Updated: Oct 8
Asset allocation refers to the percentage of your total investments that are in each asset category. Typically investors are referring to the percentage of stocks and bonds you have in your portfolio, but asset allocation can also include cash, gold, and even illiquid assets like real estate. For the purposes of this article, we're going to focus on asset allocations in stocks/bonds as that's the most common understanding of asset allocation.
How do you choose your asset allocation? Financial advisors have traditionally constructed portfolios based primarily on an investor's risk tolerance (along with stated goals and time horizons). Traditional advisors, as well as roboadvisors, use your appetite for risk to choose your allocation of stock to bonds.
Stocks = Risk?
Sarwa, a roboadvisor based in the UAE, asks potential investors to choose from risk levels 1-6 to determine the asset allocation of their traditional investment portfolios.
If you chose the Risk Level 2/6 (Conservative) portfolio with Sarwa, you would end up with an asset allocation of 50% stocks and 50% bonds. Their 5/6 Moderate Growth portfolio holds 84% stocks and 16% bonds.
Betterment, an American roboadvisor, has a similar way of equating stocks with risk.
This is a screenshot from my legacy portfolio that has an asset allocation of 90% stocks. Betterment considers this allocation "Very aggressive."
If you read the full text, you will see that this is qualified by stating that by "aggressive", they mean "potentially higher returns in the long term, but exposes you to higher potential losses in the short term."
So the risk they're talking about must be short term losses.
Loss is scary.
If you're anything like I was at the start of my investing journey, any thought of loss puts you off. I had zero risk appetite when I first started investing because I didn't want to lose my money.
For most people, losing capital is the biggest fear they have when starting to invest.
So Stocks = Risk of Loss, Right?
This is where I think the simple equation that more stocks = more risk is wrong.
There is almost no risk of losing your money if you're buying and holding a whole market index tracking ETF for the long term.
I will say that again, you will not lose money in the stock market if you are buying and holding a whole market tracking index fund over the long term. This is true for all 20+ year periods and also true for the vast majority of 10 year periods across the history of the US stock market.*
How Risky is the Stock Market?
The following chart illustrates the rolling annualized real returns** of the US stock market over long time periods beginning as far back as the 1790s. As you can see, there is no 20, 30, or 50 year period that results in a loss.
In fact, when looking at the S&P 500 from 1923 to the present the worst 30 year return was a total gain of 850%.
But wait! Didn't it take 26 years for the US stock market to regain its value after the crash of 1929? That's true in nominal terms. In real terms it took only about 5 years.
Let me explain:
If you calculate inflation adjusted dollars, it only took about 16 years to regain the spending power of a portfolio after the 1929 crash. The Great Depression was a deflationary period: goods cost less than earlier on. Normally we think of inflation as always weakening our dollars (as has been the trend for the last 50 years), but sometimes the buying power of a dollar actually increases like it did in the Great Depression.
If you reinvest your dividends, then the timeline to recovery after a crash is even shorter, and your total return even greater because each share you buy using your dividends during the crash is on discount. Total return is calculated by the growth in share price + the dividends earned. During the Great Depression dividend yields actually increased!
Total Real Returns
An investor who put a lump sum into a whole market index fund (had it been available) at the peak of the 1929 boom would have only needed about 5 years to regain the real value of the lump sum investment after the crash if they had:
Stayed invested even when it was scary
Continually reinvested their dividends (which increases the total return)
Looked at the inflation-adjusted value (the buying power) of their portfolio, AKA the real value, instead of the nominal value
Volatility ≠ Loss
When you invest in the whole stock market, what you are facing is risk of volatility, not a risk of loss. Volatility means that the price changes drastically and unpredictably. The market goes up and down a lot, sometimes quite substantially even over the course of one day. However, the overall trend is always up over longer periods of time.
It is important to remember that you're investing for the long term, and that shields you from the risk of loss over the short term.
Apply it to Your Timeline
If you are saving to create financial independence for your family, your investment horizon is long. Most people start investing 10-30 years before retirement. But even if you're starting relatively late in the game, you won't sell all of your shares once your reach retirement. You will only need to sell around 4% of your shares per year if you're following the 4% rule of thumb. The remainder of your principal remains invested continually. Most often, your portfolio will continue to grow, even while you're in retirement.
Even if you want to retire in 10 years, you're still investing for a much longer timeframe. And as we've seen illustrated above, there's virtually no risk of losing your principal when investing for 20 or more years.
So why do financial professionals still consider stocks to be risky?
Because traditional investment advice equates volatility with risk. But what most regular retail investors think of as risk is actually loss. There's a mismatch in assumptions. Risk of loss is not the same thing as risk of volatility. Risk comes in many forms.
There is no such thing as a risk-free asset.
Bonds = Safe?
Bonds are also subject to volatility, just a bit less over the short term than stocks. This is why investment advisors usually try to balance the "risk" of stocks with the "stability" of bonds. However, even bonds come with volatility. Interestingly, bonds are less volatile than stocks over shorter periods, but more volatile than stocks over longer periods. Over longer time periods, like the time frames individual investors would buy and hold for retirement, long term bonds are actually riskier than stocks. You can see below that even at 50 year periods there are some scenarios where you would lose some of your capital were you invested entirely in bonds.
Cash = Safe?
Even cash comes with risk. First of all there is the risk of losing value to inflation. There is also currency risk if you live or travel internationally. And of course, your cash is only as safe as the place you keep it. Physical cash can be lost, stolen, or damaged and banks have default risk (thankfully this risk is low due to central bank protections in many countries).
Gold = Safe?
