How “Golden Handcuffs” Kill Your Portfolio

Investors should “stay the course” and not sell out when the market dips.

But of course, investors do the opposite and sell out when the market dips.

Why do we do that?

Patrick Adams highlights that we have a real risk in our spending habits in his latest paper.

Simply put, it is harder than we realise to cut our costs.

When faced with an income shock, higher earners dip into their financial assets

In a survey, households were asked for what they would do in response to a financial emergency.

They were presented with 5 choices:

1. Borrow money
2. Spend out of savings/investments
3. Postpone payments
4. Cut back on spending
5. Work more/take on extra jobs

Notably, very few households indicated that they would cut back on their spending or postpone paying bills and debts.

For higher-income households, the majority said they would draw down their savings or investments.

This couples with the next point:

Higher-income households spend a lot on things that are hard to cut back on or defer

Adams notes that such households spend on categories like housing, healthcare, and education.

You can’t stop paying your housing loan, healthcare costs, or take your child out of childcare or school even if the market is in a downturn.

So higher-income households are stuck with hefty bills and a large income shock.

He also finds that most households in general hold less than one year’s earnings in liquid assets.

Hence, they are forced to draw down from their available liquid assets, of which a large proportion is in stocks.

Stocks are riskier than you think?

Adams concludes that the optimal equity allocation of liquid wealth for a working-age household is somewhere between 10-40 percent.

That is a far cry from the 100% equity portfolio, or even the 100% minus age in bonds rule.

This is because of a combination of risky income, inflexible spending, and a liquidity crunch in the form of bad times that causes investors to sell their equities at the worst time.

There is a simple solution

Have an emergency fund.

An emergency fund will mitigate the forced selling during a draw down.

With an emergency fund of 12 months, households will be able to take on a riskier portfolio allocation and withstand heavy market downturns.

And perhaps consider cutting back on those illiquid real estate assets, or replace them with more liquid versions like REITs.