← HerMoney with Jean Chatzky
HerMoney with Jean Chatzky
Why Playing It Safe With Your Money Might Be the Riskiest Thing You Can Do
00:34:07
Yale Professor James Choi on why your portfolio is probably too conservative.
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K Pop Demon Hunters, Haja Boy's Breakfast Meal and Hunt Trick's Meal have just dropped at McDonald's. They're calling this a battle for the fans. What do you say to that, Rumi?
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C
It's not a battle. So glad the Saja boys could take breakfast and give our meal the rest of the day.
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B
It is an honor to share.
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C
No, it's our honor.
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It is our larger honor.
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No, really, stop.
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B
You can really feel the respect in this battle.
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C
Pick a meal to pick a side
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B
but and participate in McDonald's while supplies last. Let's say that some hacker stole 10% of your brokerage account balance. Now, you'd be angry, you'd be sad, you'd be upset, which would be understandable. But does the 10% disappearance of the balance in your brokerage account mean that you need to forevermore live at a standard of living that's 10% lower than than what what you thought you could afford? And the answer is no. And that's because you don't have to cut back 10% because you have all of this labor income coming your way in the future. Now contrast that with someone who's in retirement who, let's say, has no Social Security benefit. And so they are living just on this pot of money. If 10% of got stolen, then they would really have to reduce their standard of living by 10%. But that's not the situation that the vast majority of us are in.
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C
Hey everybody, it's Jean. And this is a note that I am attaching to the top this show. I just finished interviewing James Choi, who is a brilliant Yale professor about some new research that he's done on asset allocation and the amount of money that you should be keeping in stocks versus in bonds and the rest of your portfolio. His ideas on this are really key when it comes to figuring out the right amount of risk that you should be taking at various points in your life. And so my ask is this, the conversation's a little technical. It's a little bit more technical than we often get on this show, and it's particularly a little technical at the beginning. So stick with us. I guarantee that what you are going to learn by the end of the show will make a lot of sense and will be something that you'll be able to put to use as you think about your investment philosophy, not just this year or this decade, but for many decades to come. James, welcome back to Her Money.
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B
Fantastic feedback.
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C
Let's just start with the rules that I mentioned. Right. I want to be very honest with our listeners. I've been a defender of the 60:40 portfolio on this show. I think there's real value in it. It's easy, it's pretty simple to follow. It's been the standard of pension funds for many decades. But when stocks surge, what we know is that that 60 quickly becomes 65 and 67 and 70, and suddenly you're carrying a lot more risk than you signed up for without realizing it. Which is why I'm also a pretty broken record for rebalancing. All of these are kind of rules of thumb, right? And rules of thumb have their limitations. So when you sat back to take a new look at asset allocation in general and what we were doing right and what we were doing wrong, what was in your head? What put you on this quest?
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B
The genesis of this really was a personal finance class that I teach at Yale to our MBA students and undergrads. And I was just looking to give them advice that came from the best of our science. And there has been a lot of scientific knowledge that's built up over the decades about how you should optimally manage your personal finances. And there's a very old idea that dates Back to like, 1971, a paper that was published by Nobel laureate Robert Merton. And that paper made the simple observation that for most of us during working life, our biggest economic asset is not actually our savings. It's the future stream of wage income and Social Security benefits that are coming our way. And if that is the most valuable asset that we have, then shouldn't our asset allocation be be affected by the presence of that asset? And so when we typically talk about asset allocation of a portfolio, we usually take the perspective that you have this pot of money and you're just managing the heck out of it, and that's the only pot of money that you'll ever have. And that's maybe not a bad approximation for an institutional money manager that just managing a portfolio. But for us human beings, we do have this labor income that's coming our way, these Social Security benefits that are coming our way. And we should adjust the allocation of our financial portfolio to account for the presence of all of that other income, which I'm going to call human capital.
