Locking In Failure

I examined what happens to a 100% stock investor after a severe loss. I assumed that starts out with $100000. I assumed that he would cut his stock allocation to 20% if his balance fell below $80000.

Scenario Surfer Runs

I started out with 100% stocks. I started with a $100000 balance. I cut back to 20% stocks as soon as my balance fell below $80000. I invested entirely in stocks and 2% TIPS. I selected P/E10=26 Bear Market. I made no deposits and no withdrawals. Here are the Year 15 balances. I did not vary allocations in accordance with valuations.

Run 1.
Year of Change: 3.
20% rebalanced: 124,659.
50% rebalanced: 108,660.
80% rebalanced: 92,134.
100% Stocks initially: 98,693.

Run 2.
Year of Change: never.
20% rebalanced: 148,413.
50% rebalanced: 163,053.
80% rebalanced: 168,139.
100% Stocks initially: 165,438.

Run 3.
Year of Change: 10.
20% rebalanced: 142,510.
50% rebalanced: 146,665.
80% rebalanced: 139,487.
100% Stocks initially: 84,135.

Run 4.
Year of Change: 3.
20% rebalanced: 139,094.
50% rebalanced: 138,772.
80% rebalanced: 129,942.
100% Stocks initially: 80,240.

Run 5.
Year of Change: 5.
20% rebalanced: 149,936.
50% rebalanced: 169,741.
80% rebalanced: 183,986.
100% Stocks initially: 115,308.

TIPS Baseline:2% TIPS, no stocks: 134,585.

Data Summary

Here are the ordered Year 30 balances:

165,438 (never changed).
115,308 (change in Year 5).
98,693 (change in Year 3).
84,135 (change in Year 10).
80,240 (change in Year 3).

TIPS Baseline: 134,585.

Analysis

Changing to a 20% stock allocation was a disaster. It locked in failure.

The TIPS-only baseline did better than stocks in 4 out of 5 cases. In the single instance that stocks did better, the balance never fell below the $80000 threshold.

Conclusion

A stock-only investor is in danger. He is likely to see his balance decline far enough for him to cut his stock holdings sharply. If so, he is likely to lock in failure.

Have fun.

John Walter Russell
June 3, 2008