Property = Safe?
While the home you live in should not be considered an investment, rental properties can make good returns. However, there is risk with property, much more than the volatility risk with stocks largely due to the lack of diversification and maintenance costs. Whereas the risk with index investing is that the share price drops in the short term, properties can be damaged, lose value, and rents can drop. Each property usually represents a large portion of an investor's portfolio tied up in a single asset. Properties are subject to taxation, community fees and significant costs associated with selling (if you can find a buyer). The loss of liquidity alone is a huge risk.
"Every investment is a risk asset. Each represents a basket of different risks, and the contents of the basket differ across asset types."
-Edward F. McQuarrie Stocks for the Long Run? Sometimes Yes. Sometimes No. p21
Vanguard has excellent risk explainer banners under its investment product profiles. I found the following under BND and BNDX, which are intermediate-term bond index ETFs.
Risks associated with conservative to moderate funds
Vanguard funds classified as conservative to moderate are subject to low-to-moderate fluctuations in share prices. In general, such funds are appropriate for investors with medium-term investment horizons (4 to 10 years), for those seeking an investment that emphasizes income rather than growth, and for investors who have a low tolerance for the risk of short-term price fluctuations.
Price fluctuations sounds a lot more realistic and less scary than short term losses as mentioned by the roboadvisors.
Under whole market stock index funds like VT this is the banner:
Risks associated with moderate to aggressive funds
Vanguard funds classified as moderate to aggressive are broadly diversified but are subject to wide fluctuations in share price because they hold virtually all of their assets in common stocks. In general, such funds are appropriate for investors who have a long-term investment horizon (ten years or longer), who are seeking growth in capital as a primary objective, and who are prepared to endure the sharp and sometimes prolonged declines in share prices that occur from time to time in the stock market. This price volatility is the trade-off for the potentially high returns that common stocks can provide. The level of current income produced by funds in this category ranges from moderate to very low.
A clear explanation of the risk of volatility with stocks. Vanguard is very clear-headed when explaining the risk of volatility to investors.
Volatility is still Risk
Even if you invest in a low cost, whole market tracking index fund, there is still a risk that you'll get scared and sell during a downturn. There's still a risk that you'll stop reinvesting your dividends when the market crashes. There's still a risk that you'll stop investing according to your plan while you're still earning. (You do have an investment plan? right? If not, schedule a free call with me to get started making one). Watching the value of your portfolio take a nose dive is scary, even if you don't act on your fears.
So What Asset Allocation Should I Choose?
If you're relying on the 4% rule to plan for your retirement (as I do), then you need to have a minimum of 50% stocks in your total portfolio in order for it to last through a drawdown period of more than 20 years. If you're still in the accumulation stage, where you're regularly investing your savings, then you would most likely benefit from having much more than 50% of your total portfolio in stocks. Stocks just have a higher risk-adjusted potential for growth than any other asset class.
Most people invest in stocks and bonds, the bonds are there to balance out the volatility of the stocks over shorter time periods. Common asset allocations are 60/40 and 80/20 (stocks/bonds). Warren Buffet famously invested his wife's retirement portfolio with an allocation of 90/10.
I personally invest only in a single whole world market tracking ETF at the moment (VT), after my emergency fund is included, it's a little more than 95% of my total assets. I don't choose to invest in bonds because I know that stocks hold greater growth potential. As a former teacher, I'm relying heavily on the growth of my investments over time to get to to my FI number.
I'm in my early 40s and I hope to have 50 or more years in which to keep my assets invested even though I look forward to being completely financially independent within the next 5 years. When I do decide to start living off of 4% of my portfolio instead of earning my living***, I plan to keep around 4-8% of my assets in cash (likely in a high interest savings account) and will probably maintain the remainder of my assets in stocks.
Regardless of which asset allocation you decide is right for your own volatility tolerance, it's important to stay the course over the long term, and then, you really can't lose.
*I have referenced the US stock market in this post because it represents 60% of the total world market and we have records going back to 1793. Data from world stock markets does not show the same powerful growth trends as the US market has, so the conclusions here cannot be extrapolated to the entire world stock market. Even so, I advocate for a globally diversified portfolio that includes the entire world market. If the US over-performance continues, this might lower the relative returns of a globally diversified portfolio, but that's a risk I'm willing to take for the added diversification of the entire world.
**real returns are inflation adjusted and assume that dividends are reinvested.
***Full disclosure, I'm actually living off my spouse's earnings while I take a stab at entrepreneurship. Although I continually promise him that Choose Your Own Finance will be supporting us both within the next 3 years, only time will tell. FWIW, he is invested in about 10% bonds.
Stocks for the Long Run? Sometimes Yes. Sometimes No. Edward F. McQuarrie
In-depth discussion of McQuarrie's data sources https://www.bogleheads.org/forum/viewtopic.php?f=10&t=353607
Reinvesting dividends speeds recovery https://www.fool.com/investing/dividends-income/2005/09/30/the-greatest-investing-quotsecretquot.aspx
5 years to recover from lump sum in 1929 if you reinvest dividends https://en.swissquote.lu/international-investing/smart-investing/investors-what-if-coronavirus-created-another-1929
4.5 years to recovery from 1929 "The longest was the recovery from the December 1974 low; it took more than eight years for the market to return to its previous peak, which was reached in late 1972." http://web.archive.org/web/20220512022356/https://www.nytimes.com/2009/04/26/your-money/stocks-and-bonds/26stra.html?module=Search&mabReward=relbias%3Ar%2C%7B%222%22%3A%22RI%3A13%22%7D&_r=1