Ep33 How Risky Should Your Retirement Savings Be?

[MUSIC] Hi, I'm Jonathan Burke, Professor of Finance at the Graduate School of Business at Stafford University. And I'm Jules van Binsberg and a Finance Professor at the Wharton School of the University of Pennsylvania. And this is the All-Out Equal Podcast. [MUSIC] Welcome back everybody. Today, what we're going to do is finish the episode on retirement. In the retirement episode, we just concentrated on the question of how much should you say for retirement and when? And we did not address the question of what should you do with your retirement savings as far as investments are concerned? And that will be the focus of today's picture. And so the first thing we need to get a hand along is what does this word risk? What does it mean? And I think one way to get a handle on it is that generally people, when they face a bet that can go well or can go poorly, they don't like the downside. Drops in wealth are painful. So if you invest your retirement savings into risky investment account, then if your retirement account takes a hit, that drop in wealth is a painful event for most people. And in fact, I think it's very fair to say that for most people to drop in wealth is more painful than the equivalent increase in wealth gives you a feeling of success. That's what we call risk aversion, right? If you give me the choice of a certain payout or a payout that has an equal chance going up and down, I prefer the certain payout because I know the pain of going down is greater in the benefit of going up. And so that's what we call risk aversion. And so one thing we need to discuss and come back to is this question of does one size fits all? In other words, when we talk about risk taking, what aspects of risk taking is something that we can organize with a large group of people because the same things need to be achieved for everybody? And what aspects of risk taking really have a highly personal dimension and therefore we need to tailor it to the individual. Exactly. I think that that's a very important concept. So let's start with the part of risk taking that is common to everybody. And so let me reiterate what we said before, which is we're going to assume that people do not like volatile. And we think about any portfolio of stocks or bonds or housing or any asset for which there is uncertainty. People would like to reduce that uncertainty. And so one way of doing that is to follow a diversification strategy. And so diversification strategy, think of it this way. Right? I give you two choices of bets. Suppose that you have $90,000 to invest and you can invest that money in one of two ways. Either you can invest it in one single coin flip that pays out $200,000 if it lands on your choice, which was heads. Or you lose everything if it lands on tails. Now given the fact that it's a 50/50 bet between zero and 200,000, the expected value is 100,000. You invested 90,000. So you are being rewarded for your risk there. But it's still a pretty risky proposition, right? I mean, it's either losing everything or more than doubling your money from 90,000 to 200,000. Now compare that to the alternative investment strategy, which is don't put all your money into one coin flip bet. But instead pay 90 cents for 100,000 flips. So 90 cents for each of the flips, which gives you either $2 or nothing. Now as you can imagine, the first strategy is a highly non-diversified strategy because you only have one coin flip, which either gives you everything or nothing. Whereas the second strategy, you have 100,000 coin flips in a row. And so because these coin flips are independent from each other, that becomes a diversified investment strategy. It's a no-brainer, right? If you follow the second strategy, you essentially get $100,000 for sure. It's essentially risk us. So you pay 90,000 and you get $100,000. You get a 10% almost riskless return. Whereas the first strategy, you get a 10% very risky return. And the observation is everybody would agree on this. Anybody who's risk averse would say, "I prefer the second strategy." And it's a good example of something which one size definitely does for all. Give me a choice. If you can diversify, you should diversify. Now, what does this have to do with wheel investments? Well, stocks are like coin flips. Okay, there are uncertain investments. There is one crucial difference though. Quaiflips are independent. Stocks are not. Stocks have correlation between them. But it's not perfectly correlated. So any risk that's not correlated is like a coin flip and can be diversified away. So it's always better to hold a portfolio of stocks. Take your money and spread it across a portfolio of stocks, across many different stocks. Then to put all of your money in a single stock. So this is a very good example of a one size fits all strategy. You should never invest in individual stocks. You should always invest in a portfolio of stocks. So the way we say this in plain terms is that you should not put all of your X in one basket. Put all your X in one basket as an undiversified strategy. We're putting them in multiple baskets as we call the diversified strategy. Now the assumption underneath this common expression is that when one basket falls, this does not affect the probability that other baskets will fall. But the reality for stock investments is somewhat more complicated. And the reason is that baskets can fall for two reasons. They can individually slip out of your hand, which is like a diversifiable risk. But they can also fall because you trip. When you trip, you