The arguments for and against.
There are two schools of thought on whether those who make less money should assume more risk in their portfolios.
In a recent video interview, Morningstar’s Laura Lutton--who also happens to be this columnist’s manager--argues for the affirmative. If you’re shorter, slower, and can’t jump as high as your opponent, you won’t get many rebounds unless you outwork her. (True, that was not Laura’s analogy.) Similarly, those with lower career earnings must dosomething better than their wealthier peers, if they attain equality in retirement--for example, holding a higher stock weighting.
Of course, there are many somethings available to retirement plans besides assuming greater investment risk. Better somethings, too. Saving more, retiring later, and cutting portfolio costs are superior options to boosting one’s stock percentage. The first two actions guarantee higher retirement income, no matter how the markets perform. The third is not as ironclad, as pricey investments sometimes beat their cheaper rivals, but it is safe. Whereas owning additional stocks is not.
Unfortunately, those better somethings can be unrealistic. Investing more to catch up sounds fine in principle, but in practice it means expecting the lowest-paid workers to have the highest savings rates. Good luck with that. Retiring later is a likelier hope, but no more than that. Health concerns, family issues, and/or corporate downsizings send millions of Americans to the sidelines, against their will, each year.
(Millions is no exaggeration. Each year, 4 million Americans retire. According to surveysfrom the Employee Benefit Research Institute, half these retirements are involuntary, occurring before the workers expect. For example, 45% of workers reported in 1991 that they planned to retire at age 65 or later. However, only 23% of current retirees--a group that includes many of those 1991 respondents--made it that far. A much larger number, 36%, retired before the age of 60.)
So, yes, along with using the painless lever of lowering costs, lower earners might also wish to increase portfolio risk. That action comes neither without pain nor without real danger--the possibility that poor stock market performance will leave the retiree with significantly fewer assets, and thus less income, than if she had played it safer. However, the alternatives of saving more when more cannot be saved, retiring later when later will not be permitted, and of investing conservatively, thereby forgoing all hopes of ever catching up, are imperfect as well.
Forbes contributor Frances Coppola (I presume no relation) disagrees. In “No, Living Longer And Earning Less Are Not Good Reasons To Take More Risk,” Coppola writes:
Consider the case of a 40-year old single man on the median wage. Would any decent investment adviser tell him to take higher risks in his portfolio than a single man of the same age on a six-digit salary? I hope not. Because although higher risk may generate higher returns, there is greater chance that your investments will deliver less than the returns you expected.
This looks to be a claim for asset-allocation equality.
Lower-earning workers should not attempt to catch up by owning more stocks, because there’s no free lunch in doing so. The potentially higher gains that could accrue from that tactic are more than offset by the potentially larger losses. (The gains must be more than offset by the losses, rather than merely offset, because otherwise adding stocks would be a neutral move, not a mistake.)
The same logic would seem to apply to higher-earning workers. They, too, are subject to the law of risk and return. If they buy more stocks, they also may enjoy higher returns, but they also face greater potential losses. The correct retirement allocation, it would appear, is the correct retirement allocation. Income is not an issue.
For our man on a six-digit salary, higher volatility isn’t too much of a disaster, since his investment portfolio should be large enough to deliver a decent income in retirement even if it doesn’t return quite what he expected. But for our typical woman*, whose portfolio will be much smaller, even a small underperformance could make a material difference to her standard of living in retirement. For her, increased volatility is bad news.
* Ostensibly, Laura’s and Coppola’s subject was how women should invest. However, this portion of their discussion--the relationship of income to portfolio risk--is gender-neutral, so I have treated it as such.
Ah. So, Coppola does not advocate income equality. Rather, she suggests that higher income might permit higher portfolio risk. Those with means can afford to absorb losses that those without means cannot. A high-earner whose portfolio gets drubbed will still enjoy a comfortable, if not lavish, retirement, while a low-earner whose portfolio gets drubbed will land in the metaphorical (and perhaps literal) poorhouse.
For Laura, the small chance that the relatively poor might become outright poor by investing too aggressively during the accumulation period (this discussion concerns only the working years; investing during retirement is another matter entirely) is outweighed by the large possibility that they might achieve a reasonably comfortable retirement. Because the status quo is bad.
For Coppola, the small chance that the relatively poor might become outright poor by investing too aggressively during the accumulation period outweighs the large possibility that they might achieve a reasonably comfortable retirement. The status quo isn’t pretty, but it is better than disaster.
They are both right. (You didn’t expect me to take down my boss, did you?) The level of income does affect a retirement portfolio’s asset allocation. However, the function is personal and unpredictable. For some lower-income workers, the prize is worth the risk; for others, it most certainly is not. Similarly, some high-earners chase technology stocks, while others retreat to the safety of municipal bonds to preserve what they have been fortunate enough to make.
One size very much does not fit all. Laura was correct to raise the possibility that lower-earners might wish to assume more risk. (Her specific suggestion was the mild one of buying the “aggressive” option if the 401(k) plan offers a choice of conservative-, moderate-, and aggressive-allocation funds.) Coppola was correct in her counter. Beyond that, I can say no more--not without a conversation to understand the investor’s individual risk function.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.