The most important decision you’ll make about your portfolio
Published on - January 9th, 2013 (by Robert Brokamp) This is a post from staff writer Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service.
A lot of decisions will affect the future value of your portfolio – which investments you buy, how much you concentrate your portfolio into those investments, and when you decide to sell them. But it all starts with one very important question: How much risk are you going to take? For most investors, that question begins to be answered with the decision of how much they’ll put in the stock market, and how much to keep safer in cash and bonds.
Choosing the right stock/bond mix
The amount of your portfolio you keep out of the stock market is determined by four factors.
1. When you’ll need the money
If the purpose for which you’re investing is on the horizon – within the next three to five years – then keep that money in cash, certificates of deposit, or a short-term bond fund. From 1926 to 2011, stocks beat bonds in 60 percent of one-year periods, according to Ibbotson Associates. That percentage increases as the number of years measured increases. So, depending on how firm your need for the money, and the flexibility of the timing of your goal, the more money you should keep out of stocks.
Hang in there, baby!
2. Your risk tolerance based on history
The term “risk tolerance” gets thrown around so much that it’s become almost meaningless, especially since risk means different things to different people. In the context of deciding your stock/bond mix, risk generally means how much of a decline can you stand before you can stand no more – at which point you sell your stocks after a significant drop.
But another aspect of risk is the uncertainty of future returns, and thus the uncertainty of whether you’ll have enough money to do what you want. While stocks have historically outperformed bonds over the past 80-plus years, the record is not quite as definitive when returns are broken up by decade. The table below shows the compound average annual returns of different mixes of large-cap U.S. stocks and long-term government bonds over the past four decades, as well as the worst one-year return for each allocation since 1926.
| 1970s | 1980s | 1990s | 2000s | 2002-2011 | Worst One-Year Return | |
| 100% stocks/0% bonds | 5.9 | 17.6 | 18.2 | -0.9 | 2.9 | -43.3 |
| 70% stocks/30% bonds | 6.0 | 16.5 | 15.5 | 2.1 | 5.2 | -32.3 |
| 50% stocks/50% bonds | 6.0 | 15.5 | 13.6 | 3.9 | 6.5 | -24.7 |
| 30% stocks/70% bonds | 5.9 | 14.5 | 11.7 | 5.5 | 7.7 | -17.0 |
| 0% stocks/100% bonds | 5.5 | 12.6 | 8.8 | 7.7 | 8.9 | -14.9 |
Source: Ibbotson Associates
The more bonds are added, the more the range of returns is narrowed – on the upside and the downside. If you spend some time gazing at that table, you may get a better feel for the mix of stocks and bonds that is right for you.
3. What you really did
The Great Recession, during which stock markets dropped by half or more from October 2007 to March 2009, was a frightening time to be an investor. But like many times of tribulation, it offered us an opportunity to learn more about ourselves. In this case, you learned about your real-life risk tolerance – what you’d really do when the economy and markets are collapsing. Did you hold on, buy more, or sell? If the latter, did you get back into the market before it rebounded by more than 100 percent? What you did during those dark days says a lot about how much risk you can really stand. Because make no mistake: The stock market will tank again; we just don’t know when.
4. Your other assets and sources of income
There are other factors to consider when determining the riskiness of your portfolio:
- Your job: If you’re still working, the security and variability of your present and future income might play into your investment portfolio. If you have a reliable job with steady pay, you can take more risk. However, if your income is variable and unpredictable, you might want to play it a bit safer with your portfolio. Also, we hope it goes without saying that you shouldn’t have more than 5 percent of your portfolio in company stock.
- The amount of other income: Most Americans will receive some Social Security, which will provide a foundation (however modest) of retirement income that will be immune to market fluctuations. But you may have other sources of income that are at least partially independent of the stock and bond markets, such as a defined-benefit pension, annuity, trust, rents or business income. The more of this income you expect – and the more reliable that income will be – the more risk you can take with your investments.
The bondage bottom line
Given that interest rates are at lows not seen in decades, bonds are not very compelling these days. Many investors argue that it’s much less compelling to own bonds yielding 3 percent when you can buy stocks with the same yield, and get potential capital gains and dividend growth to boot. But stocks will always fall victim to large declines; the extent that your plans and your stomach can’t tolerate such drops is the extent to which your portfolio should be out of stocks.
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As always, my favorite GRS writer doesnt’ disappoint. My wife and I try to figure out stocks/savings and what we shoudl do and always find it difficult until we throw our hands up and decide to fiddle with it next month. This post is a great primer on getting started and what to think about!
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Another great article, Robert . . . thanks so much for continuing to be a great contributor to GRS.
Love the kitty photos, btw. Always need a kitty to spice up a financial article.
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Thanks Robert. I would love a primer on buying bonds for one of your future pieces. Buying stocks and mutual funds is very straightforward but buying bonds scares the heck out of me which is why we don’t own any bonds (other than the ones that may be in mutual funds). An explanation of coupons and a bond buying and selling walkthrough would be great.
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Robert,
Great article. Does Ibbotson make the data for the table available to anyone? I would like to see it expanded to earlier decades and split off certain periods other than decade-long periods.