still drop all of the baskets on the floor and all your X break after all. So for that event, spreading your X over multiple baskets isn't actually particularly useful. And so this last event is what we call systematic risk or market risk because these movements make the full stock market move up and down together. I don't want to live with this point too much, but I do want to say a few more things about it. I teach the subject in the RMBA program. Thereably I'll have a student look at me, especially during the boom time. So anytime there's a huge run up in prices, they would have invested in a single stock, often the company they work for. And they would have made a fortune in that stock. And they look at being go, "If I'd fun at your stretch, I'd be nowhere near as rich as I am." And I point out to them, "Look, you were extremely lucky. If you wanted to take on the risk associated with that single stock investment, you can still do it and get all the benefits of diversification. You can leverage the diversified portfolio to have equivalent risk of your stock without adding lead-ahson credit for risk, without adding the part of risk that you can diversify away." So this is a very important concept, I think. And we so often see people make those mistakes. In the bankruptcies of Enron, many employees lost everything they had because they had all the investments in Enron stock. The same is true in Lehman and Nokia is really a bad idea to put all of your money in a single stock, especially if it's the company you work for. And the thing Jonathan is, and we've talked over the years with many employees that worked at these companies, when these companies are at their peak, it is almost inconceivable for people to even think about a scenario that Nokia wouldn't be the dominant player anymore. At the time that Nokia was dominating the cell phone market, could anybody have seen coming that within such a short period of time they would lose out to smartphones like the iPhone so quickly that essentially the company would lose such a large fraction of its market value. And so convincing people at that moment that they should diversify out of that individual stock and get a more diversified portfolio is an incredibly hard thing to do. Okay, so that is definitely a case at one size fits all and the general advice for retirement is if you invest in the stock market, you should hold a diversified portfolio and more generally all of your investments, even the investments outside the stock market should be diversified. You should not put too much money into real estate, for example. I mean often there's a problem, especially when people are young and they're stretching to buy a house and a huge fraction of the investment is their house. But as they get older, I think it's important not to put too much money in a particular sector like real estate, but to keep the investments diversified across stocks, bonds and other things. So Jonathan, now that we've talked about that everybody needs to try to diversify a way that what we call the diversifiable or a jargon term for it is either using credit risk. What about the other part of the risk that you can to diversify a way that has also many different names, right? It's called correlated risk. It's called market risk. It's called common risk. All of that risk. What about that? Do we have one size fits all there? And I think the answer is, well, most people will want to have some exposure to this common risk, but the amount that you can bear I think is a very personal decision. I think it's very hard for somebody else. to tell you how much risk you are supposed to be taking. I think you need to find as an individual the comfort level of the amount of risk that you find bearable and which parts you don't. Yes, so this is where we end the advice that one size fits all. Very different people have very different risk characteristics. And so the amount of risk you're taking on is a very individual decision. And it's not just the amount of risk you're taking on but also your exposure to that risk. So let's think about the overall risk of the economy. So if the economy goes down all stocks are going to go down. The men will go down the same but everybody's going to be exposed to that. But not let's think of your working tech, right? And you have a diversified portfolio. Should the diversified portfolio contain as much tech stocks as somebody doesn't work in tech? And I would argue no, it should contain less tech stocks because your human capital is already exposed to tech. And so in order to mitigate the risk of the tech sector failing, you should have your investments be under exposed to tech. Often people do exactly the opposite. Often people in a sector love the sector so much. They overweight that sector in their savings decision, which I think is a mistake. So your own personal exposure to this risk should govern what your portfolio's exposure is, what your retirement portfolio's exposure is. And to make things even more complicated, most families operate as a unit, not as individuals. And so what about the industry that your spouse works in? You already as a family have a lot of your wealth exposed to that too because that's your spouse's human capital that we're talking about. And so let's give another example. What about people that in their jobs have almost no risk, like you and me Jonathan. We are working in jobs where through to the nature of the contract that we have, essentially we own a very large bond, a bond where somebody as long as we keep working owes us a fixed stream