One of my favorite Bernstein lines came from Efficient Frontiers in reference to the 1999 book Dow 36,000. The argument put forth by the book's authors was probably based on a not-uncommon misreading of Jeremy Siegel's Stocks for the Long Run. Siegel had noted that over long periods of time, stocks nearly always outperform bonds and the authors of Dow 36,000 apparently understood that to mean that stocks are ultimately safer than bonds. If that were true, then stocks would have been tremendously underpriced in 1999. One day, investors would wake up to just how safe stocks are and the Dow would soar to 36,000 or higher.
Unfortunately for the authors of that ill-fated tome, and for all of us who invested in equities back then I suppose, sixteen years later the Dow is around half that value. Siegel's argument that stocks outperform bonds over the long run does not equate to stocks being safer than bonds. Stocks can and do take stomach-churning dives along the way and bonds don't. The short-term volatility of stocks is much greater than that of bonds and as Siegel and Zvi Bodie agreed in a famous interview (download PDF), stocks are risky no matter how long you hold them.
To quote Professor Siegel from that interview, “In other words, [stocks] are relatively safer in the long run than random walk theory would predict. Doesn’t mean they’re safe. . . Well, they’re not safer in the long run—that’s definitely not true.”
The Bernstein comment I have always remembered is “James Glassman and Kevin Hassett . . . in Dow 36,000 postulated a new species of homo economus [sic] impervious to short-term volatility.”
I suspect that the vast majority of us retirees are keenly aware of short term volatility, even if we firmly believe that the market will always recover, eventually. I haven't found research that specifically addresses this issue, so I recently conducted a simple survey to determine if at least some retirees care about short term volatility.
In that survey, I asked retirees and near-retirees if they would invest their portfolio totally in equities if their non-discretionary expenses were securely covered by a floor, noting that such a portfolio might have fallen 50% or more in value during the 2007-2009 bear market. The survey should not be confused with science – it's merely the thoughts of about a hundred and fifty or so readers of my blog – but the results do suggest that a lot of retirees care about short term volatility even when their living expenses are secure.
About 84% of respondents indicated that they would prefer to reduce portfolio volatility, presumably through a bond allocation, even with a secure floor. About 14% said they would go full bore with equities if their non-discretionary living expenses were safely covered, and 2% implied that they'd rather shave their head with a cheese grater than allocate any of their retirement savings to the stock market.
OK, not precisely in those words.
[Tweet this]84% of respondents to an informal survey say they would want to manage portfolio risk even with a solid floor of income.
My take from this informal, unscientific survey is that there are at least some retirees who would need an allocation to bonds in order to sleep at night even with a bedrock-solid floor. (No one wants to sleep on the floor, but some are willing to risk it.) Whether the numbers are as dramatic as my informal survey suggests, I cannot say. My goal was simply to find out if I'm the only retiree who cares if his portfolio occasionally crashes.
To assume that retirees with a secure floor would not care about short term volatility is to recreate the Dow 36,000-postulated homo economicus, a retiree impervious to short term volatility. My standard of living was not threatened by the 2007-2009 crash because I had a sizable allocation to cash and bonds, but it was not a fun ride even so. I suspect that most retirees see a portfolio crash as the evaporation of wealth that can no longer be replaced by human capital and that they find that worrisome.
Some will be quick to point out that the market as measured by the S&P 500 index recovered to it's 2007 high by January 2013, but as I explained in this post, retiree portfolios don't recover as quickly as the market. The market doesn't take annual withdrawals to cover its living expenses.
Your tolerance toward market volatility, even when your floor is secure, is something you want to understand up front. Getting it wrong has consequences. If you believe you can tolerate the high-equity allocation roller coaster and find out after your first big bear market after retiring that you can't, your response will probably be to reduce your equity allocation at the worst possible time – after your portfolio has crashed and before it recovers.
It's tough to keep investing largely in equities, especially for a retiree, while you are watching your wealth vaporize day by day. For a real-life example, read my next post, The Role of Xanax in the Asset Allocation.