Should Investors Hold More Equities Near Retirement?

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Professors Michael Drew and Anup Basu argue that portfolio risk should increase as retirement nears, rather than decrease, as is the practice of lifecycle funds. In a recent paper, “Portfolio Size Effects in Retirement Accounts: What Does it Imply for Lifecycle Asset Allocation”, published in the April, 2009 issue of the Journal of Portfolio Management, the professors present research to support their conclusion that investors with a 40-year horizon are 12.5% richer on average with a “glide path” that operates in the opposite direction of lifecycle funds, increasing rather than decreasing equity allocation through time. They also conclude that there is a 90% probability of being richer with an increasing equity glide path.

Drew is a professor of finance and economics at Griffith University, Brisbane, Australia and Basu is a professor at Queensland University of Technology, also in Brisbane. To reach their conclusions the co-authors ran 10,000 simulations of 40-year returns, using data from 1900 to 2004.

Reactions to the professors’ findings vary based on one’s feelings about risk and its appropriateness near retirement.  “Risk, after all, has a friend called pain,” Don Ezra of Russell told Pensions and Investments, when they reported on the study last month   In other words, Professors Drew and Basu have merely rediscovered that investors, unsurprisingly, tend to get rewarded for taking risk. If risk weren’t rewarded with some reasonable regularity, no one would take it.

The real issue is whether the reward is commensurate with the risk. To examine this trade-off, I’ve evaluated the increase in risk that accompanies an increasing equity allocation. I take the position that the amount of a potential loss is what matters, rather than the percentage loss relative to one’s existing portfolio. In other words, losing $100,000 in a $1 million portfolio is substantially worse than a $1 loss on a $10 portfolio, even though both are 10% losses. Or put another way, a 20% loss suffered today by someone near retirement hurts much more than the same loss 30 years ago when account balances were small.

I also define risk to be the risk of loss, rather than volatility. Combining these concepts, I have calculated the dollar-weighted downside deviation of returns over 40-year periods. The dollar weights are account balances through time. Downside deviation measures the variance below a target, and I use Treasury bills as this target, so it is variance of returns below T-bills.

I contrast a glide path that progresses forward through time with decreasing equities to the same glide path executed in reverse with increasing equity allocations. The glide path is the PLANSPONSOR On-Target Index (OTI), which is entirely in risky assets (equities and bonds) for the first 20 years and then increases its cash allocation over the next 20 years. The proxy for risky assets is 70% S&P500 stocks and 30% Citigroup High Grade Bonds. The proxy for risk-free assets is Treasury bills. The hypothetical investor contributes $1,000 initially and increases this $1,000 by 3% per year (representing the average inflation rate), so he contributes $1,030 in the 2nd year, $1,061 in the 3rd year, etc.