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 superfine 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, the 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.
Of course, the market’s past performance may not repeat itself. Historical information, however, is the best we have. If we focus on the long term, it can at least tell us what to expect over long periods of time with investing in the stock market.
So according to Vanguard’s chart, if you invested 100% in bonds with no stocks, your nominal return would be 5.5%. This means that without factoring in inflation, your return would be 5.5% over 87 years. With inflation, you’d only earn 2.5% over that period. Compare that to a 100% stock portfolio for the same period, and you’d have a nominal return of 10% – 6.8% with inflation. That’s a huge difference.
And that’s why we like stocks. But, of course, there’s a flip side. The scary news is that over the same period with a 100% stock portfolio, you’d actually lose 43% in your worst year. That would be a tough year. Compare that to bonds, where you’d only see a loss of 8.1% in your worst year. That’s a big difference reflected in this chart.
But the chart doesn’t stop there. It also looks at your nominal and real returns in your best year, and your worst year for a combination portfolio. In other words, it also looks at more balanced portfolios – like 90% bonds/10% stocks, 80% bonds/20% stocks, etc. And as you’d expect, as you add more and more stocks, your best years get better, your worst years get worse, and your nominal and real returns slowly rise.
So the question you need to answer with the help of this chart is, “Will I be able to handle the kind of loss that are reflected here?” For instance, if you were going to invest 80% in stocks, this chart suggests that you’d need to be prepared for a 35% loss in one year. Would you be able to stick with your asset allocation plan with that kind of year?
Risk of not enough: This is the second issue you need to balance when making this decision. Yes, there’s the risk of loss in a given year, but there’s also the risk that you could get into retirement without enough money to retire. That’s the risk if you have too much in bonds.
You may feel safer parking 100% of your money in bonds, but your real, after-inflation return – at least if history is any indication – is only going to be 2.5%. Depending on what you’re saving as you grow your portfolio, a 2.5% return likely will not grow your nest egg enough for you to retire when you want to.
That’s a risk that’s sometimes hard to focus on when you’re 20, 30, or 40. It seems so far away. You’re more concerned about losing 30% or 40% of your portfolio. Who can think about whether you’ll have enough money 20, 30, or 40 years from now?
But this is a real risk, and it’s why I think so many experts recommend a portfolio for retirement that’s heavily weighted in favor of stocks. If you can deal with short-term volatility, then you can have a portfolio weighted in stocks that address the real risk of not having enough money at retirement.
Yourself: The third issue you have to balance is you. Sometimes we are our own worst enemy when it comes to investing. You’ve heard stories where the stock market starts to crash and people get nervous and sell when the market is down. Then the market bottoms out and begins to improve, but they’re still scared and want to wait to get back in.
So what do they do? They buy into the stocks when the market’s on fire – just in time for the stock market to crash again. I’ve talked to a number of people who did this just in 2008 when the market was down. They sold out of fear, and they’re just kicking themselves now.
So, the question of stocks vs. bonds has to address these three issues. You need to understand the risk of loss for your portfolio in a given year. You need to focus on the risk of not having enough. You can’t just focus on that short-term risk of market loss. You’ve got to think about long-term returns that may or may not meet your financial goals. And as you think about these two issues, you need to think about yourself and how you’re going to handle market volatility. What will you do in case of loss?
3. Narrow it down
So now you can see how asset allocation isn’t an exact science. But where does the rubber meet the road? What should your asset allocation be? Can we narrow it down a bit?
If you’ve got 20 years or more until retirement, most experts advise that stocks should make up somewhere between 60% and 90% of your portfolio. Now, that’s a broad range. Just look at the Vanguard chart, and you’ll see that there is a major difference in terms of real returns – about 5.5% with a portfolio of 60% stocks/40% bonds up to about 6.5% for a portfolio of 90% stocks/10% bonds.
And if you think that 1% isn’t a big deal, try this Excel calculation:
In Excel’s function box, enter =fv for the future value formula. In parenthesis, we’ll input our projected return to calculate the future value of a portfolio with a couple of assumptions. First, we’ll assume the portfolio earns 6.5% – the Vanguard chart’s return for a 90% stocks/10% bonds portfolio. Then, we’ll assume you invest for 40 years, starting at 25 and ending at 65. And then we’ll assume you invest $15,000 per year (though you can easily change this number to suit your scenario).
(Make the investment a negative number because that will generate a positive number in the Excel formula.)
Here’s what you get:
That’s $2.6 million. But what if you invest in a portfolio that’s 60% stocks and 40% bonds, so that your real return is 1% less? What difference would that make? Check it out:
Your $2.6 million drops to $2 million. The difference–$600,000–is a big change for what seems like a minor change in the average return.
