Risking it all

Sorry to keep posting financial stuff, but whatever, it’s my blog.

It’s interesting how the amount of investment risk that a human can put up with is very relevant to how much they have invested, and it isn’t linear. Let’s take the case of three investors, all of whom currently can invest $1k/month and need $1M in assets to live comfortably off of assets alone. While more is more, suppose these people aren’t particularly driven to keep accumulating wealth beyond their needs ($1M).

They start with:

• Investor A: $1,000 in investments
• Investor B: $1,000,000 in investments
• Investor C: $1,000,000,000 in investments

To simplify things, we’ll say they keep 100% of their assets in stocks. Now, let’s say the market plunges by 90%: $100 invested in the market is now worth $10. What happens to each investor?

• Investor A now has $100 in investments
• Investor B now has $100,000 in investments
• Investor C now has $100,000,000 in investments

I would argue that investors A & C are in a similar boat here, ironically. Investor A started out .1% of the way towards their goal and next month, they will be back to that. Not much has changed for them: the market set them back by one month.

Conversely, it doesn’t really matter what happens to Investor C’s portfolio. They’re doing fine regardless: greater than 100% of the money they need is still greater than 100%, even if it’s less than before.

Thus, Investor B is the only one in the danger zone. They were exactly at their investment goal, and now they’re only 1/10th of the way there! Theoretically, they’re now 7 years (900 months) away from $1M!

I was reading about “bond tents” as a way to defend against stock market crashes at retirement: you don’t want a market crash right when you retire, because then you’ll sell your stocks and have no way to replenish them to take advantage of the market recovery. (This is called sequence of returns risk, which ERN does a great job explaining.) Thus, it’s a good idea to increase your bond allocation going into your retirement so you don’t have to sell any stocks if there is a crash. Bond tents might be a good mechanism for investors like Investor B, too: if you’re near your goal you have more to lose than any other time.