of money that is highly predictable, right? Because even our wage increases are very narrow and very regulated. The university cannot fire us. So essentially we have this stream of fixed cash flows that is going to be paid to us. We don't have that tech sector exposure. We don't have any other specific exposure. So it seems there that in our retirement portfolio, we are actually in a position to take quite a bit of risk. And I do. In my own personal portfolio, I have almost no bonds. I have almost exclusively invested in stocks. And it's persisting for this reason. I have a very secure job. I do not need to retire from that job. If something bad would happen in the stock market, I can just keep working. And so this is a very individual decision. Also we should emphasize jewels is what I call the idea of uncertainty versus risk. In other words, how correlated is your human capital? How correlated is your salary to whatever investment you're holding? So let's say I have a investment that does well with I'm doing well and does badly when I'm doing badly. That's going to be a much more risky investment that an investment happens to do well when I do badly, badly when I do well. It provides more insurance. So a pretty important part of thinking about what risk is is to ask the question, how does my investment portfolio perform based on my own states? Yes. Obviously we're all in the same states. So in the world where the economy is doing well, most of us are doing well. So stocks that do well in those states are going to be more riskier than stocks that do well when the economy isn't doing well. And that's what we call the beta of a stock. And it's important to understand that as a result, the risk premium on stocks that are highly correlated with the economy is going to be higher than the risk premium of stocks that are less correlated with the economy. It's precisely for this reason because I prefer a stock that does well when I don't do well. Your portfolio is like a sports team. And what you care about is that the team as a whole does well. Now, each of your potential players have been following two characteristics. How well they play on average would we call the expected return and how volatile their play is? Now, suppose that for all available players, you would rank them by the ratio of these two characteristics. That is the average performance per unit of volatility. What in finance we call the sharp ratio? And suppose I select the best one space on that ranking. Thus that get me a good portfolio. And the answer perhaps surprisingly is actually no. And the reason is as follows. Imagine the following player. This player is on average not very good, quite volatile in their play. But they do have one particular characteristic. And that is when the whole team is doing terribly and bleeding on the floor. This player tends to rise to the occasion and drags the entire team through the match. Now, this is a player I would really like to have on my team despite their low average performance and high volatility because they already insurance that I need in my portfolio to drag me through bad times. Yeah. And so these are all very individual characteristics that are specific to yourself. And in putting your optimum portfolio together, these are issues that you really do need to think about. For sure. Now, let's talk about a couple of the things Jonathan, because what is interesting to me is how we've made the choice to organize our retirement system. And you very clearly see a trade off there. Because I think that the way most retirement systems today are organized, they do push through this one size fits all philosophy in many places. Really. For example, right now, if you are in a defined benefit pension plan, essentially the fund will invest the money for all participants in exactly the same way. And whether you like that or not, or whether your risk appetite is larger or smaller than whatever that investment portfolio is, there's nothing you can do about it. And in many countries, like for example, in the Netherlands, where I am from, you're legally not allowed to even get out of that pension plan and take your money elsewhere to a fund that invests more in line with your risk preferences. You're stuck with your money in a plan that makes these choices for you. But you know, that's really only relevant if the plan fails on its promises. Now, you could say, you know, I'm out in the world with all these plans underfunded. That's a real possibility. But I think they would say so long as the plan doesn't fail in its promises to make the pension payments, it's not really the concern of the people investing in the plan, how they choose to invest in particular assets. Yes, although let's be a little cynical here. The reason why we had to luxury to keep saying that was because with two to three percent population growth, it essentially becomes a Ponzi scheme where the future generations, there are always so many people in the future that can fill up any hole that the pension plan would have throughout its existence, that therefore your story may hold. But as we know, at this point, the population is aging very quickly in many countries, particularly also in Europe. The population is expected to shrink. So it's the opposite of a Ponzi scheme. So there are fewer and fewer people that are there to fill the holes that might arise. And then your logic is not going to hold anymore. Unfortunately, now obviously most of us are exposed to the economy in the same way. Yeah, I think the way to say what you're saying is Jonathan