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C
We are going to take a very, very quick break. Back in a sec. You know that feeling. It's 7pm you are exhausted. You know you should eat something healthy. But the idea of planning, shopping, actually cooking, not happening. Eating well is not a willpower problem. It's a time and effort problem. That's why I love Factor. I've been working my way through their menu lately. The ginger teriyaki salmon one night, a Thai green curry packed with roasted vegetables the next. I even tried their new miso edamame tofu salad. It did not disappoint. All fully prepared dietitian designed chef crafted meals delivered right to your door and ready in just two minutes. I use Factor and I think you should too. It's the setup that makes healthy eating actually happen without the planning, the grocery runs or the cooking. Head to FactorMeals.com HerMoney50OFF and use code HERMONEY50OFF to get 50% off and free daily greens per box with a new subscription while supplies last until September 27, 2026. See website for more details. I've been doing a little spring reset with my closet lately. Less about adding more, more about adding better. Fewer pieces, better materials, the kinds of things you reach for every single day. And that's why I keep coming back to quints. I recently picked up the Mongolian cashmere T shirt in black and it's so soft, so classic. The kind of piece that works just as well at dinner as it does running errands on one of those in between spring days when no idea what to wear. And let's just talk about their running tights. Such amazing quality at a fraction of the price. I use quince on the regular and I think you should too. Refresh your spring wardrobe@quince.com hermoney for free shipping and 365 day returns. Now available in Canada too. That's quince.com hermoney Q-U-I-N-C e.com hermoney so when we talk about and I'm going to just take a step back and define some terms here, when we talk about asset allocation, we're really talking about our mix of stocks, bonds, cash, maybe other asset categories. There's a whole body of research that says when it comes to your investment performance. It's not the individual stocks you're picking, it's the asset allocation that really drives your success. Can you talk about why that is?
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B
Well, if you're talking about holding a fixed income portfolio, so a portfolio of bonds, money markets, if you have a fantastic year in fixed income, if you are just incredibly skilled, and there's obviously an active debate about whether anybody has the skill to be successfully actively picking securities. But you know, if you're having a fantastic year, your upside is not that huge because these are relatively safe assets, and so their upside is kind of capped. Now, when you're talking about investments in stocks, the upside is theoretically unlimited and there's a lot more variability. And stocks are risky and so they are priced accordingly. So they are priced lower than they would be if they had no risk. And so that lower price is giving you kind of a compensation for bearing that risk. You have a lower price that you can buy in at, so that you enjoy on average a higher rate of return. So that's why the asset allocation decision between all the various major asset classes is the biggest driver of your overall return over the long run.
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C
And when it comes to making asset allocation decisions, there has been a lot of talk for a lot of years that you're gonna get it approximately right if you either 60, 40, it 60% stocks, 40% bonds, or you take 100 or 110, subtract your age and put that amount in stocks. But what that basically says is as you get older, you should be taking less risk, you should have less stocks, more fixed income. Why has thinking evolved that way?
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B
I think that the 60:40 rule again takes this perspective that you have this pot of money. It's the only pot of money you'll ever have, and you need to manage the heck out of it. And then you see what kinds of risks materialize when you have a 6040 portfolio. What kind of average return do you tend to get when you have a 6040 portfolio? And this seems reasonable to people, but they are not taking a broad perspective. And so let's take the example, the extreme example, where you have a risk free stream of labor income, wage income for the rest of your life, Social Security. Well, let's just. You live in a fantasy world where your income from your job is guaranteed for the rest of your life. Okay, so now what is that? Essentially you have this risk free bond in your portfolio. It's like every paycheck, the bond pays you an interest payment and that is your wage. And so if you have this risk free stream of income for the rest of your life, then you have this enormous safe asset in your implicit wealth portfolio. And that means that you can take a lot more risk in your financial portfolio because you have this big cushion of this risk free bond sitting in the background. Now, of course, in the real world, our income is risky, but it turns out if you look at the data that the risk of your labor income is pretty uncorrelated with the risk of the stock market. And so that means that the gravitational force that it exerts on your optimal financial portfolio allocation is a lot like a bond. And so that's what pushes you to be more aggressive in your financial portfolio when you have a big bond in the form of human capital. But now as we get older, sadly we have fewer and fewer paychecks coming to us in the future. And so every time you get a paycheck, it's like your human capital sublimates and turns into financial capital. So your human capital value just is shrinking as time goes on. So the value of that big bond is getting smaller and smaller and smaller as we age. And so in compensation for that, we need to de risk our financial portfolio to make up for the fact that our human capital value is shrinking over time.
