How much stocks should I have in my portfolio? The age-old question for investors.
It's a pretty significant decision as much as 90% of your rate of return as an investor is determined by how much stocks vs bonds you have in your investment account.
So important, right? Aside from your savings habits and sticking to a long-term plan, your asset allocation, which is the mix of stocks to other asset classes in your portfolio, is one of the most significant financial decisions you will ever make.
In fact, there is Nobel prize-winning research that suggests approximately 90% of your lifetime rate of return of your portfolio comes down to the percentage of stocks in your portfolio. So why are we, in a lot of cases, leaving this crucial decision up to something as simple as a 1 to 10 subjective risk tolerance question? While risk tolerance when measured properly certainly matters, it's important to consider all of the relevant data and pros/cons to ensure this decision around asset allocation is addressed correctly in the context of a plan and proper education. That's what we'll talking about today.
Understanding Real Returns
One of the biggest misconceptions about investing is not considering different types of asset classes and "net of inflation" terms or real returns. Oftentimes, the comparisons between stocks and bonds are framed in nominal terms, that is, without accounting for inflation. Even though it has made the headlines more recently since Covid, Inflation is a silent force that erodes purchasing power over time, and it has a much greater impact on bonds. It's not just about how many dollars you have; it's about how much purchasing power you have and what you can trade for your investments especially when considering that you may want to use the portfolio for spending in retirement.
Here's the reality. Over the past hundred years, inflation has reduced annual returns of stocks and bonds by approximately 3% per year. This brings the long-term average of inflation-adjusted return for stocks to about 7%, and for bonds, it's about 3%.
So, when you factor in inflation, stocks accumulate significantly greater purchasing power, over two times the rate of real return compared to bonds over long periods. This difference underscores why understanding real returns is critical for making portfolio decisions and building wealth.
Short-term Risks and Long-term Gains
But don't bond offer protection in the short term? Well, that may be, but let's talk about risk, specifically the potential for short-term declines. Many people define risk as the worst potential outcome over a given time period. While technically any investment could go to zero, and past performance is no guarantee of future results, historic data provides valuable insights.
For example, in real returns after factoring inflation over a one to two-year period, bonds do offer significantly better worst-case scenarios compared to stocks. In that one-year scenario, the downside is roughly half of what it could be in stocks. However, as we extend the timeframe to five years, the story changes. The worst-case scenario for stocks in that five-year timeframe is negative 12%, compared to a negative 10% for bonds, showing minimal buffer against risk.
Credit to Jeremy Seigel and his book "Stocks in the Long Run"
In a five-year scenario, the small buffer in bonds is overshadowed by the potential upside in stocks. Investors would be wise to consider this data, especially if thinking about investing for over five years where risks could potentially outweigh returns when comparing stocks to bonds.
For those Nearing Retirement
What if you're nearing retirement? Should you still hold stocks if you need to start selling investments? The short answer is that it may make sense, but the allocation will vary depending on personal circumstances and goals. Short-term diversification into conservative investments like bonds, and perhaps more importantly money markets or CDs, can provide a buffer against sharp market declines right before and after retirement. This is known as the risk zone of retirement.
From Jeremy Seigel's "Stocks in the Long Run"
Even so, holding a significant portion of your portfolio in equities can still be a sensible approach. It could significantly impact your portfolio's longevity. For instance, according to research, at a 4% withdrawal rate, portfolios with 50% equity often have the lowest probability of running out of money in a 30-year period. Although a portfolio with 70% equity might have a slightly higher chance of failure by a few percentage points, it offers the potential for 1.5 times greater median wealth by the plan's end. This could translate into a significant potential difference, potentially impacting wealth in six figures or more.
Rethinking Bonds and Alternative Investments
It's essential to acknowledge that the future of bonds may look very different from the past. Over the last 30 years, falling interest rates provided capital appreciation on top of normal bond interest payments. Today, with interest rates more likely to remain stable or rise, it’s unlikely that bonds will deliver the same returns historically seen.
This raises an important question: should we revisit the role of bonds in the portfolio? Reevaluation may mean having a higher percentage of equities or incorporating alternative conservative investment strategies, such as private credit or buffered ETFs. Private credit involves loaning money to a privately held company, potentially with higher fees and returns than traditional bonds. Buffered ETFs allow participation in gains of the market up to a certain cap while offering downside protection.
These options could be valuable, especially for those seeking stability relative to their equity portfolio.
Conclusion
I hope this article gave you a fresh perspective on asset allocation and the potential role of stocks in a retirement income plan. If you found this helpful, please subscribe to our channel for more insightful financial content. If you're planning for retirement or wondering if your portfolio is working for you as best as it could be, contact us at www.ParkmountFinancial.com. We’d love to help you create a strategy tailored to your goals. Until next time.
Video of today's newsletter can be found here:
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