Unconventional wisdom: Why investing gets harder as you get older
Three tips to navigate the shifting wealth building playbook for older investors.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why investing gets harder as you get older
By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest.
- Confucius
Giving financial advice to young investors is easy. Time solves investing problems and papers over everything but procrastination.
The formula for success is straightforward. Save as much as you can and try not to invest it in something stupid.
For young people it is all about opportunity cost. Each dollar you don’t save or lose in the market has a significant impact 40 years down the line.
When I was younger, I followed this playbook religiously and I’m glad I did.
At 47 I face a whole new set of investing problems. My timelines are shorter and the consequences of making a mistake are higher.
Each day that passes I have less human capital available through future paychecks. While I’ve been careful to build financial capital as a substitute more of my focus now must be on protecting that capital so it can continue to compound.
Investing in the second half of your life means taking a more thoughtful approach. The risks and rewards are far greater.
The rules for building wealth when you are older
Two charts demonstrate how the rules for building wealth change as you age. The first chart shows what happens if you save $10,000 a year and earn an 8% annual return for 40 years.
This is the chart you show young people. Sacrifice now and you can end up with a pile of money when you are older. In this scenario $2,590,565.
But if you look carefully at the chart you start to see how the rules of building wealth change. This next chart makes it obvious by showing the source of the increase in wealth between your new savings and the returns you earn on your portfolio.
When you are young you build wealth by saving money. The formula for success is to consistently save as much money as possible to get exposure to growth assets like shares.
By year 10 things start to shift. Your annual investment returns begin to rival your savings. Eventualy this relationship is fully reversed. The main driver of wealth is no longer what you save but instead what your portfolio earns.
The stakes go up as you age. Given the mechanics of compounding 52% of the total wealth generated in this scenario happens in the last decade of the 40-year period and 15% in the last two years.
As returns play a bigger role in wealth generation your financial assets take on a bigger role in shaping your future. When you are young your peak earning years are ahead of you. Once you’re reached them your earnings power gradually declines until you choose – or someone else chooses – to end your working life.
You can undo decades of sacrifice by making mistakes as an older investor. Warren Buffett’s first rule of investing takes on more significance as you age.
Warren Buffett’s first rule of investing looms large
Warren Buffett’s first rule of investing is to never lose money. His second rule is don’t forget his first rule.
Buffett isn’t concerned with the fluctuating values of investments. He is referring to a permanent loss of capital. These large or total losses are hard for all investors to overcome. But as you get older the consequences are greater as there is less time to recover.
These losses are surprisingly common. There are cases of outright misconduct and fraud like the allegations with the Shield / First Guardian funds. But it is underappreciated how often investors in individual stocks suffer catastrophic losses. JP Morgan put out a study called The agony and the ecstasy which explores this topic.
The study focused on the Russell 3000 which represents the entire US stock market. The researchers found that 40% of all stocks suffered a permanent 70% + decline from their peaks and never recovered past 60% below their peak.
In a study by Professor Henrik Bessembinder he found that investments in 12% of all companies suffered a complete loss.
Your hard work and sacrifice when you are younger are all about these years when your wealth rapidly expands. Suffer a catastrophic or total loss on several positions in your portfolio when you are older and you can miss out on the most critical years of compounding.
Many investors become more vulnerable to this risk as they age due to a distinct but related set of data around market returns.
Professor Bessembinder’s research also shows that a relatively small number of companies that generate most of the total share market return.
As you age your portfolio is likely to be shaped by the skewed nature of returns unless you proactively do something about it.
Historically strong performers make up larger portions of your portfolio which increases your vulnerability if something goes wrong with these former highflyers. Here are three tips to consider as an older investor.
Tip one: Being more thoughtful about diversification
As you get older diversification is no longer an academic concept. Diversifcation isn’t about owning every type of investment. It is a tool to protect you from an unknowable future.
You can be the most knowledgeable and informed investor in the world and still be blindsided by an advancement in technology or geo-political event. Even the most well-established company can succumb to a changing competitive landscape.
As I’ve gotten older I’ve taken a more pragmatic approach to diversification. I base position sizing on the largest permanent loss of capital I can suffer and still achieve my goals.
For me that is a 5% limit on an individual company. That limit will likely go down as I get older and yours may be different - figure out the right number for you.
