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Can you explain – with data – why you own the allocation of stocks and bonds that you do? Can your financial advisor? This article will give you the framework to decide the appropriate allocation of stocks and bonds for your family, at all stages of your life.
What is the goal of portfolio allocation, anyway? In my eyes, portfolio allocation is about finding the optimal balance for you between 1) maximum accumulation and 2) your tolerance for risk.
Naturally, we all want the highest returns. However, your investment options with overall higher returns will tend to be riskier – the market demands a higher return in exchange for taking on more risk, which creates this dynamic. So when you show up at the table ready to purchase, you will find a smorgasbord of options with different growth and risk profiles, and you are mixing them to create your perfect blend.
I’d like to spend a moment more on the subject or risk. I don’t think that the investment industry spends enough time highlighting the fact that the evaluation of risk depends somewhat significantly on your timeline for your hold. Is holding stocks equally risky for you and for your parents? Sort of. Depends on how you define risk. If you define risk as exposure to an adverse outcome, and the likelihood of such an adverse exposure, you will notice that where you cut off the timeline matters a lot to the ‘likelihood of such an adverse exposure.’
Here’s an example. Suppose there is an investment option in which you flip a coin. If it comes up heads, you double your money. If it comes up tails, you halve your money. The expected value of those bets – in the long run – is 1.25. You would be making a 25% return in the long run. Pretty good! I wouldn’t say that is that risky at all. But we are omitting a key piece of information. If I told you that you could flip the coin only once every 50 years, the risk of an adverse outcome in the time frame that matters to you – your lifetime – would be very high. Suppose you didn’t need that money for 10,000 years, though. Now all of a sudden you are probably quite comfortable with the risk profile.
Shorten that period to months or years. Now you see a framework for many realistic retirement decisions. Many financial advisors will recommend a higher allocation of investments like bonds for older folks, not because stocks are suddenly much ‘riskier’, but because the aspiring retirees has a shorter the time frame they have before they must withdraw that money. They start to slice past data into one or two year time frames rather than decades, and they don’t like what they see. They have less time to ride out big dips in their portfolio. Keep in mind that any discussion you have with experts or friends about how ‘risky’ an asset class is requires a conversation of what time period you are both using to evaluate your exposure.
In this post, we will focus on two of the most popular asset classes for which there is a wealth of historical data: stocks and bonds.
Take Your Inventory: What’s Your Allocation Today?
What’s your current stock and bond allocation, and what tickers do you hold? If you don’t already have a single pane of glass view into all your holdings, get started now so you are informed for this walk-through. You want to be able to see your net worth and your expenses every day at a moment’s notice, and you will get the most out of this article if you are able to look at your own allocation along the way. My favorite is a free service called Personal Capital. They offer their dashboard tool for free where you can hook up all your accounts to see everything from a bird’s eye view, and it comes with automatic benchmarks like how your cash balance compares to others’ portfolios, how your expense ratios on funds purchased compare to industry standard, etc. If you want to learn more, you can check out how I use their system here.
The Problem With Rules of Thumb
You have probably seen some sort of nifty chart on the internet summarizing exactly what percentage of stocks and bonds you should have by age. Or perhaps you’ve heard the oft-cited recommendation to have your age in bonds – if you are 20, you should have 20% of your portfolio in bonds, and so forth. Is this good advice?
I don’t think it is.
Here are my two reasons.
Age-Based Rules Are Inaccurate
Most rules of thumbs like the above are age-based recommendations, but it’s not your age that dictates your appetite for risk. It’s your distance from retirement. What matters is the stage at which you will no longer be generating additional cash and must rely on your portfolio for all your needs.
As we described above, as you near your retirement, you have less time to ride out big dips in your portfolio value, so you naturally shy away from assets that could cause that. That means most of these charts are trying to fit the average age of retirement against a chart of age cohorts, and give you advice as if you were targeting an average retirement age of 60+. For us early retirees, this will cause extremely imbalanced portfolios. I’m retired in my 20’s. Should I have a 20’s percentage allocation to safer assets like bonds? No financial advisor worth their salt would say so, knowing the key fact that I’m already retired.
Most Rules of Thumbs Don’t Take Into Account Your Nest Egg Size vs Need
A chart with recommended allocations often does not take into account the amount of growth you may actually need from your nest egg.
If you had amassed a huge nest egg before you retired, one on which you could live on less than 3.5% of your portfolio, there are numerous bond options and bond ladders that could probably meet your needs completely. You could have a zero stock allocation, or perhaps a 10-20% stock allocation rather than the 40% a chart might recommend for you. Why add extra risk into the mix when you have no need for the reward? Most recommendations are made without knowing the state of your assets and how far you have to reach for growth. It assumes you want to maximize growth and are willing to take risks to get there, but it doesn’t know when to stop.
