Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 7 – The Problem of the Short Term

People sometimes get the impression that I think all investors, regardless of their personal circumstances, ought to keep 100% of their investment funds in stocks all of the time. Now I won’t be so disingenuous as to say, “Nothing could be further from the truth.” But I will say that isn’t the truth.

As books such as Jeremy Siegel’s Stocks for the Long Run and Dimson, Marsh, and Staunton’s Triumph of the Optimists have documented, equity returns have left debt returns in the dust in virtually every major country over the past hundred-plus years. You should live so long. And if your investments are intended for your children and grandchildren, maybe your investments will.

But then there’s the problem of the short term. If you’ve put next month’s rent payment or even next year’s property tax payment into the stock market just before a major decline, you might not be cheered by the news that you’ll only be homeless for a few years. Remember, it is the acceptance of high volatility that is earning you the high reward of equities. But you might not be able to accept that volatility if your spending needs will be arriving soon.

Or maybe you still can. As we discussed in the previous lesson, a 50% or so decline has historically been the trough of the worst bear markets for globally and industry-diversified equity portfolios. If your spending needs over the next year come to 1% of your current investments, is it really that big a deal when a market crash brings it up to 2%?

So it is possible, if your assets have grown enough, for even the extremes of a globally diversified equity portfolio to be manageable in retirement. Indeed, one of the best reasons to stay 100% invested in equities in your 20s, 30s, and 40s is to make it possible for you to find yourself in this happy position in your 60s, 70s, and 80s.

Realistically, though, most retirees won’t be able to sleep comfortably unless they keep sufficient amounts in low-volatility (and, don’t forget, miserably returning) cash and equivalent accounts. So how much should you keep in cash? Not so fast: we haven’t yet considered the ways in which you might reduce the volatility of your overall portfolio without resorting to minimum-return accounts. It is time to discuss Modern Portfolio Theory. Well actually, that’s the next lesson.