Life Cycle Investing Won’t Work If You Don’t Consider Valuations

Beyond Buy-and-Hold #109

William Bernstein has written an article for Money magazine arguing for Life Cycle Investing. He explains his interest in the idea: “It’s almost like a political issue. There’s a ‘right wing’ of very smart, authoritative people who think that savers and retirees should be investing conservatively because stocks are so risky. And then there’s a ‘left wing’ of equally smart and authoritative people who believe the opposite. I was trying to reconcile the two views. Plus, I wanted to deal with what happened in the 2008 financial crisis, which changed how people, myself included, think about risk.”

The thought process was: “A lot of people had won the game before the crisis happened: They had pretty much saved enough for retirement, and they were continuing to take risk by investing in equities. Afterward, many of them sold either at or near the bottom and never bought back into it. And those people have irretrievably damaged themselves. I began to understand this point 10 or 15 years ago, but now I’m convinced: When you’ve won the fame, why keep playing it?”

Bernstein’s conclusion?

“How risky stocks are to a given investor depends upon which part of the life cycle he or she is in. For a younger investor, stocks aren’t as risky as they seem. For the middle-aged, they’re pretty risky. And for a retired person, they can be nuclear-level toxic.”

The counter position on Life Cycle Investing

I don’t buy it. At least not entirely. All sorts of yellow caution flags go up in my brain when I read these words.

My first reaction is that, yes, this does make some sense. It certainly is so that risk changes the closer you are to achieving your saving goal. If you take a big hit when you have an accumulated savings of $500, that’s a learning experience, not a significant loss. But if you take a big hit when you have an accumulated savings of $1 million and believe yourself to be one month from retirement, you have indeed hurt yourself in a very serious way. So Bernstein is certainly not talking nonsense. He is making a serious and important point.

The reason why I have yellow warning flags popping up in my brain is that it is my experience that all of the most dangerous investing ideas come wrapped in solid insights. There’s a reason why it works that way. Most of us are too smart to fall for obviously dumb ideas. It’s ideas that almost make sense and that almost work that entice us into taking steps that hurt us in serious ways down the road a piece. We need to be careful not to jump on this idea and instead to look carefully for flaws before putting money behind the idea.

More investment experts need to break from the herd

I am alarmed by Bernstein’s admission that the 2008 crash caused him to rethink risk. In one sense, that’s a wonderful thing to say. I only wish that all of the experts in this field would become more open to new ideas as a result of their obvious failure to give good advice in the years leading up to the crash. So Bernstein wins some credibility points with me when he makes this statement.

He loses some too, however.

My question is — If Bernstein could get it so wrong in the years up to 2008 after studying stock investing for many years, how can we know that he has it right about how to react to the 2008 crash after having had only four years to absorb the lessons of that debacle?

I think Bernstein is beginning a learning process that in all likelihood will take him to some wonderful places in coming years. I don’t think he has completed the journey. I think the advice he is giving today is an improvement over the advice he was giving pre-2008. I do not see it as a finished, working product.

Yes, it’s true that many investors who were close to retirement took on too much risk during the crazy bull years. They were enticed by all the excessively pro-stock advice that was being put forward (by no stretch of the imagination was Bernstein the only one who became too enthusiastic about stocks during the bull market, of course). It’s great the Bernstein is searching for a better way. But is Life Cycle Investing the answer? Will it still be the answer ten years from today? Is Bernstein sure? Can we be sure?

Life Cycle Investing is a partial solution

I don’t think Life Cycle Investing is the answer. I think it is part of the answer.

The flaw in Bernstein’s thinking is evidenced in his statement that: “How risky stocks are to a given investor depends upon which part of the life cycle he or she is in.” The stage of the Life Cycle influences risk. But it is not the only influence. The academic research of the past 30 years shows that valuations are a far bigger influence.

We do have to adjust our stock allocations according to where we stand in the Investing Life Cycle. But we also have to adjust our stock allocations according to the price being charged for stocks. If stocks prices remain the same as you age, it makes all the sense in the world to lower your stock allocation as you approach retirement. If stock prices fall as you age, it might well make better sense to increase your stock allocation as you approach retirement.

It’s great that Bernstein is trying to turn the 2008 crash into a learning experience. That’s precisely the right way to proceed. I am concerned that he may be jumping to hasty conclusions. We need to consider Life Cycle issues. It’s a plus that he is getting these ideas out before people.

But we are today only in the early stages of the national debate on how stock investing works that we need to have to recover from this economic crisis. It’s too soon to be drawing conclusions. We haven’t even heard all the possibilities yet.

I believe that investors of the future will indeed be taking Life Cycle considerations into account. I don’t think they will be doing so precisely in the way Bernstein says they should be doing so. I see his advocacy of Life Cycle Investing as a positive but incomplete and thus flawed step forward.

Rob Bennett has written an article titled The First Retirement Calculator That Gets the Numbers Right</>. His bio is here.

( Photo from Flickr by Helico )

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