Risk Management and the Imaginary Portfolio

by Kevin on October 10, 2008

The above image is a chart of the S&P 500 over the last five years.

Imagine this scenario:

You’ve worked hard for 20, 25, or 30 years. You’ve saved frugally, invested heavily in your 401k and IRA. You’re coming up on retirement and you’ve built a portfolio of $1,000,000 by October 2007.

You’ve taken some risks with your investments, but they have paid off since you started investing long ago. A majority of your portfolio is in stocks. You favor stocks for their growth potential versus the conservative relative safety of bonds.

Not ultimately worried about your investments — hey, you weathered the tech bubble, didn’t you? — you don’t make much changes to your portfolio after hearing a few things about the potential downsize of this housing bubble. It’ll be alright… we can ride this thing out.

Let’s make some simple assumptions about the portfolio… it’s mostly in the S&P 500. And by mostly I mean enough that we can just use the S&P 500’s returns to estimate the value of the portfolio.

That $1,000,000 you had saved up as of last year is now worth only $546,300 (as of time of writing the S&P is down 45.37% from last year). Completely devastating.

Hope that gives everyone some perspective on the market.

A Diversified Portfolio Survives Intact

Compare to the same portfolio with a 50% stocks (S&P 500), 50% bonds ratio. I used Vanguard’s Total Bond Index (VBMFX) as a proxy for bond returns. Vanguard’s Total Bond Market has been down only 1.61% over the last year.

If you were one year away from retirement, a 50/50 split would be pretty reasonable. And your portfolio fares much better. The same $1 million portfolio would be worth $765,100 versus $546,300 for an all stock portfolio. That’s a difference of 40% and $218,800 extra in your portfolio.

Your portfolio would still be down — 23.49% — but that is much, much better than the all stock loss of 45.37%.

Take this lesson to the bank: as you get older, move more of your assets to more conservative holdings. As you age, you have less time to recover from a serious market downturn. The safer returns of bonds help keep your portfolio where you will need it when you retire.

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YoungMoneyTalks October 10, 2008 at 1:05 pm

Kudos for this calm and rational illustration. It’s so refreshing to see this during the current frenzy. The financial commentators on TV could learn a thing or two from you!

Kevin Wright October 10, 2008 at 2:07 pm

You hit it right on the head. If this market teaches us nothing else, it should show how diversification is exteremly important. I am just thankful my dad moved his IRA into bond funds before this hit. That was against his Financial Advisors advice. He would have been hurting severely.

philip October 11, 2008 at 10:08 am

So pretty much you should do what Cramer has told people they should have and/or should do, amazing!

Nice example to illustrate why people should do such things. Hopefully the person who is in all stocks will not take it all out right now and they likely will only be using some of their savings for a few years and will be able to ride some of that 46% loss back up closer to the 750,000 mark.

Kevin October 12, 2008 at 12:41 am

@YMT: Thanks! Sometimes it is hard to take a step back…

@Kevin: Exactly my point. I was shocked to see that bond fund had only gone down 1.6%. Impressive considering the conditions.

@Philip: Yea, I’m currently 100% equities (except for our target retirement fund, which automatically has 10% bonds in it). Long, long term.

Amanda October 13, 2008 at 7:22 am

My Aunt and I were just talking about this on the way to work. She has all of her retirement in oil stocks! I told her she should diversify, but she didn’t seem interested. She is only about 5 years from retirement and has only been saving for the past 3 years or so. It looks like she will be working forever. I will be sending her this link. I’m glad I am so young during this market turmoil. My 401(k) has about 40 years to recover. =)

Russell October 15, 2008 at 8:32 am

I use the “target” funds for some of my IRA investment, and I have other non-stock investments (annuities in money market) to give a blend. I’m still a large portion in stock investments but expect long-term results to be in my favor.

Amanda, one thing to remember about your aunt is she won’t be redeeming all her investments in 5 years, that will only be the beginning of retirement years. She should hope for those investments to be in place for many years beyond that.

I’ve thought about this recently with my mother who has a lot of stock investment, including oil stocks inherited from her parents. My mother is 75 years old. She has other savings to give her income and has not had to sell any of her inherited stocks. She also takes stock dividends as cash for ongoing income. For her the market price of the stock is almost immaterial because she doesn’t plan to sell any of them. The dividends are what’s important, and oil stocks don’t seem to be having any problem paying those. A lot of people seem to like condemning “Big Oil” for being profitable companies, without recognizing that my mother and your aunt and their fellow shareholders are “Big Oil”.

Andy October 26, 2008 at 9:33 pm

Some very sensible advice here. You have to constantly adjust your investments with you age.

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