Fundmastery Blog

Kurt Brouwer December 3rd, 2007

Wall Street Journal personal finance columnist Jonathan Clements weighs in on the topic of how much of your portfolio should be in stocks. He covers the topic of asset allocation between stocks and bonds, the impact such an allocation would have had on returns and lots more [emphasis added below]:

Invest It All In Stocks…No Way (Wall Street Journal, December 2, 2007, Jonathan Clements)

‘…Earlier this year, a slew of readers wrote to me, wondering why they shouldn’t invest 100% in stocks. After all, my correspondents noted, stocks always win in the end…

…My correspondents, unfortunately, were overlooking one of the basic tenets of portfolio building. Yes, holding a few bonds might hurt returns — but the financial loss is small and the benefits impressive, especially at times like this.

Trimming Risk

Since year-end 1925, the Standard & Poor’s 500-stock index has clocked 10.4% a year, easily outpacing the 5.3% annual return for intermediate-term government bonds. Yet, if you had kept a sliver of your money in bonds, you would have sharply reduced your portfolio’s price gyrations, without paying a big price in returns.

For proof, consider some numbers from Ibbotson Associates, a unit of Chicago’s Morningstar. Since 1925, a mix of 90% S&P 500 and 10% intermediate government bonds would have had annual volatility that was 10% lower than that of an all-stock portfolio.

Meanwhile, you would still have notched 10.1% a year, which means you captured 97% of the S&P 500’s 10.4% annual return. This 10.1% assumes you rebalanced back to your 90%-10% mix at the end of each year.

Even at 75% S&P 500 and 25% bonds, you would have earned 9.5% a year, or 91% of the S&P 500’s annual performance, while suffering 25% less annual volatility…

…That sure seems like an attractive tradeoff: You’re losing a quarter of the annual volatility, but getting just 9% less annual return…

It is true that stocks have generally outperformed bonds over most long periods of time, that is 10 years or more. Investors who want the highest possible return from a given portfolio, would tend to allocate 100% of the portfolio to stocks or stock mutual funds. However, an investor in an all-stock portfolio has to has a very long-term perspective and solid nerves. Fortunately for those who do not want a 100% stock portfolio, Clements points out that you may not lose a huge amount by adding a modest amount to bonds.

…Taking Comfort

While keeping a small sum in bonds won’t greatly crimp your annual returns, that slight disadvantage will compound over time. Indeed, after 30 or 40 years, you will likely end up with far more wealth if you opt for an all-stock portfolio. But this, of course, assumes you can grit your teeth and live with 100% stocks.

Can you? Remember, risk tolerance isn’t stable. In early 2007, after more than four years of rising share prices, it was easy to be big and brave.

But in October 2002, when stocks hit bottom after the S&P 500’s 49% plunge, nobody was writing to me touting the virtues of a 100% stock portfolio. Most folks, I believe, just don’t have the emotional fortitude to keep everything in stocks…

Clements is absolutely correct that our behavior as investors is heavily influenced by the recent past. We tend to assume that the recent trend will continue indefinitely. So, if the stock market has been strong, then our perception of risk is blunted because our tendency is to assume that stocks (or real estate or gold) will continue going up. Whereas if stocks have been weak, we tend to assume that trend will continue also.

…Buying Power

Allocating some money to bonds doesn’t just provide psychological comfort and a financial cushion during stock-market declines. It also gives you buying power.

When stocks plunge, that creates a sense of crisis, triggering an overwhelming urge to act among many investors. But what will you do? Now that share prices are lower, the rational strategy is to purchase more stocks. If you have some bonds, you will have the money to do just that…’

This point is also a good one. This concept is generally referred to as rebalancing. Assume an investor wants a portfolio with 75% in stock funds with the balance 25% in fixed income funds. If stocks fall by 15% then the portfolio would be out of balance. At that point, then the investor would sell bonds and buy stocks to bring the portfolio back up to its 75% allocation to stock funds. Investors who rebalance periodically have a system for buying more when stocks are down — that is, buying low.

Rebalancing is a good investment discipline because it can be done systematically and because it also helps keep the portfolio’s overall allocation from creeping either higher or lower depending on stock market activity. Clements’ point is a good one in that bond funds generally hold up pretty well when the stock market falls. Having an allocation to bonds of whatever amount gives an investor a source of capital that can be used to buy stock funds when they fall. Conversely, when stocks are hot, at some point the allocation will get above its desired 75% stock weighting. At that point, the investor can sell stock funds and take profits off the table by buying bond funds — that is, selling high.

And, after all buying low and selling high is the name of the game.

• Investing , Mutual Funds , Personal Finance
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