Conversely, say you haven’t done as great a job saving for retirement but for some combination of reasons you’ve got to call it quits anyway on the working world. A chart based on your age might say, “hey, go 65% bonds and 35% stocks.” But given the historical rate of returns on those assets, perhaps the money thrown off doesn’t come near to providing what you need. Of course no one wants take on more risk, but if you’re settling for an allocation that is almost guaranteed not to provide what you need, is that better? Wouldn’t you rather make an informed decision?
To get to the heart of the matter, we will perform the root analysis that any financial advisor building a rule of thumb chart would be doing behind the scenes. And by understanding the process and doing it ourselves, we can factor in our unique details to ensure the fit is perfect.
So where does one start when trying to build a portfolio allocation?
It is useful to get a sense for how assets have performed in the past. While past performance is not a guarantee of future performance, it gives you a place to anchor. It’s extremely unlikely an asset class yielding 5-6% returns for the past 100 years is going to jump to 25% returns, for example.
For this reason, I like to base most of my investment decision on analysis of past data. At the end, I like to layer in my knowledge of current events and potential exogenous factors to temper the analysis before making a final decision. So the research phase consists of two parts:
- Analysis of past performance data for each asset
- Addition of current events and other exogenous factors which might affect your prediction of what future performance will look like for those assets
Analysis Through Past Performance
We are going to review to common portfolio allocations together based on their historical performance. One will be a 100% total stock market portfolio, a portfolio you hear often touted for young people just starting out. We will then evaluate a 60% stock/40% bond allocation, an oft-recommended mix for those in their 30’s and 40’s. You can use this framework, find other portfolio allocation ideas, and run wild with expanding your analysis to your heart’s desire against other options that come your way.
This post’s charts come from a gem of a site called Portfolio Charts. It is only a sub-section of the visuals he’s put together and I highly encourage you to check out all the other fantastic data visualizations the site offers. For most people, I think the level of granularity of this site is perfect. You may find you want different cuts of data as you get into your analysis that are not provided on this site. Perhaps you want to measure a slightly different basket of equities, or measure it over a different time period. You can always pull the raw data yourself and build your own historical charts. The framework below still applies.
100% Total US Stock Market Portfolio
When evaluating a portfolio allocation, you want to examine a few key basic points:
- Average Return: What has the return been for the time frame I care about? What is the average return for that time period?
- Range of Performance: What has been the absolutely best and absolute worst this portfolio has yielded in the past?
- Frequency/Probability: What is the likeliest/most common return for a given time period within the range observed above?
- Recovery: In the circumstances in which there is an adverse outcome, how long has it taken to crawl out of that hole?
Here is a bar chart showing the compound annual growth rate for each 15-year period since 1970. You will notice it stops at 2002. That’s because 2002 is the last start year for which we have 15 years of data. You can run your eye along the chart to get a sense for the typical return. The median is somewhere north of 8%.
Keep in mind that this chart offers real CAGR rates, which means it has already been adjusted for inflation. You have probably heard that the stock market long term typically yields 10%+ in the long run. Add in 2-3% inflation per year to these figures, and you will find that conventional wisdom matches what you see in the chart.
Recent years look less compelling. Of course, we know that 2000 was the internet bubble, and having a huge down year early into the investment has a huge impact on overall returns. You lose a huge chunk early on, which means you have less dollars at work for you when the recovery eventually does happen. This exogenous factor is definitely something to keep in mind – we can’t discount it completely because it’s entirely possible you will end up investing into a bubble, but it’s probably unfair to say we should expect the future to look like a particularly crappy period of history. We will discuss this later when we layer in our knowledge of current events.
Overall, looking at this chart, I take away the following: 1) the median 15-year real CAGR is somewhere in the 8% range. 2) Recent years look not as great and I need to look into whether recent period performance is more indicative of what I can expect, or if I can lean more towards the average over the entire period shown.
Range of Performance
Next, we consider the range of performance. This chart shows you the CAGR observed for every period length. The most the US Stock market has grown in any one year period is about 33%, and the most it has dropped in any one year period is about 37%.
Now move further along the axis. The most the US stock market has grown in any 10 or 11-year period is about a 15% compound annual growth rate – the equivalent performance of growing 15% a year, for each of 10-11 years. The worst it’s done in any 10-11 year period is a 0% CAGR. Remember that inflation has been factored in. That means the worst anyone historically has done by investing in the stock market is to come out completely even. That’s obviously not the best outcome in the world, but it is somewhat comforting to know that over a 10-year time period, people historically don’t lose their shirts in the stock market. Looking at this data, you can start to see why many experts recommend large stock allocations when you have a long-term, 10+ year time frame for your money. In a bad case, maybe come out even. In a good case, you can see a 15% CAGR which basically means you would 4x your money in 10 years!!