look, the promises they make are actually not consistent. That given the risk profile they take out and these pension parents often do take quite a lot of risk, they will come a time when things don't go well. And then the question is how do they make up their promises? Now often public plans have a claim on this on the treasury. And so taxpayers bear it, but it is not a public plan. Then yes, the panel fangle. And then of course, how they chose to invest their money affects the pensioners. Well, to add one more thing to that, right? I mean, if you look at the recent developments, there's something that is really disturbing because early in the episode today, we said there's certain things that we can do for everybody. And this is one size fits all that we should really do, which is to make sure that we have a diversified portfolio. But the recent trends for many pension plans is no longer that there is now this movement going on that says that a large number of investments should be excluded from the portfolio because they don't fit what are called ESG characteristics. And therefore, these plans are in many cases focusing on a smaller and a smaller number of stocks. A recent example that I encountered was a fund that wants to invest in only two or 300 perfect ESG stocks. At that point, you can no longer get a very good diversified portfolio, particularly an internationally diversified good portfolio. And so the thing that pension plans were really good at, which was at least get the thing that does hold for everybody right. And therefore, maybe if then one size doesn't fit all for the other characteristics, it may still be okay to push it through even that argument is now under pressure, I think. Yeah, and more so outside of the United States because the United States, Arizona has very strict rules. You really have to maximize return for a given level of risk. And so it's much more difficult for pension funds in the United States to have other criteria. But I agree with you, there are issues with pension funds not exclusively making investments and so the interest of the pension holders. But you know, Jules, that's the situation for a defined benefit plan. But for a defined contribution plan, many people would say, well, it's not like that. There you go. So you should be in favour of defined contribution plans. Because in that case, everybody can decide the investments with themselves. And you can completely tailor to the specifics of the person. And while that's true, my major concern about defined contribution plans is that the average person doesn't really have the financial knowledge and the document to make the investments and to make those choices. And they are worried about, first of all, they're making the wrong choices. But even more worrying to me is that other people taking advantage of it. So what happens there, then, I think, is that a lot of people get their money automatically invested in what is called a QDIA or a qualified default investment alternative. And in many cases, this QDIA in these defined contribution plans is going to be a total target date fund. But those target date funds, particularly for young people, very aggressively invest in stocks. So in the past, we had that your money was automatically invested in cash, which meant no stock exposure. Now or more in the other extreme, where essentially, most of your money is defaulted into a very risky stock portfolio. But I do think it would be important indeed for participants to think through a little bit, whether or not they want to be disexposed and to not assume that whatever this default investment alternative is, is automatically the right thing for them. And maybe the right thing for the average person, but that doesn't mean it's the right thing for you. Yeah, Jules, I mean you've heard me talk about target date funds before I'd really don't like them. It's true, they do better than just a 50/50 strategy stocks and bonds. And you could imagine that they are somewhat tailored to the individual because they change your investment as a function of your age. And obviously, age is an important individual characteristic. But I think age is what have many and not that big a part of it. And so there are many other characteristics which they do not tailor to the individual and then I think should be tailored to the individual that said, as I said before, the problem is the average individual doesn't necessarily have the financial knowledge to make these choices. But many of our listeners are not average individuals. And for those people, I would strongly suggest that they think about the concepts we spoke about their own exposure to risk and what the optimal exposure they want in their investment strategy is. Okay, Jules, well, that's I think pretty good summary of the risk associated with saving for retirement. I think we should finish though with two overall pieces of advice. The one I would say is diversification is such an important tool and that really I think it's important that people recognize that. And if you do have a portfolio that hasn't got many, many stocks and that you should rethink your portfolio. And the last thing I would say is you never get something for nothing. So if somebody comes to you promising a higher return, then I would say it's one of two things either aligned to you, you're not getting a higher return or they're taking on a lot of risk. And so you should be very skeptical when people seem to give you deals that are too good to be true. Couldn't agree more. 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