My brain is still not working so well after taking a short break from work. I think I cannot remember how much I do not like Monday morning but I do feel that if you take too long of a break, it amplifies that feeling a lot.
If your break is shorter, you do not get a feeling that you are very detached from the work, and so its easier to kick start the engine. However, because if you took a short break, you wonder whether that is enough.
So my mind is a bit blank this week but just chance upon this article from Financial Samurai, that I would like to give it a plug.
This article gives a good way to frame the problem of managing your equity exposure, balancing up your risk tolerance.
This article would be less timely, considering we just went through some volatility in the markets in December. However, there will always be another period where this is applicable.
Some of us cannot take a large draw down to our wealth.
People call these kind of folks risk adverse people. The opposite are those who feels very OK to see their net worth go down by 75% and carry on with their lives. These are the risk seeking folks. Risk adverse folks are less risk tolerant. Risk seeking are more risk tolerant.
So how do we factor this into the management of our wealth?
For the more risk adverse folks, they favor financial assets that are less volatile.
These kind of financial assets include individual bonds, fixed deposits, government bonds, insurance savings plans, investment property. These are less volatile in the eyes of wealth builders (which might or might not be true in reality)
Then there are the more volatile financial assets such as individual stocks, commodities futures, options, non money market/bond unit trusts.
Financial Samurai states that we often overestimate our risk tolerance.
What this means is that we think we can endure much downside to our net worth but in reality we struggle with some residual mental issues when we implement our portfolios based on this assumed high risk tolerance.
And thus he introduced his Financial SEER, which is short for financial samurai equity exposure rule.
Sizing your Equity Exposure according to the Number of Months of Income
He raised the point that when your portfolio is down, usually the main way to “rescue” your portfolio is via capital injection.
And a lot of the capital injection comes from your income.
For example, your portfolio is $10,000. The average decline in this region is about 50% for example. So you could see your portfolio get cut to $5000.
If your income is $5,000 a month, that decline is almost like 1 month of your income.
You can view it as an opportune time to buy into volatile assets with a prospect of higher return at a good price.
If you frame your brain that way, you should sleep pretty well at night.
However, if your portfolio is $300,000, the average decline is the same. You could see your portfolio being cut to $150,000.
That $150,000 reduction in value is almost 30 months of your income, or 2.5 years. Generally it is also a good time to purchase more, at a good valuations, but psychologically, it is hard to endure such a great net worth reduction, and the income cannot readily “rescue” your portfolio.
If your portfolio is 50% stocks, 50% bonds, then the reduction is probably half, or around there. So it will take 15 months instead of 30 months to come back.
Generally, I do think if your capital injection to your portfolio, can make up for the unrealized losses in 12 months that is pretty good.
So according to Financial Samurai, the portfolio size, the allocation to volatile equity and your working income is related.
With that he came up with this rule:
Your Risk Tolerance = (Public Equity Exposure X 35%) / Monthly Gross Income.
Suppose your portfolio is $500,000 and you are 70% in equity, and your monthly gross income is $7000/mth.
The expected equity draw down is 40%.
Your risk tolerance = (500,000 x 0.70 x 0.40)/7000 = 20 months.
If your risk tolerance is higher, you could take it that your monthly income makes up for the decline in net worth. If it is lower, generally you can take less.
My metrics is a little different from his in that, I generally only consider the recurring capital injection from gross income into the portfolio and not the entire paycheck. If we use the same metrics, the multiple will be higher.
As financial samurai says, 12 to 18 months is a good gauge.
Calculating your Maximum Equity Exposure
Given that we know this relationship between income, equity draw down, portfolio size and equity allocation, we can re-arrange them and compute your maximum equity exposure.
Suppose you are rather moderate, and can frame your mind to inject 1.5 years of your income to make up for the declined in portfolio value. The higher percentile decline you are afraid of is 40%. Your portfolio size currently is $500,000. Your monthly salary is $7,000.
Maximum Equity Exposure = (Your Monthly Salary X Risk Tolerance Multiple) / Expected Percentage Decline
Your maximum equity exposure is = (7000 x 18)/0.40 = $315,000.
That would be a 63% equity exposure.
Now, that is probably your psychological point if you would like to preserve your mental capacity to make investment decision soundly. It coincides with what I always say that you can be an entrepreneur by concentrating when your portfolio value is lower, but over time it might make more sense to increase the returns per unit stress by being a little more diversified.
