Conventional Wisdom: Asset Allocation

This is the third in an occasional series inspired by a toy at CNNMoney. Previous installments covered how big your housing payment should be and emergency funds.

Today’s topic is asset allocation, which in the dumbed-down context of the CNNMoney "tool" means the NYSE floor Old - Croppercentage of your savings to put in stocks. If you type in that your age is 45 and that you’ve got half your kitty in the stock market, you get a big red flag and a warning. But maybe not the warning you were expecting.

Uh-oh… Looks like your portfolio is invested too conservatively. Stocks can provide good growth, but pose plenty of risks in the short-term. Bonds offer more stability. If you’re saving for retirement and want a quick idea of what percentage of your portfolio should be in stocks, subtract your age from 120.

So at 45 the right answer is 75% in the stock market. In fact, from experimenting with it a little I find that for a 45 year-old anything between 65% and 84.9999% gets the "Good Work" pat on the back.

Where to begin? First off, I’m not a big fan of the widely held belief that age should be the primary driver of how much risk you take, something I wrote about in one of the very first posts on this blog.

If you want to see what your financial advisor looks like with a deer-in-headlights stare, try asking him why a person should take on less risk as they get older. If he is honest he will admit that you’re the first person who’s ever brought it up. The best justification, and it is a weak one, is that younger people have the option of scaling back their lifestyle and saving more later in life if investments sour.

Then we have the old chestnut that stocks are a good engine for long-term growth but are risky short term. There are no such things as short or long term stocks. Stocks is stocks. A twenty year return in the market is made up of twenty annual returns, 240 monthly returns and about 5000 daily returns.

Holding for a long time does give you some risk reduction of a kind, but it’s not diversification in the proper sense. Holding several different assets at the same time is diversifying because you get to average the returns between the assets. It’s the eggs in different baskets argument. But owning stocks for 20 years is not like owning 20 different assets. The returns don’t average, they compound. It’s as if you used different baskets for your eggs by shifting all your eggs from one basket to another periodically on your journey.

Bonds do "offer more stability" but that’s not their only offering. There are many different kinds of bonds, including, for example, short and long term ones. Fixed income investments encompass a spectrum from the practical equivalent of a checking account to assets that are as high risk and high return as a stock.

Amongst the many dangers of reducing the asset allocation question to how much should be in stocks is that it leaves open what happens to the rest of the portfolio. The risk taken with a portfolio split 50/50 between stocks and a money market fund is miles from one split between stocks and high yield corporate bonds.

And yes, these sorts of things are only meant as guidelines and the "How Healthy are Your Finances" thing at CNNMoney is obviously not intended to be detailed or comprehensive. But from such acorns grow great oaks of bad money advice.

Conventional wisdom, as captured in the CNNMoney toy, has young people putting virtually, or even actually, all their savings in the stock market and tapering this down so slowly that even at retirement around half is in stocks. CNNMoney actually calls this question in the quiz "Diversification". Of course, their message is quite the opposite.  It should be called "Stock Market Obsession".

Giving a clean bill of health to somebody with 80%+ of his investments in one risky thing is, or really ought to be, irresponsible. It is based on what can fairly be called a stock market fetish, a half mystical belief that stocks are the magic asset that will return so much more than other things that you should put nearly all your eggs in that one basket.

What’s worse is that if people are buying this idea now, only a few months after a retirement destroying 50% drop in stock prices, then this is a bit of the conventional wisdom that will be with us for a very long time.

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