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C
So as you then approach retirement, what does your formula now suggest that we do differently?
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B
I think the main thing is it does recommend for most people allocation that is more aggressively in stocks than you might be used to. And so let's just take an example of somebody who has looked deep within their hearts and they think, well, you know, if I had to invest all of the resources I have coming to me in my life into stocks and bonds right now, so I could somehow sell off the proceeds of all the wages I'm going to get in the future and all these Social Security benefits I get, I'm going to get in the future. I now have this lump sum of money, I'm going to add that to the savings I already have. And now I need to invest that amount of money and say that you say you look deep within your heart and you decide, no, I'm a 50, 50 type of person, so I'm just going to use big numbers because it makes the arithmetic easy. But obviously these are big numbers. I suppose it you now have $10 million of your money that you've already saved up and then the value of that human capital that you just sold off. So now you should be investing $5 million, that 10 million in stocks and 5 million in the safe asset. So that's if you could sell off all of your human capital. Now in real life, we can't do that, but we do have this human capital that is coming our way. And so now suppose that I have saved up $5 million and I have $5 million of human capital that's coming my way in the future. Well, I'm still a 5050 type of person, so I should be investing 50% of my $10 million total wealth in the stock market. But I have to do it through my financial portfolio. I can't do it through my human capital. So I'm now going to invest $5 million in the stock market. I'm doing it all with my $5 million of financial capital. And so I'm actually 100% invested in my financial portfolio in the stock market. But that's really a 50, 50 position when you consider my overall wealth portfolio. And so the difference is that you have the safe asset lurking in the background, which is your human capital.
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C
Many of my listeners are in their 40s and their 50s, right? We've got a body of people in this audience for whom retirement is closer than it is further away. And so I sort of want to talk about Social Security and guaranteed income in this context. I've been working on a book called the Forever Paycheck. It's coming out in September. And basically it takes a look at the money that you've saved for retirement and this idea of using some of it to create a paycheck for the rest of your life. One of the arguments that I make in the book is that if you have created a stream of guaranteed income, Social Security, whatever, you know, that you've got for sure coming from Social Security, plus any annuities, pensions, other guaranteed income that you know for sure is going to last you for the rest of your life, you actually can invest the rest of your money more aggressively because you know that your needs and a decent portion of your wants are going to be covered for as long as you need live. I think we're talking about apples and apples, am I correct?
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Absolutely. I totally agree with the advice that you're giving. And in fact, this is exactly the advice I gave to my father in law 10, 15 years ago because he was retiring and he was a University of California employee. And so he had a nice pension coming his way for the rest of his life. Inflation adjusted, very hard to find those things nowadays. And so I told him, look, you can be pretty aggressive in your financial portfolio because you have this backstop and in the form of Social Security in form of your California pension. And indeed, he was very aggressive in his portfolio and the stock market has happened to do very well over the last decade plus. And so he's been very happy with the advice that I gave him.
