Stocks vs. Bonds: Picking the Right Mix for Your Situation
[The way you divide your portfolio between stocks and fixed income investments has a greater influence on your eventual returns than any other single decision. In this article, we look at historical patterns and how they can be used to guide your portfolio allocations in the new year.]
Like all the other kids, I wanted to see Jurassic Park when it came out in the summer of 1993. As I expected, it turned out to be an action-packed, nerve-wracking tale overflowing with amazing special effects. Having read the book, I enjoyed the intellectual stimulation and the way the story got me to thinking about the critical importance of boundaries.
Boundaries exist for safety reasons; breaking through them can be dangerous. The film is frightening because the prehistoric creatures break through physical boundaries and attack the tourists. And it provokes us to weigh the risks before breaking through scientific boundaries and playing with the building blocks of life. It may even have something to say to societies that are breaking through moral boundaries and removing limits on personal freedoms that have characterized civilized societies for thousands of years.
Because I'm a person who thinks a lot about how to help people invest more successfully, the film caused me to also reflect on the risks taken by those who willfully ignore time boundaries. We are quite limited as to what we can know of the future with certainty.
My favorite character in Jurassic Park is Malcolm, the "chaos theory" scientist. In the book, I particularly liked this passage where he is describing to a co-worker why many events are inherently, inescapably unpredictable: "Computers were built because mathematicians thought that if you had a machine to handle a lot of variables simultaneously, you would be able to predict the weather. Weather would finally fall to human understanding. And men believed that dream for the next forty years. They believed that prediction was just a function of keeping track of things. If you knew enough, you could predict anything.
"Chaos theory throws it right out the window. It says that you can never predict certain phenomena at all. You can never predict the weather more than a few days away. All the money that has been spent on long-range forecasting is money wasted. It's a fool's errand. It's as pointless as trying to turn lead into gold. We've tried the impossible-and spent a lot of money doing it. Because in fact there are great categories of phenomena that are inherently unpredictable."
"Chaos says that?"
"Yes, and it is astonishing how few people care to hear it."
Consider that last line: ". . . it is astonishing how few people care to hear it." How well that applies to us when we're making investment decisions! We refuse to believe that the markets, like the weather, cannot be accurately predicted. Throughout my advisory career I've seen people suffer financially because they look to the forecasts and opinions of gurus and experts to guide their decisions.
I was slow in accepting this limitation myself. But it's very important we learn to admit, "I don't know what the future holds. The financial commentators in the media don't know. Investment experts don't know. Nobody knows. So, I must face the fact that I can never know in advance which investment alternatives will make the most money, lose the most money, or do little at all."
This uncertainty makes it difficult to know how much to increase or decrease our investment risk-and the potential gains we're hoping for-after experiencing significant changes in wealth, or as we near the end of our investment timeframe.
In 5 Easy Steps to Start Investing the SMI Way, I offer my opinion on how this might best be done. The risk matrix (step 3) balances the two competing influences in your investment planning-your fear of loss and your need for growth. On the one hand, I believe that you should "be yourself" as you make investing decisions. The quiz I designed (step 2) helps you select the investing temperament best suited to your personality by probing the intensity of your fear of losing money (an ever-present possibility in the markets). It's important that you be emotionally comfortable with your strategy. Otherwise, it's questionable if you'll develop the confidence and discipline needed to hang in there when the periodic storms of market turbulence blow through. Your responses to the market during these past three years may provide an even more accurate view of your true risk tolerance!
On the other hand, your investing strategy must face the realities of your present stage of life-how much time remains before you reach retirement, and what financial goals do you hope to achieve by that time? If you structure your portfolio too conservatively, your investment capital may not grow by the needed amount. But if you take too great a risk, you could suffer a large loss just before you need to withdraw capital for living expenses.
In the risk matrix, I offer suggestions on how much to invest in stocks and stock funds versus how much to invest in savings accounts, bonds and bond funds, and other fixed income holdings. As I point out, however, this matrix reflects my personal sense of risk. Other investment advisers might feel more comfortable with less conservative guidelines.
In determining your ideal stock/bond allocation, balance is the key. You need stocks for growth and bonds for income, but, putting your emotions aside, how much of each would be best given your current age and the amount of time before you'll need to begin cashing in your portfolio?
