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When should you stop growing and start protecting your money?

Scrooge McDuck: Plenty rich enough already.

One of the troubling trials the rich face is deciding when to dial back on wealth accumulation to focus on wealth preservation.

Icarus flew too close to the sun, and plenty who’ve made fortunes have lost them, too, when instead they could have lived out their days like Scrooge McDuck in a bathtub filled with dollar bills.

Much too young

On the other hand, given how quickly life expectancy is increasing (though not quickly enough for me!) and the ease with which a champagne (or even a cava) lifestyle can become an everyday habit, others adopt excessively conservative strategies too soon.

Perhaps the young-ish and rich-ish are not as greedy as they’re cracked up to be? I’ve known high-flying 30-something investment bankers to keep their money entirely in cash, bonds, and their West London property. Not a share in sight!

Sometimes they blame the onerous trading rules of their firms, but that’s hooey. The truth is once they’ve made their ‘nut’, they want to squirrel it away, as opposed to correlating their net worth even more with their market-related jobs.

You’ve got to lose to win

Protecting what’s yours may be sensible when you’re raking in six-figure bonuses each year. Didn’t Warren Buffett say the first rule was not to lose money?1

True, but you and I aren’t made men at the last Wall Street bank standing, and you’re probably not Warren Buffett, either. Buffett can apply his loss-avoiding rule by spotting a final puff in an investing cigar butt. We mere mortals have to open cash ISAs to play safe, and that will hit our returns.

Most of the past decade was unusually kind to cash savers. But over the long run, history is clear — if you’re aiming to grow your way to wealth through modest savings and compound interest, then you need to forsake the short-term preservation of wealth for the potentially higher rewards (but greater volatility) of equities.

To give a simple example of how you could split a portfolio and expect very different results, according to Moneychimp’s standard deviation calculator:

  • A 75% cash / 25% equity split predicts a return of 4.5%, with a volatility of 3.75%
  • A 50% cash / 50% equity split predicts a return of 6% with a volatility of 7.5%
  • A 25% cash / 75% equity split predicts a return of 7.5% with a volatility of 11.25%.

You pay a very high price for sleeping more soundly at night. The 7.5% return from the most volatile equity-dominated portfolio might not sound that much more lucrative than the 4.5% you’d get from the 75% cash-dominated one, but turning to our compound interest calculator we see:

  • Low volatility, smaller returns: £10,000 a year sunk into the low return cash-dominated portfolio would be worth £638,000 after 30 years.
  • High volatility, bigger gains: £10,000 a year invested into the high return equity–dominated portfolio could be worth £1,112,000 after 30 years.

The lesson: For most people, concentrating on reducing volatility to protect their net worth too early will greatly cap their returns.

Volatility is the price we pay for chance of a superior final outcome. But once you’ve made what you would consider enough money, this flips and you’d rather not lose it.

Target acquisition

To see just how hard it is to plan how much money you need, have a play with FireCalc’s returns simulator to see how long your money could last in retirement. It uses US data but the general principle applies in the UK.

Start with too small a nest egg, or experience a bad run of luck with a risky portfolio, and you can be left with nothing to explain to St Peter – but many years in poverty before you have to.

How much is enough? I don’t have an answer – however much I need, I’m not there yet!

True entrepreneurs like Branson or Bannatyne will certainly never be satisfied, but then they’re in it for the money like a scorecard. Nearly everyone else will find money after a certain point does not buy more happiness, and the law of diminishing returns kicks in.

A good aim for most of us mere mortals is to have enough to replace your salary with a diversified investment income – one with a decent proportion of real, inflation-sensitive assets like equities and commercial property in the mix, to keep you going long-term.

Complicating the timing of the shift to wealth preservation, if you can ride out the ongoing volatility there’s a good case for keeping some equity exposure even in your old age, perhaps via income investment trusts or a HYP, to further guard against inflation.

Income tends to be much less volatile than capital2. If it’s too soon to worry about preserving the latter, then concentrating on the former while accepting the capital will fluctuate may be a practical compromise.

Happily wealthy every after

If you continue to work and save after you reach your income target – or if your investments do better than expected, sooner than expected – then you can look to reduce risk a little by allocating still more money to your income fund in total, but directing a greater proportion of it towards safer assets like government bonds.

Think you’re rich enough already? Then switch to preserving your wealth, and work too on simplifying a few of your tastes to have a margin of safety!

  1. The second rule is, of course, not to forget rule one. []
  2. Interest on cash aside []

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{ 13 comments… add one }
  • 1 Ben June 2, 2011, 11:21 am

    nice article but you haven’t answered the question in the title

    there needs to be some sort of timeline against asset allocation chart as a rough guide for us DIY investors

    Maybe thats in another article somewhere?

    Also I think the suggestion of replacing salary with investment income is off the mark – you want to replace the amount you spend with investment income

    you should know this in detail by keeping monthly accounts

    These should be two different amounts, preferably salary being much greater than spend

    otherwise replacing salary is a constantly moving goalpost (if your career is going well). Outgoings can remain constant or even go down if you try hard

  • 2 The Investor June 2, 2011, 1:31 pm

    @Ben — Yes, fair comment regarding the title. As ever the subject outgrew my initial ambition! Will definitely require a part two.

    As for the income question, there are many ways to skin a cat, and downsides as well as upsides to your suggestion, too. The main takeaway I think is to think in either case about cashflows, not fluctuating net worth.

