Most investors worry mostly about market risk—the risk of a sizeable drop in market prices for their holdings. But when investing over longer time horizons, two other key risks should be weighed against market risk: shortfall risk and inflation risk.
Shortfall risk is the chance that your investments won’t grow enough to meet your spending needs. Inflation risk is the chance that inflation will erode the spending power of your wealth.
Unless your current wealth is very large relative to your projected long-term spending needs, you are likely to need a substantial allocation to return-seeking assets, such as stocks, to protect against shortfall risk. You’re also likely to need a modest allocation to real assets (real estate or commodities) or inflation-protected bonds to guard against inflation.
When we help clients choose the asset allocation that is right for them, we project the range of after-tax returns for various asset allocations, based on our proprietary Wealth Forecasting System. Because plans can succeed only if you stick with them in difficult times, we highlight the likelihood of experience a large peak-to-trough loss—such as 20%—at some point along the way. For clients who rely on their portfolio for spending, we also show the risk that they will run out of money.
The Display below shows our projections for how much $1 million could grow after taxes over the next 30 years if invested in several simplified mixes of stocks and bonds, ranging from no stocks at the far left to all stocks at the far right, with various mixes of the two in between. It also shows the odds of a large loss for each asset mix.
The projected value in typical markets rises gradually with the equity allocation, while the projected value in great markets rises dramatically. Even the projected value in very poor markets rises with the equity allocation, until the portfolio has 60% in stocks and 40% in bonds. Then, it declines slightly, as the portfolio loses the diversification benefit of bonds.
We project that the all-stock portfolio will likely do much better than the all-bond or all-cash portfolio over the full 30-year span in average and great markets, and even in most poor market scenarios—but that it won’t be smooth sailing.
We expect the all-stock portfolio to fall at least 20% from peak to trough for some period within that 30-year horizon. By contrast, there’s less than a 2% chance that portfolios with 20% or less in stocks will encounter such a big, temporary loss. The odds of a large loss rise with the stock allocation.
These are simplified allocations. As discussed in a previous blog post, allocations to diversifying assets such as real assets or hedge funds can reduce the likelihood of a large loss in balanced portfolios, without reducing long-term return. Real assets also tend to provide protection against inflation.
But for most long-term investors, neither all stocks nor all bonds would provide an acceptable trade-off between long-term growth and the risk of large losses. Most investors close to or in retirement are likely to allocate between 30% and 70% of their core capital, designed to support retirement spending, to stocks, unless they are unusually risk-averse. Similarly, younger investors who are not withdrawing for spending are likely to allocate between 60% and 80% of their target financial capital (money to support spending when they retire) to stocks.
When we work with clients, we adjust the mix of the various components to show them various potential balances between expected return and risk, so that clients can pick the balance that best fits their objectives and risk tolerance.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.