How much investment risk should you take?

After a long, profitable run, the stock markets fell in 2018, then headed upward early this year before retreating to current levels.

What’s an investor to do? When should you head for the exits? When should you hold tight?

Of course there is no way to know these things until after the fact.

Investing in equities is all about accepting and managing risk.

It might seem like a daunting task, but it’s actually quite possible if you’re willing to examine some investment returns from the past, then examine your own psyche — and see how they fit together.

This is our topic today.

Risk and reward go together

It’s well known that, in broad terms, risk and reward go together.

If you want high returns, you have to take significant risks. And if on the other hand you want to seriously minimize your level of risk, you’ll need to settle for lower long-term returns.

There are many ways to tweak your risks, but the most important one by far is to adjust the balance of your portfolio between stocks and bonds.

For most investors, the ideal portfolio is likely to include both equities (for growth) and fixed-income funds (for income and portfolio stability).

To illustrate the trade-offs, I’ll make some comparisons using only the S&P 500 to represent stocks and only intermediate-term Treasury bonds to represent fixed-income investments.

This simple combination is not what I recommend for most investors, but it’s a good way to illustrate how risks and rewards work together.

The following comparisons of returns and risk factors are based on market data for 49 calendar years, from 1970 through 2018.

Table 1: Three choices of bonds vs. equities (1970–2018)

These three variations make it obvious that higher returns — and higher risks — go along with higher proportions of equities in a portfolio.

I have long believed that a moderate allocation of 50% in equities may be suitable for many — perhaps even most — investors, including those who are retired. This is the approach I take with my own investments.

Younger people can afford to take more risk while they are accumulating assets. Likewise, some investors are quite uncomfortable with equities; for them, a 20% to 30% equity allocation may be all they can tolerate.

Fortunately, there are many choices. In the full table, you’ll find allocations in 10% increments.

Table 2: 60% equity, 40% fixed income (1970–2018)

Large institutional investors such as insurance companies and pension funds traditionally adopt a 60/40 allocation. They need growth to stay ahead of inflation, yet they also need protection from catastrophic losses.

When you compare these numbers with those of the 50/50 portfolio, they support one of my long-standing observations: Every additional 10 percentage points of equity exposure tends to increase long-term returns by about 0.2% to 0.5%.

An initial $10,000 investment at 9.1% grows to $325,829 in 40 years. At 8.8%, that same investment grows to $291,847. The difference becomes life-changing when applied to larger sums over longer periods.

Three important takeaways

1. Future returns may be lower. I think the S&P 500’s 10.2% return over this period is a reasonable long-term expectation. But it’s hard to believe bonds will continue to return nearly 7%. Historically, bond returns were far lower.

2. Staying the course required courage. Investors endured severe losses during 1973–74, 2000–2002, and 2008 — plus a one-day loss of 22.5% in October 1987.

3. Bonds reduce losses, not uncertainty. No one can predict the timing or severity of market declines. Bonds help mitigate losses, and if that keeps investors from abandoning their strategy, the trade-off is worthwhile.

Note: Figures for the S&P 500 represent the index itself. Portfolio returns shown are reduced by 0.1% to reflect potential fund expenses.

Richard Buck contributed to this article.