Thanks
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Great advice on bonds. I love that your #1 point is “When You’ll Need the Money.” Too many people take on risk that they shouldn’t gambling for a few extra dollars in their pocket….
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“In the context of deciding your stock/bond mix, risk generally means how much of a decline can you stand before you can stand no more – at which point you sell your stocks after a significant drop.”
That’s an interesting way to look at it. Of course, the greater the decline in the stock market, the stupider it would be to panic and sell at the bottom. It’s probably pretty safe to assume that the stock market as a whole will eventually rebound from any crash – and if it doesn’t, that we’ll have bigger problems to worry about than the value of our investments.
In that sense, I’d say that “What mix of stocks and bonds is right for you?” is a less important question than “What are you going to do when the market tanks?” – and the latter is a question that people more often get wrong.
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Nice primer, Robert. For some reason, I have never been able to wrap my mind around investing in bonds. Not that I don’t believe they’re an important part of an investing portfolio, but just because I’ve found them a little confusing. I don’t even know if I’d be able to buy them in ShareBuilder!
It’s always been easier for me to just hand-pick a dozen or so blue-chip stocks, or to pick a low-cost index fund. Though as I’m in my low-30s now, I know that I need to gain some bond exposure.
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That table is really fascinating. My 401k is invested in a Target Date fund that is supposed to update the asset allocation as I get closer to retirement. I have another “fun” account outside of my 401k where I invest in stocks and index funds but maybe I should be looking at bonds as well. Thanks for the insight.
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While your asset allocation should be determined by your goals, that doesn’t mean your asset location must be. I keep all my after-tax money (except 1% cash for liquidity) in stocks, and keep my bonds in my IRA. That lowers the growth rate on my IRA and helps keep my RMD at age 70 down, and lowers income taxes now. If I need a large amount of cash, I’ll sell stocks in my after-tax account and buy in my IRA to rebalance.
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Re: “buy in my IRA to rebalance.”
I am a retiree, too. but the last part was confusing to me. I see the part about selling stocks in after-tax account when you need cash, but are you buying more bonds in IRA with some of this cash? That implies you take more cash than needed for the purchase requiring the cash in first place. I had not considered adding money to my IRA; didn’t realize one can do that after retirement. Thanks.
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Sorry for the confusion. No, unfortunately, you can’t add to the IRA if you’re not working. I also have stocks in my IRA, so if I have to sell after-tax stocks, I would buy enough stocks in the IRA to get my percentage up to target. Hope that makes things clear.
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Robert, as a financial planner, I don’t know how you can call bonds safe. Governments around the world, especially our own, are in a race to see who can destroy their currencies, and hence their economies, the fastest. Why on earth would anyone lend money to the US government, the most indebted entity in history, for 30 years at 3%? It doesn’t make any sense. The main buyer of US bonds is the Fed. You’re going to get paid back, if at all, in a rapidly depreciating currency. TIPS don’t work because the core CPI is nonsense, unless of course you don’t need shelter, food, or energy. That’s asking the fox to guard the henhouse anyways. All bonds are at artificially low and unsustainable yields.
Just as people thought housing prices would go up forever, they think interest rates and bond yields can stay low forever.
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What I should have done a better job of in the article is being more specific about how people should invest their non-stock money, and that bonds should be kept short-term, and that cash/CDs are a fine alternative for money you need in the next few years.
That said, you have to put your non-stock money somewhere, and regardless of what interest rates do, I’m comfortable saying that bonds — as a diversified asset class — are “safer” (less volatile, smaller drawdowns, less risk of total loss) than stocks.
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Thanks Robert. I think your article is great (should have said that before). But I worry that people think bonds are safe. Bonds, as a security class, are safer than other investments, true. But, their prices are so manipulated in today’s world that they are very dangerous, even in the short term.
I didn’t mean to imply that stocks are safer than bonds right now. No way. The low yields on bonds is artificially elevating stock prices. When interest rates rise (and they inevitably will), stock prices are going to come down too. The government can print money to pay back your government bond (with less purchasing power). A bankrupt company can’t return your equity.
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Thanks for the compliment on the article!
Your point about how a rise in interest rates will affect stock prices is a good one. I seem to recall the Leuthold Group doing some research on this, and finding that a modest increase is fine, but that bigger increases will begin to affect stock prices. I THINK I’m remembering that correctly.
Of course, the question then is: If both stocks and bonds look bad to you, what do you recommend? Cash? Gold? Tactical strategies?
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The people who forecasted the housing bubble are recommending hard and productive assets like gold, silver, oil, natural gas, land, etc., but outside the US (90% of home mortgages are owned or guaranteed by the wonderful people in Washington). I own physical gold and silver, stock in a Canadian natural gas company, stock in two oil companies, and I also put some money into a fund that invests internationally in equities of financially sound countries, like Australia, and parts of Asia that aren’t dependent on US consumption.
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I have a silly question….
I have a ShareBuilder and I was able to trade a few stocks. I wanted to get mutual funds but I found I needed a minimum investment of 1,000 for many of them.
