These are tough times to be an investor. The stock market’s long-term return of 11-13% fades in relevance as the value of your portfolio declines. Investors begin to doubt their decision to invest in this wild, volatile, crazy, anxiety-creating market. I’m not writing this article to say you shouldn’t feel that way. I’m writing to suggest you grasp the lessons an ugly market teaches us, and evaluate whether you have the correct plan for your portfolio.
Striking the Right Balance
The most important decision an investor makes is the allocation of their money between stocks, bonds, and cash. Some research has shown that 90% of your long-term return comes from this asset allocation decision. Many, maybe most, people jump right into buying stocks and mutual funds before they have crafted their stock/bond/cash strategy. They end up with too much in the stock market, making them susceptible to larger losses than they can tolerate.
The stock market over the long term has provided higher returns than bonds because investors demand a premium for accepting the higher risk in stocks. Why do stocks pose more risk to investors? The brief answer is when you buy shares of a company, you become part-owner in the firm. There are no guarantees of dividends or that you will ever get your money back. If you buy a bond issued by the government or a corporation, you become a creditor. You have lent them money. They in turn will pay you interest over the life of the bond. Upon maturity you get your principal back. Regular payments and your money back. Not much risk in that. Oh, if a company you lent money to goes broke, you get paid before stockholders get a dime. Common stockholders get paid if there’s any money left after bond holders and preferred stock holders are satisfied. It’s not unusual in bankruptcy cases for common stockholders to receive $0.
Points to consider.
There are three major considerations when deciding on how much to invest in stocks. How comfortable you are with market ups and downs, called risk tolerance, how long your money needs to last, called time horizon, and the size of your financial base relative to your financial needs.
Risk tolerance. Investors familiar with the stock market have a better idea of how they’ll react if the market drops. If you have been in the market the past few weeks, you may have decided you want less risk than you have. This market is putting every investor through a risk tolerance test. But if you aren’t sure how much risk you will be comfortable with, you can take a smaller bite of the stock market than would be recommended based on your time horizon. You can always add to that position as you learn through experience.
Time horizon. Too often individuals consider the years up to retirement as their time horizon. Not so. You could be in retirement for 15-30 years. Let’s say you are 45 years old with plans to retire at age 65. You are healthy and expect to live to be 90. Your time horizon is 45 years. The goal is to accumulate enough funds by retirement, the pre-retirement years, that will last throughout retirement, the retirement years. Generally, it is recommended that about five years before retirement the investment in stocks is reduced and bonds and cash are increased. But your money needs to last a long time, and it’s the stock portion of the portfolio that provides growth.
Financial base. The larger the difference between your portfolio size now and where you want it to be at retirement, the larger the allocation to stocks. Stocks are the growth engine of a portfolio. Bonds and cash protect the downside risk and provide income.
Let’s say Madeline wants to have $750,000 in her 401k when she retires in 20 years. She has $50,000 today with plans to add $6,000 per year. To achieve her goal, Madeline needs to earn 11% annually. Stock market returns over the long term have averaged 12%. Therefore, Madeline would need to have a 90 – 100% allocation to stocks to achieve a 11% return.
If Madeline had $100,000 in her 401k, instead of $50,000, she could reduce her allocation to stocks because she only needs an 8% annual return to achieve her goal of $750,000.
Sample Portfolios
Here are some examples of portfolio allocations during different stages of life according to Richard A. Ferri, author of the book All About Asset Allocation.
Mid-life Allocation Range
| Aggressive | Moderate | Conservative | |
| Equity + REIT | 70% | 55% | 40% |
| Fixed Income | 30% | 45% | 60% |
| Cash | 0% | 0% | 0% |
Pre-retiree and Active Retiree Allocation Range
| Aggressive | Moderate | Conservative | |
| Equity + REIT | 60% | 50% | 35% |
| Fixed Income | 38% | 48% | 63% |
| Cash | 2% | 2% | 2% |
REIT = Real Estate Investment Trust
Fixed Income = Bonds
Each investor has an allocation that is unique to his or her situation. The above examples may or may not be appropriate for you.
A risk of NOT investing a portion of your portfolio in the stock market is that you will outlive your money.
A risk of investing TOO MUCH in the stock market is you will not have time to recover large losses. In addition, fear may cause you to sell in a panic when stocks are at their lowest prices.
Now is the time for rational decisions. “This time is different” is the phrase that pops up each time the stock market takes a precipitous fall. It may or may not be true this time. What we do know is what has occurred in the past. History demonstrates that markets recover and eventually move up.
An exodus to cash will leave you with the daunting decision of when to re-enter the market. Investors who run to the side-lines often wait too long to buy back in, missing some of the best days’ in the stock market. This is one of the reasons the average investor significantly underperforms the S&P 500. The other reason is that investors chase performance, buying last years’ winners. For most people the best action is no action for now. You may want to consider making adjustments to your portfolio later, after the market had recovered.