Those ranges look eye-poppingly good as you come out to a longer term, 5-10+ year hold. Of course, you may be shrewdly asking yourself an important, related question. Sure the best case looks way better than the worst case, but what also matters is your probability of achieving that best case vs your probability of achieving that worst case. If there’s a 90% chance you make 0% over 10 years, and only a 10% chance you 4x your money, maybe that’s not so compelling.
We now turn to a chart that helps us narrow in on this. This chart shows you each start year, and it’s CAGR along every period of time. For our purposes, we want to look at all the outcomes for a given 5-year period, or 10-year period, or 15. To do this, we find the corresponding number on the X-axis, and just drag our eye straight down that column. Here’s an example of the 10-year view:
There are 38 colored boxes for the 10-year period. That means there are 38 data points of 10-year holds we can look at. The boxes are color coded for approximate real CAGR (again, inflation adjusted already). Here is how the 10-year hold breaks down:
|Real CAGR||# of Data Points||Percentage Frequency|
By this point, you should have a pretty good feel for whether you like this allocation or not. The final chart is in many ways optional, but I think it is especially comforting for the worriers in the room who secretly fear their nest egg will get cut in half and they will live in a cardboard box in the gutter with only two cats Harry and Sally to keep them in company and two empty tins of…
Oh, did I give myself away? Yes, I’m a worrier, too. And this chart can get you over the hump enough to pull the trigger on an allocation. It essentially measures every single instance of a nest egg dropping below its initial value, and then measuring how many years it took for the nest egg to get back to even. Note that for some of these data points, this doesn’t happen at the beginning of the investment. Maybe you invest and for a couple years things are going well. Then a giant 2008/2009-type crisis happens and your portfolio loses a huge chunk of its value, now dropping below what you had before you started investing. That’s the point at which this chart picks up a data point.
You can pull three things from this chart. You can count the number of individual lines, which will tell you how many instances there were of a portfolio ever dropping before its initial value. Then, you can observe a) how long it took to get back to zero and b) how many lines required that same amount of time to get a frequency feel.
When I look at this particular chart, I see that the longest recovery took 12 years. A little longer than I expected, but there’s only one data point there. The majority of losses, more than recovered by the 5 year mark. You have to pair that with the frequency of average CAGR’s you observed above and determine if the risk is worth the reward. I look at that and think yes, it certainly is. In fact, for my particular risk profile, this chart makes me start to think that I’m comfortable with a large stock allocation if I have a 5-6 year hold horizon, not necessarily a 10+ year hold horizon. I might be one of the lines that takes more than 5 years to recover, but there don’t seem to be many of those. I can mitigate any potential pain by having a year’s worth of living expenses in the bank so I’m not drawing money down at the worst time in the market, and various other strategies to give me cushion.
More conservative folks will say no, I’d like to set a hold period longer than the absolute worst case scenario to stay safe. This is where the rubber meets the road and you make a personal decision that fits your appetite for risk vs reward.
60% Stocks, 40% Bonds – Rebalanced Every Year
Now that we’ve done one together, you might try evaluating the following visuals on your own and comparing the results to the 100% stock allocation above. I’m going to skip the long explanations and just call out the major points I see this time.
The median return appears to be close to 6% vs the median return of 8% in the 100% stock allocation. This is the difference of growing your money 5.7 times vs 10 times in 30 years.
Max 1-year real CAGR of 25% vs worst 1-year real CAGR of -23%. This compares to a max 1-year real CAGR of 33% and a worst 1-year real CAGR of -37% in the 100% stock allocation.
Max 10 or 11-year CAGR of 11% and worst 10 or 11-year CAGR of 0%. This compares to a max 10 or 11-year CAGR of 15% and a worst 10 or 11-year CAGR of 0% in the 100% stock allocation.
These data points make me think that if I have a long period to hold, I am much better off with a 100% stock allocation, where as a short 1-year time frame is kind of a wash, probably leaning towards the 60-40 split because that kind of rollercoaster does not seem very fun. Of course, we are still missing a very critical piece of information which is the frequency of the outcomes in these ranges.
I look at the colored boxes again for the 10-year period, and these are the key data points I pull out:
|Real CAGR||# of Data Points||Percentage Frequency|
And here’s the side by side comparison to the 100% stock allocation above:
|Real CAGR||60-40||100% Stock|
100% stock seems noticeably better for the 10-year hold I’m evaluating. The frequency of the negative and breakeven scenarios is basically the same, but my outcomes of 6%+ real returns – which I consider pretty strong – are 52% in the 60-40 split vs 66% in the 100% stock allocation. Perhaps even more importantly, when you win in the 100% stock allocation, you win big: the frequency of 9%+ CAGRs is twice that of the 60-40 split.