Now on to the silly question. How do I purchase bonds? Do I have to go directly to a bank to get them? Are these bonds you talk of like those paper ones that my parents used to give me for my birthday that I had to put in a safety deposit box for 10 years for it to mature only to make a few dollars?
Thanks for your patience with my questions in advance
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As the goal really is to diversify, unless you have massive amounts of assets ( I mean close to a million dollars if not more), individual bonds are not really for you, or any small time investor. To get bonds it would be best to invest in a bond mutual fund, or Exchange Traded Fund (ETF). This is because most bonds are sold in 1000 dollar increments, which for small portfolios is an aweful lot tied up in one given company. ( Just like how you don’t want to have a lot of stock in any one given company, you don’t want to have too many bonds in a single company).
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I may be completely wrong, but I was under the impression that bond (and bond fund) prices are very high now in part b/c of the low interest rates – and that as soon as interest rates start going up, bond funds will lose value.
So I’ve kept my paltry 401k holdings 100% stock-based mutual funds even though I’m old enough that general recommendations would put a small slice into bonds, thinking that 4-5 years from now might be a better time to begin holding bonds.
I had not heard that stock prices would also go down if interest rates go up like Matt mentions –
Can anyone clarify?
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I too was at 100% stocks until I recently read William Bernstein’s “Investor’s Manifesto”. He makes a few points that a truly diversified portfolio cannot leave out a whole basic asset class, especially in an era where there is an increasing correlation between classes that used to have zero or negative correlation.
I’ve also read other things agreeing with this point that say 100% stocks does not increase returns by all that much, but significantly increases risk. A 20% increase in risk for a 0.5% extra return might not be worth it.
In response to this, I’ve updated my target asset allocation in my 401(k)s to be 80% stocks, 15% bonds, and 5% cash (to be ready to buy more stocks in the next inevitable market decline).
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Interesting take, thanks much – and I’d never thought or heard mention of keeping a small % of a 401k in cash for future purchases – it makes a lot of sense.
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Bonds are inherently safer than stocks: that company is legally “bonded” to make those payments.
A stock, on the other hand, could go to zero, and as an equity shareholder, you’re last in line to get paid back. In the event of bankruptcy, bondholders and senior security holders all get paid before common stock holders.
So, by lowering interest rates across the board and buying up bonds, the Fed effectively incentivizes investors to take more risks with their money. Instead of going for that puny yield on a 10 year, an investor will instead buy a stock, maybe one yielding 3%. This drives up the price of stocks, because people are more willing to put their money into them.
Should interest rates rise, bond yields will look more appealing, an investors will sell the risky 3% stock to go into the safer 2.5% bond. This will cause stocks to go down.
This is all in a normal economy. In our economy, if interest rates rise, The US defaults! That makes everything that much riskier, both stocks and bonds.
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Very informative article. Asset allocation is very important, thanks for breaking it down. Interesting to see how the various mixes would have performed.
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I’m all in. 100% in stocks. However, I am 22 and have time to recover losses. My funds are vanguard funds.
As far as asset allocation, I’m looking more at the sector the funds are in, whether they are US, International, or Emerging Markets.
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Sectors aren’t particularly import as compared to asset class. Large Cap, Small Cap, and Bonds all operate on different cyclical intervals. Being invested in most major asset classes (without overlap) ensures that you capture the average growth of the market as a whole.
I would also add (and this is my opinion) people look at the stock market the wrong way in that they expect it to go up and panic when it goes down. I think the most effective view is to expect it to not grow very much (at inflation) and be excited when it goes above that.
Power of positive thinking and all that jazz.
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Good post Robert,
I would add to the list taking back control of your portfolio from your broker.
If you loose money you’ll get over it.
If someone else looses your money you want to loose your mind.
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I enjoy Robert’s articles, but traditional retirement advice always seems to focus on a playing not to lose strategy (i.e., a sterile top-down approach in terms of % stocks, % bonds, U.S. vs. foreign, etc.).
Here’s what I really want to know: is the goal to beat the S&P 500? If these retirement strategies rarely beat the S&P 500 over 25 or 30 years, then why do people follow them? Seems like a waste of time, especially since people tend to withdraw from their retirement gradually over a long course of time (instead of a lump-sum cash-out, where the market may be at a nadir).
In other words, who cares about the best or worst years over 30 years? Why not focus on total ROI?
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The Great Recession was actually a GREAT time to be an investor…assuming that you received a large amount of money and had the ability to invest in proven winners that were suffering as a result of the economy.
I was lucky enough to have enlisted in the Navy and was in boot camp when the worst hit happened in October of 2008, and sure enough when I finished that, I found myself a few thousand dollars of bonus money and GE at a ridiculously low price. 3 years later, that stock has more than doubled, added a nice dividend, and voila.
Same with the housing market…I ended up purchasing my first home last year when the mortgage rates were rock bottom and home prices had barely started to rise. Sadly, this luck doesn’t extend to the casino!
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Thanks for this write-up. It’s interesting to see suggestions on portfolio diversification. I’ll have to check out other pages on your site as well.
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