Part of must-read guide: How to build an all-weather portfolio, step-by-step.
Step 7: Use your chosen risk level to determine your allocation to bonds and stocks.
- Understand how much risk you are taking.
- Assess your risk profile and learn the corresponding ratio of stocks/bonds.
- “Own your age in bonds,” or any other plan, might be fine. It is only a good plan if you can stick to it.
The Financial Industry Regulatory Authority (FINRA) warns that: “The single biggest mistake bond investors make is reaching for yield after interest rates have declined. Don’t be tempted by higher yields offered by bonds with lower credit qualities, or be focused only on gains that resulted during the prior period. Yield is one of many factors an investor should consider when buying a bond. And never forget: With higher yield comes higher risk.”
Taking risk isn’t inherently a bad thing. But it’s bad to not understand and control how much risk you’re taking.
What’s An Investment Portfolio?
Your investment portfolio is simply the sum of all the taxable savings and investment accounts and all tax-advantaged investment accounts for both you and your spouse. Always consider this as a whole because money is interchangeable—it doesn’t matter what account pays when you use it, but it does matter what you hold in these different types of accounts to minimize your tax costs.
Key Point: Treat your entire portfolio as a whole (include spouse).
Here’s what is useful to consider in your long-term portfolio:
- Your taxable savings/investments
- Your spouse’s taxable savings/investments
- Your tax-advantaged investments (e.g., IRA, 401(k), 403(b), SEP IRA, Roth IRA, etc.)
- Your spouse’s tax-advantaged investments
- Other valuable assets that you would not hesitate to liquidate to finance your goals (e.g., vacation time share)
- Emergency fund (3 to 6 months living expenses). This one may surprise you. But since this is the money you should save first, this will give you an immediate sense of progress. Further, you’re not planning to have an emergency, right? It’s there if you need it.
Then list your liabilities:
- All significant debt (beyond home mortgage), including school loans, car loans, and residual credit card debt). This may also surprise you. Some find it constructive to view this debt as “negative bonds” to determine their net asset allocation. It also helps shine a light on debt service that exceeds what your bonds are yielding.
Here is stuff you should not consider part of your investment portfolio:
- Valuable art and jewelry that you don’t intend to sell.
- Cars and home furnishings that you don’t intend to sell.
- Home equity (realistic market value less mortgage). You will always need a home, or will need these savings to pay rent or other senior housing.
- Savings earmarked for short-term needs (e.g., college educations, car, trips, furniture, etc.).
- Your anticipated Social Security benefit.
- Your anticipated pension and annuity benefits.
For these planning purposes, we want to focus on the saving and investment decisions that you have control over to achieve your goals.
Understand How Much Risk You’re Taking
The primary factor is your allocation to the stock market. Our rule of thumb is to expect losses in the stock market up to 50% in any year. Expect this to occur multiple times during your investment lifetime. The most recent example was the stock market falling in 2008. Did you own stocks? Did you “stay the course”? Did you panic?
If you were investing during that global financial crisis, and you rebalanced to maintain your chosen stock/bond allocation throughout, then your actual behavior is a solid indicator of your risk tolerance. If you weren’t, then you are untested and might easily overestimate your risk tolerance. Proceed with caution.
To assess your risk profile you must consider your ability, willingness, and need to take investment risk.
Ability to take Risk. What would be the consequences of, say, losing half of your investment wealth in the stock market later this year? Could you recover? Clearly, a high-income doctor in his/her thirties has a lot of time and opportunity to recover from a stock market crash, or several. We refer to this as human capital and job security, or some measure of your expected lifetime earnings. A tenured professor would also have a lot more ability to carry investment risk than, say, an auto mechanic.
But notice that the spouse of that doctor or professor may not carry that same ability, should they need to. Their income earning potentials might be poor. For this book, we will consider lifelong singles or couples and always consider all assets combined—because the money doesn’t care which account it came from. But you definitely do because you can minimize or defer your income taxes.