Patterns from the Past
To help put that question into historical perspective, I've prepared the table linked to below. The six columns correspond to the different approaches for organizing your investments that are found in the risk matrix. They range from a very aggressive strategy of investing all your money in blue chip stocks to a more conservative strategy of investing only in government bonds. For each of the six portfolio combinations, the historical results over the past half-century are shown. You may wish to print the table, as we will refer to it repeatedly throughout the remainder of the article.
Table: Historical Investment Returns of Various Portfolio Combinations 1950-2003
Let's start at the top (scenarios one through six) with a look at "rolling" one-year periods. Market results are usually stated in terms of calendar years. For instance, an analyst might claim that a search of the historical data since 1950 revealed that the single worst twelve-month performance for a portfolio of large-company stocks was a loss of 26.5%. What the analyst has done is to look at the year-by-year results and picked 1974 as the twelve months with the worst performance. But investors don't invest only on January 1, so that report is somewhat misleading as to the potential risk. That's where the use of "rolling" periods can be helpful. Here's how I ran the calculations.
After looking at the results from buying on January 1, 1950, and holding for twelve months, I then "rolled" to the next month to see what happened if the stocks had been purchased on February 1 and held for twelve months. Then I moved to March 1 and did the same thing. And so on. Continuing in this way, I computed the results for all of the 637 twelve-month holding periods from 1950 through 2003. This is in contrast to just 54 periods when only calendar years are considered. Using this more exhaustive process provides a more accurate picture of the degree of volatility and level of returns that can be expected from different blends of stocks and bonds. In our example, I found that the worst-case one-year performance for the large-company stocks in the S&P 500 index was actually a loss of 38.9% (October 1973-September 1974), as shown in scenario 1.
This analysis is based on the Stocks of large companies that make up the S&P 500 index. Including small company stocks would improve the profit potential but also increase the risks. For a similar table contrasting large vs small companies, see page 290 in my book.
Lessons to be Learned
The forty-eight different scenarios shown in the table reflect the basic risk-reward relationships that apply when owning blue chip stocks and government bonds in combination. If you study the numbers you'll see once again that:
• The shorter your holding period, the higher the risks and potential rewards. Over a thirty-year holding period (scenarios 43-48), the range of likely results is relatively narrow. They are shown on the line where it says "result 95% of the time." Even in an all-stock portfolio (such as scenario 43), this range of likely results is less than five percentage points per year from low to high. As you move up the table to shorter holding periods, the range broadens, that is, it becomes more volatile. By the time you get to a one-year holding period in the all-stock portfolio (scenario 1), there is more than a 64 percentage point difference from low to high in the range of likely results.
• The more you allocate to stocks, the higher the risks and potential rewards. The table illustrates the extent to which blue chip stocks carry greater risks than intermediate-term government bonds. As you move from right to left across the table, from mostly bonds to mostly stocks, the "best" and "worst" results become more exaggerated. These extremes don't come along very often, so you shouldn't weigh them too heavily in your decisions, but it's good to keep in mind the full range of possibilities.
• There's no sure thing. Pretend you watched the companies in the S&P 500 index return an average of 20.8% per year, every year, for five years. This is what happened from October 1992-September 1997. You say to yourself, "I want to get in on this!" and in October 1997 you invest your retirement money in those very same stocks. You are sorely disappointed as the next five-year period unfolds and you actually lose money-an average of 1.6% per year. You didn't earn the "average" 12.5% gain typical of a five-year holding period (scenario 13). Nor did your returns fall within the range of results that investors who held on for five years received 95% of the time. You, unfortunately, were invested during one of the few five-year periods that was an uncharacteristic underachiever. You knew it could happen; scenario 13 shows that stocks have indeed lost money during some five-year periods, the worst being losses of 4.1% per year. You were hoping it wouldn't happen to you. But it can, and it did. That's why Wall Street is always reminding you that "past performance is no guarantee of future results."
Applying This to Your Situation
Here's how to apply this information to your situation. First, define your timeframe. If retirement is your goal, you will want to determine how long you plan to continue working and then match that with the row of the table that comes closest. Along with your timeframe, it helps to know the target dollar amount you are trying to accumulate. The reason this is important is that you want to select the allocation most likely to help you achieve your target, while incurring the least amount of necessary risk along the way. A tool like our Retirement Countdown bonus report can be valuable in helping you define a precise target amount.