We could layer this with what Morgan Housel illustrated in my previous article on how much you would invest, at different market falls. The data, is based on developed markets. And if you are afraid of a more than 20% fall, it happens once every 3.5 years and typically lasts 10 months.
So if this is the average, to cushion this, your maximum equity exposure is (7000 x 18)/0.20 = $630,000. This is more than your current portfolio, so it also means you can be rather fully vested, to cushion greater than 20% fall.
The main reason you can have more equities is that
- the draw down is lower
- your risk tolerance is 18 months which is less conservative but not to the point of being very aggressive
I do think that this ratio is very useful but it could possibly make a person under invested in equities at the wrong time.
Let us go through some thoughts.
The Maximum Exposure Should be More Fluid
I think it pays to layer this with how long has been the duration a secular bull market.
The average duration of a bull run in developed markets is 4 years plus. In emerging markets probably shorter.
And thus if we just emerged from one big market draw down, or in the midst of one, your maximum exposure might make you under invested.
The general equity market are in a process of dropping and you might have already suffered some losses. It will be challenging to implement something like this in the middle of it as your portfolio have already taken hit, and then you found yourself over exposed.
This maximum exposure can still work, but perhaps you need to tweak the parameters a bit. Since the value is already down a fair bit, the potential draw down should be adjusted downwards, and not used like 40-50% of your portfolio. If you use that, you will probably be so overweight in cash or bonds at the wrong time.
If we are in the midst of some initial recovery (if you can spot this, which can be difficult), limiting your exposure to equity this way… just feel really weird and not right.
At the end of the day, we have to recognize that this way of portfolio allocation is to manage your downside based on risk tolerance and that, downside will shift.
There are some markets, such as the emerging markets, that the volatility is so much that perhaps fluid shifting of equity exposure is just difficult.
If you cannot take this volatility, then most likely it is better for you to form the majority of your portfolio with bonds.
What if you Do Not have Income?
One of the components of determining risk tolerance and maximum equity exposure is income.
If you do not have income, then it means that this way of determining risk tolerance is not applicable to you.
What both financial samurai and myself advocate is a trick on your brain by showing you that in the future you will accumulate more human capital in the future, greater than your current portfolio.
If you do not have income, then it probably means that your asset allocation plan will have to be determine by the financial or life plan.
For most that do not have an income, you could be a student, or a retiree. For the former, wait a while more, and the maximum equity exposure rule will be applicable to you.
For the retiree, you should have an asset allocation plan based on whether your portfolio should be subjected to such volatility.
The safe withdrawal rate can be used as a guidance.
For example, if your annual expense is $30,000/yr and your portfolio size is $750,000, this makes your initial withdrawal rate to be 4%. In some past 30 year periods, it has shown that if you withdraw a consistent inflation adjusted amount, there are some 30 year periods that you would run out of money for a 50% equity/50% bond allocation. It is even more so if you suffer negative returns on the portfolio in the early years versus suffering from that in the later years (read sequence of return risk).
And so reducing equity exposure near the early stage of your retirement make sense (before ramping back up later)
However, if your annual expense is $30,000/yr but your portfolio size is $1,100,000, this makes your initial withdrawal rate to be 2.7%. Based on the research, looking at past rolling 30, 40, 50, 60 year periods of real returns, the probability of your money lasting for those duration should be very high for a 50% equity/50% bond allocation.
The asset allocation would still matters but more of if you increase the bond allocation at the expense of equity allocation. More bonds, means lower rate of return, which means your money do not last as long.
The summary is that, when you are in the retirement phase, its not so much about tricking the brain already. Its about having a plan that works.
I think Financial Samurai conceptualize something good here.
This rule show you the relationship between your current income and equity exposure, which is seldom mentioned.
Do go and read his article, or subscribe to his blog. It is pretty good for those who are high income earners, or high net worth.
As mentioned, this is not the first time I talk about this related subject. You might want to check out these relevant posts:
- How Traditional Portfolio Allocation Strategies Can Alleviate Large Market Plunge Fears
- You Not Only Have Downside Risks. You have Upside Risks as Well
- Taming Portfolio Size Risk
Let me know if this way of determining things work for you too.
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- Building Your Wealth Foundation – You know this baseline, your long term wealth should be pretty well managed
- Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
- Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
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