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 argues for the affirmative. Those on a lower wage must do something different than their wealthier peers if they wish to attain equality in retirement, such as holding a higher stock weighting.
Of course, there are many levers available to retirement plans besides assuming greater investment risk. Better levers, 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 predictable. Whereas owning additional stocks is not.
Unfortunately, those intentions 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 redundancy send millions of people out of work, against their will, each year.
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; there is a chance that poor stock market performance will leave the retiree with significantly fewer assets, and therefore less income, than if they 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.
But is More Portfolio Risk the Answer?
Forbes contributor Frances Coppola 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.
Coppola continues:
“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, Lutton 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.
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.
Conclusion?
Lutton and Coppola stand at the same place, looking in opposite directions. For Lutton, the small chance that the relatively poor might become outright poor by investing too aggressively during the accumulation period 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. 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. 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.
A version of article originally appeared on Morningstar.com. It has been edited for a UK audience.
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.