I’ve heard all the arguments about the benefits of a concentrated portfolio and the need to let winners run. I agree with those arguments and if I was a professional portfolio manager investing other people’s money that is how I would likely invest.
For my own portfolio at this stage of my life I’m more interested in guarding against the unknown than squeezing every percentage of return out of each position. So far this year I’ve trimmed two long-standing positions on strong AI related runs.
These were hard decisions which leads to my next tip for older investors.
Tip two: Consider the costs of not doing the hard things
Both positions I trimmed this year I’ve held for over a decade and I still believe in the long-term prospects for each company. They’ve both appreciated significantly and sat within taxable accounts.
I did not want to sell and I did not want to realise the capital gains. Many investors struggle with similar decisions.
It is easy to become attached to positions in your portfolio if a particular share has delivered consistently high returns over the years.
If a company has done well in the past it is reasonable to assume it will do well in the future – even if you know that logic doesn’t hold up.
It is easy to convince yourself not to sell for good reasons like avoiding taxes.
I had to work to overcome these mental roadblocks. What helped me was to add some context to the positions and my portfolio.
Was my reluctance to trim these positions worth having to delay my eventual retirement if something went wrong? Were they worth having to alter my current lifestyle to aggressively save money to try and make up for losses at this stage of my life?
When you are young you are making investment decisions to maximise future outcomes.
The investment decisions I make now are more closely tied to the quality of my life. The consequences of forming an attachment to some share I hold is higher. Framing the decision in this way helped me move forward.
Tip three: A more nuanced view of asset allocation
Conventional wisdom calls for a more conservative portfolio as you get older. This generic advice often raises more questions than answers.
At what age should a portfolio become more conservative? How conservative should the portfolio be? In what ways can you make a portfolio more conservative?
Like most investing questions the answer depends on your personal circumstances. At a high level given longer lifespans it is important to continue to invest in growth assets even once you’ve retired.
But I think a more nuanced view of portfolio construction is needed instead of the simplistic growth / defensive classification of assets.
I hold two asset classes – cash and shares. Given my portfolio is heavily weighted towards shares this makes my asset allocation extremely aggressive on paper. And yes I do still have decades of compounding ahead of me and want the higher returns from shares.
However, this masks the types of shares in my portfolio. I buy boring companies that are well established and pay dividends. I’ve previously written about the evidence that ‘boring’ shares with lower volatility offer higher long-term returns.
This doesn’t eliminate the risk that I could suffer a catastrophic loss but it is much lower than a portfolio filled with small cap mining exploration companies.
My portfolio is diversified and as I’ve gotten older I’ve shifted more of my new investment dollars into ETFs which further lowers the risk of catastrophic losses.
The strategy I follow is not optimised to get the highest return possible. Instead, I’m trying to provide a growing stream of passive income and broad exposure to growth assets. I want my passive income and wealth to healthily outpace inflation over time.
There are lots of different directions you can tilt a portfolio within a broad asset class. There are fixed interest investments like private credit that have similar risk / return characteristics as shares. There are types of shares that are safer and riskier types of share.
When you are young it is all about getting as much market exposure as possible. As you age it becomes more important to be thoughtful about how your portfolio is positioned to ensure it is aligned with your personal circumstances.
Final thoughts
When I first started investing the finish line was beyond the horizon. I had only a vague sense that saving and investing would enable a great range of choice in the future.
When you are young your biggest asset is your future earnings. I’m well past that stage in my life.
I’m more aware that one day the assets I’ve accumulated will be all I have left to support me. To live the life I want means being a good steward of those assets.
Experience has dampened any false sense of invulnerability. My eyes are open to the impact that both my own mistakes and random events can have on my future.
I’m a different person and I invest differently than when I was younger. Those are both good things.
Investing when you are young is all about enabling compounding to play a meaningful role in the future. When you are older is about protecting compounding. The rules have changed and success requires a different mindset.
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What I’ve been eating
My guess is most readers haven’t had biscuits and gravy. If you fall in this camp you are missing out. I stopped at the Fifth Street Diner in Bowling Green Kentucky during a drive from Lexington to Nashville and knew what I was ordering before the menu hit the table.
Biscuits and gravy are a breakfast staple in the southern US. A buttermilk biscuit is covered with a white pan gravy made with sausage. This meal isn’t going to win any awards from nutritionists – especially when you also order country ham. But life wouldn’t be any fun if you didn’t indulge every once in a while.