Willingness to take risk. This is very personal. If you simply cannot stomach the risk of one (or several) serious stock market crashes during your investment timeframe then this becomes the driver.
Also remember that bond values can be volatile. Interest rate sensitivity increases with maturity—especially for long-term TIPS.
The whole reason for this introspection is to avoid judging yourself as having more ability or willingness to take stock market risk than you actually have, and then do a panic sell to get out of a plunging stock market. This common investor behavior guarantees poor results!
Need to take risk. Simply saving regularly into your bank account isn’t going to help most people achieve their dreams. You must take some investment risk. This is alleviated by starting early and using the miracle of compound interest. But for the 50-year old who is just starting to wonder about retirement, the need to start saving might be a huge wake-up call. In an earlier section we looked at the investment return you would need to get from where you are to where you want to go. But caution, there are no guarantees that by choosing higher risk you’ll achieve a higher return.
One of my wise friends calls this need to take risk a sham in this context—that it really just indicates a need to save more aggressively. The implication being that it is the reckless individual that failed to save and invest, neither early, often, nor sufficiently, and hence would need to take more risk to achieve his/her financial goals.
Example: Building on the previous example, suppose your list concludes that your total needed for goals is $800,000. You are saving a total of 15% of your income through automatic payroll deposits into a balanced fund (60%stocks/40% bonds) and you see that a 3% real return will only grow to $600,000 by retirement. Does that mean you need to take more investment risk? Careful. Neither buying lottery tickets nor speculative stock investing are going to increase the likelihood of success. In this case, your decision should be governed by your ability and willingness. If you are sure you would stick with a wild ride then you could consider even higher expected risks and rewards by adding a small portion of a small-company index fund or of a small-value index fund. The other options for getting to a high goal are to earn more, save more, retire later, or re-prioritize your goals.
Most of us need to use the miracle of compound interest to grow the market returns faster than inflation to meet our biggest goals. And once you accomplish that, you can become more conservative for that investment goal and remain more aggressive for others. For example, you might choose to leave excess wealth intended for a charity invested in the stock market.
Take Your Risk In The Stock Market, Not Bond Market
We’ve already discussed how interest rate risk can be controlled by choosing bonds with appropriate duration. That still means there will be short-term fluctuations, but we’ve also highlighted that Treasury bond fluctuations are poorly correlated with stocks (when viewed broadly over long time periods).
In his book Common Sense on Mutual Funds, John Bogle cites an article by Laurence Siegel to tell us that, for long-term investors, risk is not short-term volatility:
“Risk is not short-term volatility, for the long-term investor can afford to ignore that. Rather, because there is no predestined rate of return, only an expected one that may not be realized, the risk is the possibility that, in the long run, stock returns will be terrible.”
And while John Bogle says these comments provide a healthy reminder of the uncertainty of future returns in the financial markets, they hardly invalidate his central message: “Focusing on the long term is far superior to focusing on the short term. It is a lesson too few investors have learned.”
“Remember,” Bogle says, “the goal of the long-term investor is not to preserve capital in the short run, but to earn real, inflation-adjusted, long-term returns.” He advises using bonds as a source of regular income and as a moderating influence on a stock portfolio, not as an alternative to stocks.
Bond expert Larry Swedroe constantly makes the point that it is better to take your risk in the stock market. He looks at risk factors that investors can choose, how much they have historically been compensated for them, and concludes: “While investors have been well rewarded for taking the risks of investing in stocks in general, and specifically small stocks and value stocks, as well as for taking term risk [in bonds], they have received almost no reward for accepting corporate credit risks [in bonds].
Owning long-term corporate bonds—and especially owning junk bonds—makes your portfolio more correlated with the stock market. So, a 60/40 portfolio using high-yield bonds might have the same volatility (risk) as a 70/30 portfolio using Treasury bonds—but the expected return is lower.
