Q. What should the mix of stocks and bonds be in my retirement portfolio?
Explore This IssueACEP Now: Vol 36 – No 11 – November 2017
A. Unfortunately, the answer to this simple question is incredibly complex and doesn’t even necessarily have a right answer. The short answer is, assuming future market returns resemble past market returns, you should invest as much of your portfolio in stocks as you can tolerate without selling low in a terrible bear market.
Unfortunately, explaining that sentence is going to take the rest of this article. The process of deciding how much of your portfolio to invest in what type of security, such as stocks, bonds, and real estate, is called asset allocation. It turns out that, in the long run, asset allocation (ie, determining the mix of risky assets such as stocks to less risky assets such as bonds) matters far more than individual security selection or your ability to time the market, so it is a great place to spend your limited financial planning time and effort.
The mix of assets determines both your long-term return as well as the volatility of the portfolio. Now, upward volatility rarely bothers investors—it’s the pesky downward volatility that represents losing the money you invested for retirement instead of spending it on a kitchen remodel. Let’s just focus on that. Vanguard, the only mutual fund company owned by its investors, put together a nice study of asset allocation models using data from 1926 to 2015 that gives an idea of the return and the maximum drawdown (the peak-to-trough decline during a specific period) you could expect in the past with a given stock-to-bond ratio. I summarize its data in Table 1.
There are a few things that can be learned from Table 1. First, there is a general correlation between risk and return. If you were willing to tolerate the possibility of bigger losses, you experienced higher returns. The difference between earning a 10 percent return and an 8 percent return is not insignificant. Over 30 years, investing the same amount every year, a 10 percent return results in your nest egg, your retirement income, being 48 percent larger than what you would have with an 8 percent return.
Second, there is no mix of stocks and bonds that eliminates the possibility of loss. Investing means losing money. If you invest, your portfolio will decline in value from time to time. This should be expected, but do your best to increase your ability to tolerate that volatility.