund is required for all financially prudent individuals that covers at least 6 months of cost. There are many careers that can have longer unemployment periods than 6 months or cyclical industries that will lead to significantly lower income for employees during slow times (think commodity mining or real estate/construction). Even if that individual believes they have a long investment time horizon based on age, it would be wise to have at least a 20-30% fixed income allocation at all times to ensure they have finances to ride out unexpected times. This may lead to sub-par long term investment returns, but it is wise on a risk adjusted basis considering their career.
My belief is health care professionals work in a relatively stable sector that allows for a higher risk adjusted allocation compared to other individuals. Supply and demand of physicians can change and increase job competition, but it is unlikely to fluctuate suddenly.
Gross Income Earning Potential And Absolute Savings Rate
This is a more controversial point. I believe that someone who is saving a large absolute amount of money has more flexibility in taking above average risk. My logic here is in the event of a market downturn during the early phase of wealth accumulation, the greater disposable yearly income will still allow for meaningful purchases of cheap assets moving forward.
It seems counter-intuitive, but every investor who is young should beg for a prolonged period of poor market performance in the first phase of their wealth accumulation. The longer and larger the magnitude of the downturn, the greater the future expected returns should be above the historical average to level the event out.
This risk modifying variable should only be considered in the early phase of wealth accumulation when the portfolio is small. Once the yearly savings amount is less than 20% of the total portfolio value, this concept makes less sense to factor in.
Diversity of Income Stream
The most stable job still has risks of unemployment or unexpected disability. Even with disability insurance, it often won’t replace the full income of a high income earning professional without expensive premiums. If a family unit has two reasonable income sources, this creates a hedge in the risk profile of future income.
Given that my wife and I are both physicians, I analyzed cash flow needs and savings rates assuming we lost one income to act as a risk hedge. I wanted to ensure we wouldn’t run into a cash deficit with any increased debt or lifestyle cost.
Our overall variable inputs were two young doctors with reasonable expectation of a stable income and significant earning power above what our lifestyle needs were. Can you guess what our final bond allocation looked like?
Stay tuned for the conclusion of this post next week!