How Much Should You Invest in Stocks?

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After nine years of rising stock prices, it's easy to think that stocks only go up. While that may be true over very long periods of time, whether stocks will be worth more one or even five years from now is far from certain.

For this reason, it makes sense to diversify your portfolio with investments in stocks and bonds with the goal of generating a reasonable return without undue risk. How much of your portfolio you should put in stocks is an inexact science, but two rules of thumb can be useful for determining the right mix for you.

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A timeline-based approach to stock allocation

The last thing any soon-to-be retiree wants to see is a 20% drop in his or her retirement account just as he or she prepares to start taking money out of it. That's why virtually everyone is in agreement that the amount of risk you take in stocks should go down as your retirement date nears.

I like the idea of borrowing wisdom from people and institutions who spend a lot of time thinking about the right mix of stocks and bonds based on an expected retirement date. The stock allocation of Vanguard's target-date funds, which automatically shift in composition toward safer investments as the investor reaches their retirement date, may be worth copying in your own portfolio.

Notice Vanguard's stock allocation is particularly high (90%) for anyone who is at least 25 years from retirement. That's likely because there haven't been any 25-year periods over which a diversified portfolio of stocks has declined in value, so people who have a lot of time until retirement can confidently afford to be heavily invested in stocks.

Over shorter periods of time, though, returns can vary, often wildly. History tells us that stocks produce negative returns in roughly one out of three one-year periods. Even if we increase the time span to five years, stocks produce negative returns about 20% of the time. But as your holding period lengthens, the probability you earn a negative return on stocks nears 0%, which is why people who are further from retirement can afford to invest more in stocks.

Investing in stocks based on your risk tolerance

Not everyone is keen on blindly following asset allocation guidelines through the ups and downs. While you might plan to retire 40 years from now, a 90% allocation to stocks may lead to stomach-churning volatility in your portfolio that makes it hard to sleep at night. Investing isn't worth losing sleep over.

In his book, The Intelligent Asset Allocator, William Bernstein lays out an easy-to-use table to determine your asset allocation, based on your risk tolerance. Here's a reproduction of that table:

So, based on Bernstein's advice, people who can stomach a 35% drop in their portfolio can afford to keep 80% of their assets in stocks. Based on historical returns, that seems pretty reasonable.

As anyone will tell you, it only gets harder and harder to stay rational when you have more of your net worth tied up in stocks. For a 25-year old who just began saving, a 20% decline in the S&P 500 is far from disaster, a rounding error in the grand scheme of things. But for a 45-year-old who has been in the market for 20 years, it's possible that he or she could lose the equivalent of a year's salary, if not more, to the occasional bear market in stocks.

Imagine going to work every day for a year, sending a chunk of your salary to your 401(K), and ending up $50,000 poorer in December than you were in January. That happens when stocks drop, and it's certainly not fun for anyone who has to experience it.

I like Bernstein's tables because they show you what it really means to have 80% of your assets in stocks (suffering the occasional 35% drop) or 20% of your assets in stocks (occasionally losing 5% of your portfolio). Having a lot of money in stocks does result in higher returns over the long run, but it also means you'll have to tolerate getting punched in the gut from time to time.

Knowing yourself is what matters most

There's nothing wrong with being more conservative if it means you'll be able to stay in the markets through their ups and downs. It's better to have 60% of your money in stocks and stick with it than have 80% of your money in stocks and sell everything you own in the next downturn.

It's easy to forget how it feels to lose money, and quickly, in stocks, even if stocks generally go up in value over time. A New York Times story documents the widespread panic that happened less than 10 years ago, when investors called up their financial advisors to talk about their asset allocation, but only after stocks had already dropped more than 30% from their peak during the financial crisis.

"There was a marked increase in the number of calls focused on asset allocation and 401(k)'s," said one broker quoted in the story, referring to an increase in phone calls he received during the fourth quarter of 2008, a three-month period in which stocks plunged 22.6% as investors bailed out.

The point is that no one knows with certainty whether stocks will be worth more or less tomorrow or even five years from now. The key is having a mix of investments that will enable you to hold on for long periods of time, since over the long haul, the data is clear: Stocks produce very good returns, but only if you can stick with your asset allocation plan when everyone else is losing their mind.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.