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C
We are going to take a very, very quick break. When we come back, James, I want to talk about how to use this advice sort of tactically at the different stages of your life. So we're going to parse it out because I know that these are complicated concepts, everybody, but they're also really important concepts. So I want you to be able to wrap your brains around them. We're going to talk about how do you do this when you're in your 30s, your 40s, your 50s, your 60s? Back in a sec. You know what's funny about tax season? It's one of the only times a year most of us actually sit down and look at our full financial picture. What came in, what went out and where on earth the rest went. And every year a lot of us think, I wish I had been paying closer attention to this all along. That is exactly why I love Monarch. Simplify your finances with Monarch. It's the all in one personal finance tool designed to make your life easier. Bringing your entire financial life together in one dashboard. Feel aware and in control of your finances this tax season and get 50% off your Monarch subscription with Code Hermoney. Achieve your financial goals for good with Monarch, the all tool that makes money management simple. Use code hermoney@monarch.com for half off your first year. That's 50% off@monarch.com code hermoney when we launched Hermoney, I remember thinking, what if no one listens? What if this doesn't work? Starting something new, whether it's a podcast, a side hustle or a product you've been dreaming about, always comes with doubt. But having the right partner makes all the difference. Shopify is the commerce platform behind millions of businesses around the world and 10% of all E commerce in the United States. From brands just getting started to household names like Thrive Cosmetics and Allbirds, it gives you everything you need in one place. Inventory, payments, analytics, no juggling multiple platforms. You can build a beautiful online store with ready use templates. It's time to turn those what ifs into with Shopify today. Sign up for your $1 per month trial today at shopify.comhermoney go to shopify.comhermoney that's shopify.comhermoney we are back with Yale professor James Choi. And James is Here, because I read about a concept that he introduced in the Wall Journal, which is this idea that we're getting asset allocation a little bit wrong and that we should be taking perhaps more risk with our money at various stages of our life. So we're going to talk through how do you apply this advice in your 20s, 30s, 40s, 50s, 60s? And what risks might we not be taking thinking about along the way? So when you are in your 30s, let's just start there, James, how do you look at asset allocation for somebody at that age? And does this new research tweak what you thought of previously?
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B
Well, as I was saying before, this concept of taking into account your human capital is a very old concept going back to the early 1970s. But what was different about my paper was that it provided a way for ordinary people who are comfortable with a spreadsheet to implement that advice for themselves. As a note, the paper is called Practical Finance and there is a link to a Google Doc on my website at Yale where you can actually go and it'll give you instructions how to use the spreadsheet and do the calculation for yourself. But for somebody in the 30s, what the spreadsheet will with very high probability recommend is that you be 100% invested in stocks because the amount of money that you have saved to date is probably pretty small relative to the future income stream you're going to have from your job and your Social Security benefits. And so Even if you're 100% stocks in your financial portfolio, that is a very small amount of risk you're actually taking in proportion to the total lifetime resources that you have coming your way.
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C
That makes sense. And in your 40s, I would imagine that tapers off a little bit. The Journal piece laid out an example of a middle aged couple, both 50. They were making $160,000 combined. And in one scenario they had $400,000 saved. In the other scenario they had $800,000 saved. And your formula gave very, very different recommendations for them. For the couple that had less saved, you had them take more risk putting 88% in stocks. For the couple who had $800,000 saved, they only had to put 53% in stocks. Same age, same income, very, very different asset allocation. And it feels just a little counterintuitive, I think, because most of us assume that if you've saved more, you can afford to take more risk. But your research says if you've saved more, you should take less. Can you break it down?
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B
Yeah. So it's all about trying to keep A constant fraction of your lifetime resources invested in the stock market. And so for somebody who has saved more to date, if they are taking more risks with their financial portfolio, they're putting a bigger fraction of their total lifetime resources at risk versus, let's take the extreme example of somebody who has saved only $1 to date. If they put the entire dollar into the stock market, let's say that they lose it all, well, they've only lost a dollar. It's not going to really change their lives. And so it's really about trying to keep that fraction of your total lifetime resources at risk constant over time that is driving the difference in that recommendation.
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C
One of the things that we know historically about women, and I think it's gotten less true over time, but that many of us, and I include myself, are wired for safety and security, and this idea of leaning more heavily on on stocks might be difficult to take. What are you finding in practice?