Let's walk through an example of how this might work in real life. Consider a couple with ten years left until they hope to retire, and a portfolio of $180,000. After crunching the numbers using the worksheets in the Retirement Countdown bonus report, they determine they will need $560,000 on hand when they retire. This somewhat shocking revelation inspires a close look at their budget, where they see an ability to contribute $7,000 each of the remaining 10 years into their retirement plan.
Using a financial calculator, they learn they will need to earn 9.6% per year to meet their goal. (Many good financial calculators are available online. For this calculation, try this rate of return calculator.) Looking at the 5 Easy Steps risk matrix, this couple sees that a 40% stock, 60% bond is recommended for their age and risk tolerance. However, in looking at the table from this article, they see that the average 10-year return of a 40/60 allocation has been 9.1% (scenario 22). If the next 10 years is "average," they will fall short of their goal. On the other hand, 10.1% has been the average annual gain from a 60/40 allocation (scenario 21). By moving up the risk ladder to a higher stock allocation, our hypothetical couple has a good chance of meeting or exceeding their goal. Even so, this is no lock-the table also tells them that results as low as 2.6% annually are not outside the historical record. This means they should repeat their analysis annually and be alert for the need for further adjustments to their portfolio mix and savings rate.
There's one wrinkle they can add to minimize the risk that poor results in the final few years will sabotage their strategy. If at any point along the way, they find they could reach their 10-year target with a dramatically lower stock allocation, they should make that change. For instance, assume they are able to add more to their retirement plan each year than expected. At the midpoint, they run the numbers again and find that in order to reach their goal, they now only need to average 5.3% returns. In that event, they might consider CD's or another secure savings device guaranteed to meet their goal. At the very least, they would likely want to drop down to a lower stock allocation. Some would hesitate, saying they could make more by staying with their 60/40 allocation. Perhaps. Perhaps not. Nobody knows. The important thing is to reach their goal, not "make more money."
How you react to the data in this article depends laregely on your temperament and how long you plan to invest.
Nothing in this article is meant to sway you toward a certain class of investments. Rather, it was written to help you better understand that there is no single "right" way to arrange your portfolio, and that you must make trade-offs between the risks you're willing to take and the rewards you hope to reap.
The length of time you plan to invest will also likely impact your interpretation of the table. If you are:
• Within 5 years of retirement (or other financial goal), your focus should be on the worst case scenarios. You don't have the time cushion to recover from severe losses, making preservation a higher priority than growth.
• More than 10 years away, your focus should be on the averages. For one thing, the exact amounts you'll need are much more variable and likely to change. You should also have a bias towards stocks, due to your longer time frame. As you can see in the table, at 15 years the worst case scenarios of all the different allocations start to bunch together, and for twenty year periods and longer the worst cases favor owning more stocks rather than less.
• Between 5-10 years, this is probably the toughest group to plan for. At this time interval, your projected needs should be coming into focus, and you may be feeling that the only way to hit your goal is to take on more stock market risk than you're comfortable with. In this case, you may find comfort looking at the lowest result within the 95% "normal" range. Someone with a 20/80 allocation in their five-year portfolio (scenario 17) might gather the boldness to move up to a 60/40 mix (scenario 15) when they see that the average and best case results are substantially better while the low end of the "normal" range is only slightly worse.
One way to continue using a relatively high stock allocation as you approach retirement is to extend your time horizon. You can do this by investing a portion of your capital in a money market fund. Pick an amount that, along with your Social Security and any pension you receive, will absolutely ensure you can live comfortably over the next five years. Then, knowing your liquidity needs are met, you can commit to at least a five-year holding period and the higher stock allocations that such a time frame permits. Shorter-term fluctuations won't be a concern.
Let's return to the opening theme of this article-nobody knows what the future holds or which investments will do best in the coming years. That's why our SMI portfolios are based on a strategy of diversification-spreading out your money into several different kinds of assets so that you won't be overinvested in any single hard-hit area and you'll have at least some investments in the more rewarding areas. We can't avoid risk altogether, but we can tailor our portfolios to reduce risk while having reasonable expectations of achieving our goals. The historical record shown in our table can help you knowledgeably select the mix of assets that combines profit potential and risk avoidance in the way that makes the most sense for your personal situation. That's Sound Mind Investing.
© Sound Mind Investing
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. Visit the Sound Mind Investing website.
Originally published September 12, 2006.