Finally, bear in mind that investing isn’t science. Returns, correlations, and standard deviations vary over different time periods. So while this is useful to help motivate common sense principles of a diversified and low-cost portfolio, don’t get bogged down in this or other investing models. Keep it simple.
While saving early and often is your most important investment habit, the ratio of stocks to bonds is your most important investment decision. Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources. Then, stick to your plan!
How Much in Bonds? How Much in Stocks?
We described how to match the duration of fixed-income investments to short-term needs—so we can set those aside for now. That money is earmarked—already spent. The rest of this book will consider our long-term investment portfolio.
It’s fairly common to see asset allocations with descriptive labels—like Conservative, Moderate, Growth, or Aggressive Growth in the following picture. I urge you to not consider these labels, but rather assess your risk tolerance more overtly. The issue is: how will you behave when there is a sudden drop in your portfolio value and it looks like it will fall further. Will you sell to get out? Or will you sell some bond funds to buy more of the falling stock funds?
It’s too tempting for investors to decide their stock/bond allocation based on these labels. You’re apt to feel attracted to a growth or aggressive-growth portfolio when the news and economy is generally positive, and then decide you want to be moderate or conservative after a spate of bad news. This is letting your emotions interfere with your plan and would be terrible, as Carl Richards brilliantly depicts in this sketch.
The simple ratio of stocks/bonds determines the risk of your portfolio. Do you know what your ratio is? What you want it to be? Yes, it is that important!
Know Your Enemies:
- Your investing behavior—if not disciplined.
Which is Enemy #1 for you? What will you do about it? Choose your ratio of stocks/bonds; then stick to it through thick and thin.
Your Needs Change Over Time
Haven’t figured out what ratio of stocks/bonds is appropriate for you yet? Don’t worry—but don’t put this off either. Here is some guidance to help. Happily, this isn’t an area that requires precision. Rough numbers like 80/20, 70/30, or 60/40 are good enough. Author Rick Ferri cleverly observed that “being close is good enough when it comes to horseshoes, grenades, and asset allocation.”
Benjamin Graham’s timeless advice was to never hold less than 25% of your portfolio in bonds, or more than 75%.
John C. Bogle suggests a good starting point is to consider owning “your age in bonds”; for instance, if you are 45, 45% of your portfolio should be in high-quality bonds. Such a portfolio becomes more conservative in a slow and gradual way.
“Own your age minus 10% in bonds” is another popular guideline. There are no wrong answers if it is a plan you can stick to.
The Vanguard Target Retirement funds gradually shift towards bonds every year, at first slowly then more rapidly approaching the retirement date. If you are doing this yourself remember that adding complication increases that chance it won’t get done.
Before retirement, this asset allocation plan helps you decide where to deposit your new savings. In retirement, it helps you determine where to take your withdrawals from.
This ratio is the foundation of this book. This is your rock. This book is all about managing the bond portion of this rock. More important than the actual ratio is having the discipline to stick to it. Many don’t, and inadvertently chase performance or sell in a panic—both with catastrophic results.
Happily, our most important investment decision costs nothing but a little time.
The loser’s game is to be dazzled by the excitement and the chance to win big by hiring the right fund manager, actively trading stocks, and choosing the next winning mutual fund. This is evident from the devoted television channels, newspapers, and newsletters—and distracts us from the important decisions, and sticking to them.
John C. Bogle recognizes this behavior as “speculating” as opposed to investing—which is to own a piece of businesses that create value and are the source of all returns. He begrudges the industry that focuses on financial transactions and all the new financial products and marketing that accelerate those transactions which ultimately only subtract from value flowing to investors.
Earlier in this book we talked about the two characteristics of bonds: term to maturity and credit quality. But for ordinary investors we must add a third: costs.
Three Factors For Choosing Bonds or Bond Funds:
- Credit quality of issuer
Next is STEP 8. Find low cost ways to achieve your target allocation.