- [24:09]
B
So at one level, economists would say there's no arguing with taste, and if you are more risk averse, then that's your legitimate preference and you shouldn't be argued out of that. So there's that aspect where I think your preferences are your preferences. On the other hand, I think that there are two misconceptions that could be impacting your financial portfolio choices in a bad way. One is just having an overly pessimistic view of what the stock market returns have been historically and what they might be in the future. So we have emerging evidence that, on average, Americans are too pessimistic about how well the stock market at least has historically performed and maybe perform in the future. That's mistake number one. Mistake number two is just not taking a broad enough view of what your resources are. So I remember when I was 22 years old and I lost like $500 in my stock portfolio. I felt like a lot of money. And, you know, $500 is not nothing. A lot of sushi dinners you can buy with $500. But in the context of my lifetime resources, the $500 loss was not that big of a deal. And so I could afford to take that risk and take that loss in the short term. And it didn't have a particularly negative impact on my life. And one other way to kind of see how our financial portfolio losses don't really fully trickle over into an equivalent proportional loss to our overall standard of living is, you know, suppose that we took your financial portfolio and let's say that some hacker stole 10% of your brokerage account balance. Now you'd be angry, you'd be sad, you'd be upset, which would be understandable. But does the 10% disappearance of the balance in your brokerage account mean that you need to forevermore live at a standard of living that's 10% lower than what you thought you could afford? And the answer is no. You might cut back a little bit, but you're not going to cut back 10%. And that's because you don't have to cut back 10% because you have all of this labor income coming your way in the future. Now contrast that with someone who's in retirement who, let's say, has no Social Security benefit. And so they are living just on this pot of money. If 10% of it got stolen, then they would really have to reduce their standard of living by 10%. And so that's the scenario where, in fact, that financial portfolio loss passes fully through to a proportional loss in the standard of living. But that's not the situation that the vast majority of us are in.
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C
I want to ask you about temperament, but before I do that, tell me more about this evidence that we're overly pessimistic about the stock market.
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B
There is survey evidence from, I think it's the Michigan Consumer Confidence Survey, where they ask people, what is the likelihood that the stock market will go up over the next 12 months? And pretty consistently, people will, on average, report probabilities that are lower than what they have been historically. Also, very fascinatingly, if you just group people by their income percentile, so from the poorest to the richest, every income group is too pessimistic relative to the historical average. But the poorest people are much more pessimistic than the richer people. And so we're all making a mistake on average. But the mistake seems to be the biggest among the poorest, who frankly, could use the money the most. So there's that. And then there's other research that I've done where after we inform subjects in a study about what the historical returns of the US Stock market have been, you see subjects increase their allocations to stocks thereafter, suggesting that they had too pessimistic of a view of what the history actually was.
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C
Why do you think that this is the case? Is it because we feel the losses more than we feel the gains?
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B
That's a great question. I don't know what the genesis of that is. I mean, you could have an accurately calibrated view of what the market did historically and just say, well, the market returned 10% per year on average. But I felt the losses a lot more than the gains. And so I still know that it was 10%, but I'm going to be conservative. So there are ways to be loss averse while still being accurately calibrated in your memory of the historical experience. And just seems that people are too pessimistic on average.
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C
Fascinating. You mentioned temperament and I do think temperament is an important part of this. Your research talks a little bit about a 70 year old couple who are comfortable with market swings and they might have 60% plus still in equities, while somebody who loses sleep over every market diploma might only have about half that much. Is that just something that we should know about ourselves and adjust accordingly?
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B
No. So economists have a very specific way in which we think about risk tolerance. The fancy word is the coefficient of relative risk aversion. You don't need to remember that term. Basically we have this number that actually goes from negative infinity to positive infinity, but we think that a reasonable range is somewhere between 1 and 10. And we can ask ourselves, you know, Cosmo quiz like questions where we just do some thought experiments, say, you know, how do I react to certain gambles and what gambles do I find attractive relative to for sure amounts to pinpoint what that risk aversion number is. And so on my website that link to the Google Doc will have an example of this kind of quiz question that will allow you to get a sense for what that number might be for you and people. I've read online some reactions to this paper and people say, well, I chose five because it's in the middle of the range. Five is not there because economists think that five is the average for a person. Five has a very specific mathematical meaning. But when I