Fine-Tuning Retirement Portfolio Allocations
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
One of the toughest tasks for investors — and it can be equally tough for financial advisers trying to help investors — is determining how much of a retirement portfolio should be in equities and how much in bond funds.
In fact, this is one of the three most important decisions that every investor makes. (The other two are selecting the best asset classes andselecting the best funds.)
If investors were purely rational beings, this wouldn’t be much of a problem. Statistical probabilities can guide us to stock-bond allocations with varying levels of predictable return and risk characteristics. But in the real world, investors are people who have emotions.
When the stock market is declining, real-world investors often want to own lots of bonds and fewer stocks. This not only feels good, but it’s easy to rationalize. After all, your money won’t do you any good unless you can keep from losing it.
When the stock market is going gangbusters, real-world investors tend to favor having lots of stocks and fewer bonds. This also feels good and is easy to rationalize. After all, why own bonds that pay only paltry interest rates when your neighbors and friends are making double-digit returns in the stock market?
If it were possible to know in advance when the market would go up and when it would go down, this choice would be obvious and easy. And in fact it would become a self-fulfilling prophecy. When everybody “knew” the market was about to start a big gain, everybody would pour money into stocks; that in turn would raise stock prices (supply and demand at work), and everybody could see that this was “working.”
And if everybody “knew” a bear market was about to start, trillions of dollars would desert the stock market, stock prices would fall, and everybody would be “right.” At least for a little while.
But because it’s impossible to know the market’s short-term future, this sort of emotion-based pendulum is counterproductive.
Year after year, millions of investors learn that painful lesson the hard way. Fortunately, many people eventually realize they need to approach the stocks-bonds question based on facts, history and probabilities. This is one of the things I’ve been teaching for many years.
In hundreds of investing workshops that I led, I would often ask for a show of hands: “How many of you would like me to make a guarantee that you can absolutely count on?” As you can imagine, nearly every hand went up.
But they were always startled (and not always happy) to hear my guarantee: “If you follow my best advice, I guarantee you will lose money.”
But it’s the truth. I don’t care if your portfolio is all in fixed income, all in equities or some combination of the two, there will be periods when your investments will decline. The trick isn’t to avoid all losses. The trick is to control those losses — and your emotions — so you can let your investments do what they’re supposed to do for you.
At that point in the workshop I would introduce a table of historical investment results. It’s the most helpful tool I have ever used in helping people come to grips with the relationship between risks and returns.
I call that table Fine-tuning Your Asset Allocation.
Its purpose is to help people determine how much of their portfolio to hold in stock funds and how much in bond funds. The table presents year-by-year historical performance showing gains and losses for various combinations of stocks and bonds.
For example, if you held 60% in equities and 40% in bonds, the table shows that from 1970 through 2012, your compound return would have been 10%, and the worst 12-month loss would have been 33.5%. This tells you that, in order to achieve that long-term positive return with this combination, you would have needed to tough out the loss of about one-third of your portfolio.
I encourage you to study this table for yourself. What you do with the information depends on your primary objective as an investor.
If your main goal is to get the highest return within your risk tolerance, then use the numbers at the bottom of the table to find the column with losses you are sure you could tolerate without “jumping ship.” That will give you an idea of what your stock-bond ratio should be. Example: If you think you can tolerate a maximum loss of 20% in any 12-month period, you should have somewhere between 30% and 40% of your portfolio in stocks. Historically that would give you a long-term return in the range of 8.5% to 9%.
If your main goal is to obtain the return you need with the least amount of risk, then use the annualized return figures at the bottom of the table to find the column with that historical return. Example: If you require a long-term return of 9% to meet your goals, you should consider holding 40% in equities and be prepared to tolerate a 12-month loss of at least 23%.
Estimating the return you need and the loss you can tolerate is necessarily subjective. To get the most from this exercise, I suggest you consult a financial adviser.
Many times when I have presented this table to investors, I’ve been asked if I think these past returns are suitable for building a financial plan. Even though it’s obviously impossible to know the future, I believe these historical percentage losses are reasonable to expect in the future for the various equity-bonds combinations.
What I’m really being asked is: “Should I expect to get these returns in the future from these combinations?” My answer: You can hope for these returns, but you should base your expectations — and do your planning — by subtracting two percentage points from each annualized return figure in the table.
For more on this topic, check out my recentpodcast.
Here’s one final guarantee: If you use this table as I have described, I guarantee you will be able to get a stock-bond allocation percentage that’s based on historical evidence instead of emotions.
That’s worth a lot.
Richard Buck contributed to this article.