So these decisions, as you can see, have a real impact. That’s one of the reasons that I so heavily stress keeping your investment costs low. If you’re paying an investment adviser 1% a year, that’s huge. Or if you’re paying expense ratios of 1.5% as opposed to 10-20 base points with a Vanguard fund, it can have a huge impact on your portfolio.
Armed with this information, why wouldn’t you just put 90% in stocks? Well, there are a couple of reasons.
One is risk tolerance. Yes, 90% in stocks should give you a higher return over the long run than 60% in stocks. To achieve that, however, you may have to live through a loss of 30% or 40% in one year.
If you can’t commit to doing that on an emotional level, you’re better off with 60% in stocks, rather than putting 90% in stocks and selling your stock funds out of fear when the market crashes. If you can’t weather the market drops, you’re better off with a more conservative portfolio. But only you can decide how risk tolerant you’ll be.
You can develop more risk tolerance with experience. I’ve lived through a number of bad markets, including the 2008 crash. I was investing in 2000 when the tech bubble burst, and I have some experience in weathering these bad markets. Now I know that I’ll stick to my asset allocation plan.
But if you’re just starting out, you may not know that. It’s one thing to listen to this podcast or read a book or blog where 90% in stocks sounds great. But it’s a whole different thing to live it. So once you live through a bad market, you’ll have a better idea of how you’ll react.
Another thing to consider is the significant other in your life. If you’re married, think about how your spouse or partner will react – not just you. How they’ll react will have some influence on your investing decisions. That’s why there’s no one size fits all with asset allocation. You have to ask yourself how you – and others directly involved in your investing choices – will react in bad years.
Again, when you have 20+ years until retirement, I think that, generally, putting 60-90% in stocks is best. Some would even argue that you should put 100% in stocks if you’re a long way from retirement. But my big question would still be: “How will you handle a 50% loss in your portfolio?” That’s a very real possibility over a long period of time.
On the flip side, if you’re significantly below 60% in stocks, you may not earn enough to retire when and how you want to. If so, are you willing and able to save even more so that you can reach your retirement goals?
4. Know what comes with a bad market
Investing 100% in stocks looks good on paper, but you need to think about everything that comes with a down market.
I get emails and comments from folks all the time who will say that if you’re 20+ years from retirement, you should be 100% invested in stocks. Theoretically, I can’t argue with this approach. In fact, my portfolio was pretty much all in stocks at one point a number of years ago. Even Rick Ferri advises is children to invest everything in stocks.
If you are considering this allocation, understand that with a down market come a lot of other problems that may tempt you to sell out.
For instance, in 2008 it wasn’t just that the stock market was down. The housing market was a complete mess. People were underwater on the mortgages, and they were scared. Unemployment was on the rise, and people were losing their jobs. And it wasn’t even just job loss; people were having trouble finding new jobs even six months to a year later. There was concern that our whole financial system was going to collapse.
It’s easy to forget that this wasn’t just about a bad stock market. When the markets are down 30-40%, there are a lot of other scary things going on. So when you think about whether or not you can stick to a 100% stock allocation, it’s not just about the market. You’ve got to think about all the other things that go along with it.
In my experience, out of 100 people who are invested in 100% stocks, probably 98 of them shouldn’t be. It’s a rare breed of person who can truly stick to a 100% stock allocation during an ugly market like what we saw in 2008 and 2009.
5. Do what’s right for you
Finally, when it comes to this decision of stocks vs. bonds, it’s important to look at asset allocation as part of your total financial plan. For instance, look at the debt that you have, how much you’re saving, and your spending needs.
Can you get by on relatively low amounts of spending so that you can save a lot? Or are you spending a lot right now? How stable is your career? Would it be easy to get a comparable job if you were let go? Are you in a vibrant, growing market like the technology industry? Or would it be hard to find another job?
You may be thinking: “Yeah, those are all important things. But what do they have to do with how much I invest in stocks vs. bonds?”
All of those factors go into the question of whether or not you’ll be able to stick to your asset allocation plan during tough times. If you’ve got a ton of debt, you’re not saving a lot, and your career’s on shaky ground, you’re much more likely to abandon a stock-heavy asset allocation plan during a down market. You’re already under a lot of other pressure, and this is just one more thing.
But if you don’t have a lot of debt, are saving a lot of money, and are in a sustainable career, you’re probably less likely to abandon your asset allocation plan if it’s heavy in stocks – even if it’s at 80%, 90% or even 100% stocks.
That’s why you need to look at other factors outside of asset allocation in the stocks vs. bonds debate. Other factors will help you assess what type of risk you can tolerate – in good times and bad.
As a companion to this article, check out these 5 free resources to help you decide how much to invest in stocks.