was learning economics back in college, the professor said one is actually my benchmark for what a reasonable risk aversion would be. So anyway, 10 is what we think of as almost pathologically risk averse. So we think the 10 is the upper limit of what would be reasonable. But again, you can't really argue with taste. So if you're 10, if you're 12, so be it. So there is a way for you to at least get some sense of what your risk tolerance is, what your preference for risk is, and then that's going to affect your recommended portfolio allocation. And again, I've spent a little time online looking at some message board reactions to this paper and some people are complaining, oh, the portfolio recommendation is really sensitive to what my risk aversion number is. Isn't that terrible? And I'm thinking No, that's a feature. Why wouldn't you want your portfolio allocation to be sensitive to your risk tolerance? So that's one dimension of it, which is we're going to get a risk tolerance number for you and we're going to output a portfolio allocation for you. Now, there's a separate issue, which I think is a psychological issue, an emotional issue, and a relational issue, where the formula might say that you should be 100% stocks. And every once in a while the stock market goes down by 20%, and you're kind of cool with it because you have this big stock of human capital in the background. So you're okay and not panicking, but we're human beings. And if you're going to sit at the dinner table and look at your family and wonder, have I just put my family's future in jeopardy? Am I now having these arguments with my spouse because my spouse says, you idiot, you said to be 100% stocks because you followed this crazy Yale professor's advice, and now we're 20% of the hole. And like, so those kinds of costs are real. They're not in the economic model. And so I want to acknowledge that all models are simplifications of reality, and that's why we get insight from it. You know, you don't want a Google map that is as large as the city that you're trying to navigate and has all the detail in the city. No, the map is useful because it throws away a lot of detail. And so we are getting insight from this economic model by throwing away a lot of detail. But you are the one that are living your life, and if it's going to ruin your sleep, ruin your relationships, ruin your emotional state to have a certain asset allocation, then, hey, those are real costs, and I don't want to discount that at all.
- [32:36]
C
Before we wrap up, I just want to come back to one thing that is mentioned in the journal piece and in the paper. You point out that how much we ultimately save matters more than how we allocate. And I think that's a really important reality check because we can spend a lot of time obsessing over our portfolios and our percentages. But if we're not consistently putting away enough in the first place, none of the fine tuning has the ability to make as big an impact. So for my listeners who are hearing all of this and feeling like they're already a little bit behind when it comes to the saving part of things, how do you suggest that people get on track?
- [33:27]
B
So I think that you just need to have a plan. And if you look at the survey data, it is shocking how many Americans, even Americans that are not so far away from retirement age, have never tried to figure out how much money they might need in retirement and how they might get there to have some financial plan year by year. How much do I think I'm going to save? What would that get me under a reasonable return scenario? And so your life is complicated and there are things that happen in a given year. You know, some years you get married, some years nothing happens. Some years you have a disaster. So these fixed formulas that say you must save 13% at age 42, like, I don't think that they necessarily work, but you should have a plan. So the way I do it is I have a spreadsheet and for every year between now and retirement, I have some estimate of what I think I'll save in that year. And then I have an assumed rate of return, which is pretty conservative. So it'll be the treasury interest rate plus like 1% or 2%, which is probably less than what I would get on average. But it's building in a margin of safety. And then I just grow this thing. It's very simple. And I just see, okay, when I retire, when I'm at age 65, when I'm age 70 or 75, whenever I choose to retire, how much money is that going to be? Am I comfortable with that amount of money? And if I'm not, then I need to have some sort of plan. And I think it's not good enough to say, oh, I can't afford to save today. Because what you're saying is my future self can afford to not have that money. Which might be true, but you should at least be wide eyed and cognizant of what you're choosing for your future self.
- [35:06]
C
James, thank you so much for sticking with me and with my questions. I know that they were a little repetitive as I tried to get to the heart of this, but it's really important and I think it's really fascinating. So thanks for doing the work.
- [35:20]
B
Oh, a real pleasure.
- [35:23]
C
And before we go, if you love today's episode, please take a moment to leave us a five star review on Apple Podcast. Your feedback means the world to me, but it also helps other women find the show. And if you're ready to grow your investing skills and make smarter decisions with your money, come join Investing Fix, our twice monthly Women only investing club. Expert stock pickers bring ideas to the table and together we help build a portfolio. Since launching four years ago. We've built a strong track record and more importantly, a community of women who are learning and winning together. Tap the Link Link in the show Notes to check out Investing Fix today. Your first two classes are always free. Her money is produced by Hailey Pascalides and our music is provided by Video Helper. Thanks for listening and we'll talk soon.
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D
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