In the 31-Day Money Challenge, we covered the basics of asset allocation. Today we are going to focus more specifically on how much to invest in stocks and how much in bonds. The stock/bond allocation is the most important piece of asset allocation.
The question of stocks vs. bonds is much more important than the question of US stocks vs. foreign stocks or whether you focus more on emerging markets, REITs, or small caps. Over the long term, your portfolio’s overall return will be driven by how much you invest in stocks.
There’s no one perfect way to divide your assets between stocks and bonds. It’s not like you can dump a bunch of information into a calculator and have it spit out the perfect allocation. Instead, my goal here is to give you a good base of knowledge, tools, and resources that you can use to make an informed decision as to what’s best for you and your family.
With that being said, I do think that there are some wrong ways to allocate assets between stocks and bonds. Either extreme on the stocks vs. bonds spectrum is likely to be problematic. But, even there, the key is that you understand for yourself the pros and cons of any division you make.
So with that, here are my four best pieces of advice:
1. Don’t get hung up on the small things
Readers send in a lot of emails asking about making small changes in the stocks vs. bonds balance: “What if I put 75% in stocks, when I should have put in 70% or 80%?”
People are really nervous about this, and they start getting hung up on a couple of percent here or there. This is putting too fine a point on it. Yes, it’s an important decision, but don’t get hung up on the smaller increments.
The bigger question is more like: “Should I put 75% in stocks or 50% in stocks?”
Asset allocation is not an exact science. So try to look at overarching divisions, rather than super-fine distinctions between stocks and bonds in your portfolio. Sure, every change is going to make some difference, but in the long term a few percent isn’t going to make that big of an impact.
2. You’re balancing three competing issues
The question of stocks vs. bonds is complicated in part because you’re balancing three competing issues: risk of loss, risk of not having enough, and yourself.
Risk of Loss: This is the issue I think gets the most attention because it’s the one that everyone is most afraid of. We’re scared of the stock market because we see it go down 10%, 20%, or even 40% in a year, and that gets a lot of attention. Most of us appreciate that in the long run, stocks will do better than bonds – but we’re still scared of them.
To put this in perspective, let’s look at a resource from Vanguard. This PDF resource includes a chart that shows you everything you need to know about the potential risks and rewards of stocks. It looks at 87 years’ worth of market history for stocks and bonds.