  • 3 Paul June 2, 2011, 4:17 pm

    The Investor, Love your stuff but I think you have this the wrong way round. When you are poor, volatility is frightening. People with little hate the possibility of losing what they have. Perfectly understandable too. The rich (in the sense of having more than adequate for their needs) can view volatility for what it is……temporary ups and downs that are irrelevant to the long term outcome. This is why the rich get richer. Rather sad but true.

  • 4 RetirementInvestingToday June 2, 2011, 5:22 pm

    Hi TI

    A thought provoking post and one that certainly highlights the miracle of compound interest. It’s interesting that the delta between each of your 3 “portfolios” in terms of return was 1.5% per annum. Goes to show how important fees are in this discussion as people will happily give 1.5% to their fund manager + IFA every year. A DIY investor who minimises fees and charges could therefore get the same return for much lower volatility.

    When should you stop growing and start protecting your money? As with everything I have a mechanical solution. I’m not going to try and time it but simply move 1% of my allocation from high risk to low risk assets on my birthday every year.


  • 5 The Investor June 2, 2011, 6:10 pm

    @Paul — I think you’re partly making my point for me: Excess caution id one reason why the middling off stay middling. It may be understandable, but we should strive to do what makes most sense, yes? Not just what others happen to do.

    And it’s not just a poor thing, it’s the middle classes too. There’s billions languishing in Cash ISAs that should be in stocks ISAs etc.

    In contrast, as I discuss in the preservation article I link to, the enduring rich most often DON’T seek to maximize returns as you suggest. Au contraire, they accept lower returns as the price of dampened volatility.

    Cheers for your comments and kind words! 😉

  • 6 The Investor June 2, 2011, 6:15 pm

    @RIT — Indeed (and further to my comments to Paul) the wealthy have powered the growth in 2/20 hedge funds. They are often high fee payers, not savvy low fee paying ones. Such fees might make sense for the rich if they’re getting special tax advice, say, or relatively inaccessible diversification (eg Brazilian farmland or unlisted opportunities) but not to get market returns or less, dressed up as something else.

    I get the strong impression that the average rich person would rather earn an average of 3% real a year over say 20 years and no drawdown, rather than average say earn 5% real on average p.a. but with down years. Perhaps everyone would prefer that on some level, but the fact is most of us can’t afford it.

  • 7 Paul June 2, 2011, 6:28 pm

    TI, By poor I was not referring to a class but those with “not enough for their needs” (which probably describes many in all classes!). My point was that because the rich (by my definition) can afford to ignore volatility, they can invest in stock with lack of fear and thus get richer. I am not suggesting that they all do….although generally the rich do get richer.
    Cheers, Paul

  • 8 Salis Grano June 2, 2011, 9:27 pm

    I must say, I can’t really see the point in changing your investment style as you get older if you are comfortable with what you have been doing. For older people with reduced opportunities for work, inflation is always a threat. A volatile, inflation linked asset may be preferable to a non-volatile one with a diminishing real income stream. Obviously, ILSCs and index-linked annuities can be part of the package.

  • 9 ermine June 2, 2011, 9:33 pm

    high-flying 30-something investment bankers to keep their money entirely in cash, bonds, and their West London property

    It’s the, ahem, West London property that’s doing the lifting of their net worth 😉

  • 10 The Investor June 2, 2011, 10:14 pm

    @salis – I know what you’re saying but assets can crash from favor for the rest of a lifetime, or be unfavorably taxed or similar. That’s why the very wealthy old money / well advised money ‘over’ diversifies. (See again that article I link to!)

    @Ermine – It doesn’t hurt which was of course why I mentioned it. But I personally know a banker who had a high six figure sum (likely nearer seven!) in gilts in his early 30s.

  • 11 stuart June 3, 2011, 8:28 am

    i pound/cost ave monthly into a ftse-all-share-index 0.27 t.e.r i.s.a

    amount of shares im accumulating is the only figure im concerned about–and it goes UP each month.

    i beat bank saving rates and with yearly compounding am slowly buiding a large nest egg

    im never worried about the market–sleep very well

    i wont be the richest–but that doesnt concern me—i will be very comfortable

    p.s. –i lov watching analysts on tv predicting the mkt—–a well respected fund manager said 2009—best to keep out

  • 12 Moneyman June 3, 2011, 9:01 am

    Interesting topic and comments.This is a perennial theme – and one that is also faced by the 40% of affluent investors who practise DIY investing.

    The key issue is that when you retire you lose your main income stream and so have less flexibiity to make up for any hiccups in your investing – by then you will need to have reduced volatility sufficiently. So it is partially age-related but adjusted for expected retirement age. And of course the retirement age is influenced by your expenditure level and lifestyle. Many people have realised that they can live on a lot less than they thought and therefore can retire a lot earlier. The portfolio mix then has to be adjusted. I quite like the idea of investing an increasing proportion of my annual savings in fixed-interest securities – the old rule-of-thumb of holding your age as a percentage in fixed-income stocks is probably as good a guide as any – adjusted, as I have said for expected retirement age.

    The other main point is the lower volatility of income – hence my own bias in favour of income investing. For this reason I don’t like index investing.

    Finally, the point about paying for fees – even investment trusts. Most people can manage a perfectly good investent strategy themselves

  • 13 The Investor June 3, 2011, 9:02 am

    @Stuart – Actually, relatively speaking, you are maximizing your growth prospects with that strategy. Assuming you’re youngish, have an emergency fund, and can take the dips, I applaud it. The only way you could do more is leverage , market timing, or stock or fund picking — all riskier and with no guarantee of greater rewards.

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