What If I’m Retiring In Less Than 10 Years?
If you are less than 10 years away from retirement, you may want to examine different time periods using the same technique. Maybe you want to look at the 5-year period as well. Keep in mind that even if you do retire in less than 10 years, that doesn’t mean the 10-year hold isn’t still relevant to you. If you are comfortable with the risk of falls before the 10-year period, you can still allocate more aggressively towards stocks. Maybe you mitigate your risk because you’ll be retired but you have social security coming in and that pays for most of your basic needs, meaning you don’t have to touch your nest egg if it hits a rough patch.
Longest recovery time was 12 years. Interesting. I would have thought it would be less than the worst scenario in the 100% stock allocation because of lower overall volatility, but they are identical.
In general, the total dip appears to be within a more narrow band – it would be easier to sleep at night witnessing a 20-30% total fall in net worth in the 60-40 scenario than it would be to witness the 40-50% haircut the worst period of 100% stock allocation created. If the idea of a 40% haircut makes you queasy, you may need to rethink a 100% stock allocation despite all the positive points we’ve noted. Perhaps a 60-40 split even when you have 10+ years to hold your investments is a better fit for you.
The final step in coming to an allocation decision is to layer in your perspective on current events and future outlook on top of the historical data. Past performance is no guarantee of future performance. What do early indicators suggest will be happening.
I’ve written in some detail about what I think will happen to the stock market here and the bond market here. In short, I expect the average stock return to come down from historical averages by one to two points. You would think that would mean I would want to go more overweight on bonds. That is somewhat true, but more in the long-term. The article touches on some intermediate-window forces that make me hesitant to go too heavily into bonds right now.
Finally, the political climate makes me more nervous about a stock correction. Exactly how nervous? Nervous enough to be checking the news every day, not nervous enough to sell of everything and hide in a nuclear shelter. Yet.
100% Stock vs A Stock and Bond Split
My general view is quite positive on a near 100% stock allocation for those who have more than a 10-year investment horizon. Keep in mind that a 10-year investment horizon does not necessarily mean 10 years to retirement: you could be less than 10 years away from retirement but have a financial system set-up with pensions, social security, part-time jobs, a few years of expenses in cash at the bank, or any other various levers that make a 10-year hold bleeding into your retirement a very real possibility.
Given some of the current events and political issues we are facing, I am somewhat leery of a stock market correction. The challenge is there is always some valid-sounding argument to be cynical about the stock market (the market has hit ‘historical highs’ many years in a row), and if you pull out too soon, you miss years of potential double digit returns by sitting on the sidelines. What is an informed, worried investor to do? I personally am not concerned enough to go to a majority bond/cash allocation as some of my compatriots are, but I am cynical enough that I have a chunk of my portfolio sitting in reserve ready to buy stocks at a discount if they drop steeply. The opportunity cost of leaving this money in a high yield savings account is steep, so I’ve instead devised a different place to put it to work – we’ll talk about my current portfolio allocation and how I’m trying to handle the current economic winds in a separate, more detailed post next week.
Know that these ideas are just the first building blocks to a deep understanding of portfolio allocation. There are numerous additional analyses which are valid and useful (you can find some more of them at portfoliocharts.com) should you desire a more nuanced perspective. For example, once you complete the accumulation phase and enter retirement, you can model what withdrawal rate has been safe to draw using these allocations. The possibilities are endless. However, if you understand the above, you are more than 95% of the way there and easily one of the most informed of your colleagues when it comes to investment allocation. I’d challenge the majority of financial advisors – who make allocation recommendations every day – to rattle these key pieces of information off at will. You will now be able to.
No matter your personal risk appetite and growth needs, working or retired, there is an allocation for you. Hopefully with these tools and frameworks you will be able to find it.
Maximize Your Wealth
Keep track of your new allocation with a free net worth and expense tracking tool. You improve what you measure, and you want to have these key pieces of data at your fingertips. My favorite service for this is Personal Capital, and it’s free. Their dashboard allows you to see all your holdings from bird’s eye view, as well as drill down in real-time to tweak your behavior like isolating problem spending patterns, trimming your budgets, and cutting your investment fees by benchmarking them against other options. They monetize by eventually trying to upsell you on wealth management services and offer you a free consultation with their advisors, but you can always decline the consultation. You can read more about how I use their system here.
What is your current portfolio allocation? What do you like about it? What concerns about your allocation, if any, are you struggling with?