Choosing an Appropriate Asset Allocation for Your Investment Portfolio

One of the most important decisions you will make about investing is the percentage of your portfolio that will be in stocks, bonds and cash. Assuming you invest in low-cost index funds (see Investing Basics), your portfolio’s risk and rate of return will primarily be determined by this decision.

Cash

If you are saving for an expense in the next few years (e.g., tuition, down payment, a used car, living expenses), the only safe place to hold these funds is in a savings account or GICs. The values of stocks and bonds can fall over a short period of time, and you have to assume that this will happen at the worst time.

A stock market crash should not result in changes to your stock/bond allocation. If you need to sell stocks during a downturn, then you should have held more cash. It’s not a great feeling to hold funds in an account that basically just keeps pace with inflation, but that is the price of safety.

Stocks and bonds

Why does your stock/bond allocation matter? Take a look at the chart below.

The blue line represents the total returns on $100,000 invested in the US stock market since September 2003, and the green line shows the total returns for the US bond market.

The stocks have seen higher returns than bonds, but those returns have been quite volatile. They have even been negative in some years. In contrast, the bond returns have been lower, but much more stable.

If you want the highest long-term returns, you could hold a portfolio entirely of stocks. But bonds are important to reduce volatility. In the chart below, the blue line is the total return of the US stock market and the green line is the total return for a portfolio that is 60% stocks and 40% bonds.

The 60/40 portfolio had lower long-term returns, but was also a lot less volatile than a portfolio of 100% stocks. Also, while it’s hard to see here, adding bonds to the portfolio lowered volatility more than it lowered returns. This is easier to see if we compare a portfolio that is 90% bonds and 10% stocks (green) to an all bond portfolio (blue):

The 90/10 portfolio (green) had higher returns and is also slightly less volatile (lower standard deviation) than the 100% bond portfolio (blue):

This is because these two asset classes often move in opposite directions. When stocks crash, investors tend to buy bonds, which drives up the price of bonds.

Why does volatility matter?

You might wonder why you would hold any bonds in a retirement account, given that stocks get higher returns.

The main reason is if you are close to, or in, retirement, you will regularly be selling off the stocks and bonds in your portfolio in order to fund your living expenses. But you don’t want to be selling off your portfolio at a discount. After 2008, it took about 5 years for the US stock market to fully recover. You may not want to keep around enough cash for 5 years of living expenses. The 60/40 portfolio only took 2-3 years to fully recover.

Even if you are decades away from retirement, you never know what might happen. You might lose your job, decide you want to buy a house or have some other unexpected expense. A less volatile portfolio provides a lot more flexibility in terms of when you can comfortably sell some of your stocks and bonds.

You also don’t want your portfolio to keep you up at night. Even the calmest investors can feel a bit of anxiety when the value of their portfolio drops by 50% over the course of a year, as stocks did from late 2007 to early 2009. You start thinking that this time might be different and that stocks may never recover. The worst thing you can do in this situation is sell. It’s worth having a less volatile portfolio if it helps prevent you from selling at the worst time, because that would hurt your returns more than anything.

So what should my asset allocation be?

It depends on your situation:

  • how far you are from retirement
  • your job security
  • the long-term return required to hit your retirement goals
  • how calm you will be during a downturn
  • your other sources of retirement income

This is such an important question that it’s worth talking to a proper financial advisor if you have any doubts.

I would just say that most young people think they are comfortable with a more volatile portfolio than they actually are. Don’t be someone who discovers this during a stock market crash.

Also, no one spends 100% of their retirement savings on the day they retire. Don’t assume that you need to move almost completely into bonds as you approach retirement. If you retire at 60 and live until 90, that is a 30-year investment horizon for some of those dollars. Most likely you would benefit from taking a bit more risk in exchange for higher returns.

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