Lots of investors are wary of bonds these days, given the possibility that interest rates could rise again. And although bonds won’t make you much money, for most people they remain a necessary component of a sound portfolio.
So how do you decide what the proper allocation of your portfolio should be?
Think of an automobile. Its purpose is to get you from one place to another, and for that you need an engine. But it would be foolish to build a car without brakes. Even though the purpose of the car isn’t to stop, it’s essential for safety.
In a portfolio, equities are the engine — they provide the power to get you somewhere. Bonds are the brakes. They help keep you safe when equities get a bit rambunctious.
The crucial question is how much of your portfolio should be in bonds and how much in equities.
Expected returns vs. hoped-for returns
This question highlights the classic trade-off between the higher expected returns of equities and the lower risk of bonds.
A useful tool for addressing this trade-off is a table that has helped thousands of investors over the years.
Each column in the table shows year-by-year returns for 11 different combinations of diversified stocks and bonds, ranging from 100% bonds to 100% stocks. A 12th column shows the return of the S&P 500 Index for reference.
These figures provide a realistic picture of what it would have been like, from 1970 through 2015, to own various mixes of stocks and bonds.
For example, a portfolio invested entirely in diversified equities experienced several difficult years. The worst was 2008, when the portfolio lost 41.7%.
The years 1973, 1974 and 1990 also produced double-digit losses. However, the reward for long-term investors who stayed the course was a 46-year compound return of 11.4%.
Now look at a 50/50 portfolio. Having half the portfolio in bond funds significantly reduced losses. In fact, the only double-digit loss occurred in 2008.
The bottom portion of the table helps quantify risk by showing the worst losses over various time periods — three months, six months, one year and more.
How much risk can you take?
To make the most of this information, you must know how much loss you can tolerate without panicking or losing sleep. You must also know the long-term return you need to meet your goals.
To help determine those numbers, you may want to download a free chapter from my book “Financial Fitness Forever.” Once you’ve done that, this table becomes a powerful planning tool.
If your goal is the highest return within your risk tolerance, look at the bottom of the table and imagine enduring the losses shown in each column. Choose the mix you believe you can stick with during difficult times. This is challenging, and professional guidance can be very helpful.
If instead you want the lowest-risk way to meet your needs, look for the portfolio with a return close to what you require.
Although these numbers are from the past, they illustrate the kinds of losses investors should expect in the future. The period studied included three severe bear markets and the infamous one-day crash of 1987, when the market fell 22% in a single session.
I also believe it’s wise to assume future returns will be lower — perhaps by two percentage points — than those shown in the table.
For example, if the table shows an 8% return for a portfolio with 30% in stocks, you might need closer to 70% in stocks to achieve that same return going forward.
If that level of risk feels uncomfortable, your alternatives are to save more each year or postpone retirement slightly. That advice is conservative — but saving more rarely leads to regret.
What I’ve learned
After years of studying this data, here are three conclusions I’ve drawn:
- Adding 10 percentage points of equities tends to increase long-term returns by about 0.55%.
- Each additional 10% allocation to stocks increases volatility by roughly 10% to 20%.
- Regardless of the mix you choose, bad years are inevitable — and those years often push investors toward expensive “alternative” products with lower long-term returns.
A few historical notes
The 46 years studied were especially challenging for bond investors, with dramatic swings in interest rates. In the early 1980s, banks offered certificates of deposit paying as much as 16.5%. Some investors thought they would never need stocks again.
This period was also a golden age for equity investors. Many baby boomers benefited enormously from fortunate timing.
During this era, investors in a fully diversified equity portfolio enjoyed 15 consecutive positive years (1975–1989) and a 25-year stretch with only one losing year.
The 25-year compound return for the diversified portfolio was 17.1%, nearly identical to the 17.2% return of the S&P 500. These results encouraged dreams of early retirement.
Investors who started saving more recently were less fortunate. Since 2000, the S&P 500 has suffered four annual losses, including three consecutive years from 2000 to 2002 and another steep decline in 2008.
During this period, the S&P 500 returned just 4.1% annually, compared with 6.8% for a broadly diversified portfolio.
How you experienced these years depended largely on when you started investing. What appears to be skill or wisdom may have been, at least in part, good luck.
You can’t know the best time to invest or withdraw your money. But if you diversify properly and keep expectations reasonable, the odds of success will be in your favor.
To learn more about using stock-and-bond combinations, check out my podcast “Fine Tuning Your Asset Allocation.”
Richard Buck contributed to this article.