What should be the response to a low return environment (i.e. high prices on stocks and bonds)? I have touched on this before (here for example), but it seems like it might be time again.
If returns are lower than they were in the past, but risks are the same (i.e. the return per unit of risk is now lower), there are three perfectly rational responses:
- Keep your portfolio the same but realize you will not get the returns you once did with that portfolio.
- Decrease the risk in your portfolio. Since you are not getting paid as much for taking risk you decide to take less of it.
- Increase the risk in your portfolio. Since you desire a certain level of return the only way to get it is to increase risk.
Now, the problem is that although the options above are opposed to each other, they all make sense and are rational. But we have to pick one.
I don’t have a simple answer though. I think it depends on your resources compared to your needs. For example, if someone is wealthy (compared to their needs, not in absolute terms) the correct choice is probably different from someone who is not at all wealthy (again, relative to need). For example, suppose we have three families, each newly retired, and each need $120,000/year. Social Security/pensions/whatever are expected to provide $40,000. That means $80,000 must be provided by the portfolio. One client has an $1,600,000 portfolio; one has $2,000,000 portfolio; and one has a $2,400,000 portfolio.
- The family with the $1,600,000 should probably have a slightly more aggressive portfolio than they would have in a higher return environment.
- The family with the $2,000,000 should probably have the same portfolio they would have in a higher return environment.
- The family with the $2,400,000 should probably have a slightly less aggressive portfolio than they would have in a higher return environment.
I think. This answer is tentative, provisional, and preliminary!