Tolerable Loss = Half of Equity Allocation Percentage?

There a regular poster on the Bogleheads forum called Adrian Nenu who always posts the following, which is said to have origins with author Larry Swedroe.

Tolerable Loss x 2 = Equity Allocation < 50%

I don’t know if I agree with the last part that says that your equity position should always be less than 50%. However, the first part seems to offer a good rule of thumb when it comes to investing in a target date retirement fund.

Let’s say you have the Vanguard Target Retirement 2050 Fund (VFIFX) and it currently contains 90% stocks. Using this rule of thumb would mean that a possible one-year loss for such a fund is 45%. You should ask yourself – can you handle a 45% drop in the value of your retirement assets, even if you have 40 years before you need it? The good thing about living through 2008/2009 is that you probably have a better idea of the truth. If you’re going to run for cover in cash, only to buy back in later (like now) when prices are 50% higher, then that’s something to avoid.

One thing that I recommend to my more conservative friends who still want a simple investment is to simply buy a different “date”. For example, if you could purchase the Vanguard 2025 Fund (VTHRX) which has 75% in stocks. Who cares if the label is 2025. Meanwhile, I encourage them to continue to learn more about investing so that the can understand the risks trade-offs better and adjust their tolerances accordingly (up or down).

Comments

  1. Good point Max

  2. Great post.

    Don’t forget that 40 years from now the dollar is not going to be the same. If you had $10,000 in retirement in 1970, then lost 45%, you would be left with $5,500. If your investment just kept up with inflation (calculated through the CPI), you would have $27,500 by 2000. That’s a 500% “return on investment” over 40 years.

    The point I am making is that nobody seems to care about inflation, all they talk about is nominal gains. Who cares? At a measly 5% per year, your money loses half of its value every 12 years.

  3. So how do you protect yourself from inflation?

  4. There is risk in everything. There is risk in investing too cautiously…what if you invest very cautiously at a young age and are ready to retire at 75…but die at 74. Maybe you’ll wish you had been more aggressive so you could have retired 10 years earlier.
    My point is, since we really have no choice but to gamble, why not at least gamble with the odds on your side. That means picking stocks if you are young. It also means using vanguard or some other really low fee solution. That also will give you the luxury to investment more conservatively near the end of your life, intead of trying to make up for lost money.

  5. Q: “So how do you protect yourself from inflation?”
    A: Treasury Inflation Protected Securities (TIPS) is by far the best way. Also, Real Estate Investment Trusts (REITS) and Collateralized Commodity Futures (CCF) to a lesser degree. Gold is speculative and too volatile, so I believe a poor inflating hedge.

    BTW, I agree, the last part of his formula is bunk and the danger is it discredits the first part which has considerable value.

  6. Interesting that <50% bit at the end. I could have sworn that I’d seen Adrian Nenu post numerous times that he increased his equity allocation to nearly 100% after the crash.

  7. Sammy posted about gold being speculative and volatile… well, it is pretty volatile, but some interesting numbers for your consideration:

    Since the argument for stock investing is long-term, the inflation prevention aspect of any scheme should also use a long-term argument. TIPS have not been around very long, so it is difficult to judge their effectiveness (although I do own TIPS as a portion of my portfolio). But certainly your return in TIPS won’t exceed the rate of inflation.

    As recently as 1930, gold was $21/oz. Right now, it is about $1100/oz. That equates to a 5.14% rate of return.

    In 1930, the DJIA was in a range of about 175-300. If we use a value of 200 (the lower end of that band) for comparison, we know that the DJIA is now around 10,500. That also equates to a 5.14% rate of return. Of course, that is only nominal stock prices, and excludes dividends. Including dividends, the return would be much better. But, based on price only (which seems fair since gold does not pay dividends), gold and stocks have been IDENTICAL for 79 years.

    In 1930, the CPI was between 16 and 17 (let’s use 16.5). Now, the CPI is 216.33. This equates to a rate of 3.31%.

    So it would seem that both gold and common stocks have shown to be effective at protecting against inflation.

    But a more interesting question… how could gold actually *exceed* the rate of inflation by 1.8% per year? Could the same reason gold has performed well also be the reason that stocks have performed well? Or, is CPI understated by 1.8% per year? Or, is gold in a bubble, and stocks are not? Over such a long timeframe, it is hard to imagine exactly how gold could appreciate relative to inflation unless it had some particularly amazing use that made it particularly valuable. But this doesn’t seem to be the case since it is still mostly used for jewelry and investment, same as in 1930. In fact it probably had MORE uses in 1930 since it was worldwide currency. If gold had appreciated at ONLY the rate of inflation according to CPI, its current price would be $275 (which it was at back in 2000). Certainly, though, even at $275 at its low, it was effective at combating inflation, at least as much as TIPS would be.

  8. After reviewing my 401K target funds and determining the allocation of my target retirement year was more riskier than I liked – I picked the closest target year to my perferred allocation and supplimented it with allocating a few % of future investments to the 401K bond fund available. After the big downturn in the market I was suprised how many of my co-workers (in their 50′s) were in invested in the target funds with 70+% in stocks.

  9. Adrian Nenu says:

    Tolerable Loss x 2 = Equity Allocation < 50%

    The <50% part is to ensure that you are not totally wiped out by a 1929 type event during which stocks lost 89%. It also prevents a big bet on stocks in case they happen to have low returns during your accumulation period. You have to accept that we don't know and cannot predict future returns for this strategy to make sense. If you can predict future returns, don't use the risk tolerance formula.

    RIsk of loss formula: (1 – SD) ^ number of years. That's one minus the standard deviation of a fund to the power of the number of years. Morningstar has the 3 years SD for most funds. This gives you some idea of the risk of loss involved, how much money you will have after a 1 sigma event.

    Adrian
    anenu@tampabay.rr.com

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  1. Sunday Link Rodeo 13 says:

    [...] Tolerable Loss = Half of Equity Allocation Percentage from @mymoneyblog I haven’t heard this concept before.  I like the way it is written up and definitely something I’ll remember. [...]

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