The Most Important Decision You'll Make About Your Portfolio

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Published January 16, 2013

| GetRichSlowly.org

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% 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.

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%? 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% 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% 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.

The original article can be found at GetRichSlowly.org:
The most important decision you'll make about your portfolio

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