Is your portfolio ready for bad times?

After a string of mostly very favorable years, the stock market in early 2022 has produced a roller-coaster ride to shocked investors.

Last year, it might have seemed that making money was easy. But that view does not seem quite so obvious now.

Early in March, the S&P 500 index SPX, -0.04% was down 8.2% for the year to date, not enough to trigger much panic, but perhaps enough to wash away any unbridled optimism. And that says nothing about world events that seem poised to potentially get much worse.

So now is a particularly good time to revisit the topic of how much of your portfolio should be in bonds vs. how much in equities. This article is an update to one I have been writing every year for decades.

My goal is to help investors make the difficult but essential tradeoff between the long-term returns of equities and the relative safety of bonds.

As always, if your priority as an investor is achieving high long-term returns, and you don’t worry too much about short-term and intermediate-term losses, you might want to consider a portfolio made up mostly of equities.

But if your larger concern is to avoid losing what you already have, you should keep more … maybe even the majority … of your portfolio in bond funds. If you do this, you’ll have to accept that your long-term returns will most likely be significantly lower.

For most people, the right balance is somewhere in between

The following short table shows returns and a few risk factors from the past 52 calendar years, with stocks represented by the S&P 500 and bonds represented by a combination of intermediate and short-term government bonds plus TIPS.

You’ll see the results for three quite different allocations: 20% equities for the very conservative investor, 50% equities for the moderate investor, and 100% equities for the aggressive investor.

Table 1 – Three choices of bonds vs. equities, 1970-2021

To help you interpret those numbers, standard deviation is a statistical measurement of variations from the average. In financial literature, it’s often used to measure risk, when risk is defined in terms of volatility. In general, a higher standard deviation means more volatility, and more volatility means more risk.

 The last two columns measure the worst losses: over any 12-month period and over a period of any length during these 52 years.

I have long believed that a moderate allocation of 50% in equities may be suitable for many investors, and this is the approach I — at age 78 — take with my own investments.

Fortunately, there are lots of other choices. You’ll find other combinations, in 10% increments of equity exposure in Table B1, which you can find here, which also shows year-by-year returns for stock-and-bond combinations in 10% increments.

Over the years, this information has helped thousands of investors fine-tune their asset allocations.

The results of the worst periods, ranging from three to 60 months, offer a sense of what you’re likely to have to endure in order to earn the expected long-term rates of return.

There’s no way to know in advance when the market will be favorable and when it will be dismal. From 1995 through 1999, the S&P 500 compounded at 28.7%.

But over the next 10 years, 2000-2009, the index wound up with a loss – a compound annual growth rate of -1%.

At the bottom of the table you’ll see clearly that every additional increment of equities brought a higher long-term return. I have argued before that a difference of only 0.5% in return can translate to an extra $1 million over a lifetime — so these increments really matter.

I believe strongly in diversification beyond the S&P 500, and the best way I know how to achieve that in only four funds is a world-wide equity combination that I described here.

This combination is made of equal parts of four asset classes: U.S. large-cap blend, U.S. small-cap value, international large-cap value, and international small-cap blend.

Table 2 shows the 52-year results of this combination.

Table 2 – Three choices of bonds vs. four-fund world-wide equities, 1970-2021

The risk figures are higher in Table 2 than in Table 1. As predicted, the returns were higher as well.

I understand that many investors are unwilling to invest beyond the U.S. stock market. For them I recommend a four-fund U.S. equity portfolio with equal parts of the S&P 500, large-cap value, small-cap blend, and small-cap value.

You’ll see the 52-year results of those in Table 3.

Table 3 – Three choices of bonds vs. four-fund U.S. equities, 1970-2021

Earlier I linked to Table B1, which gives a wealth of information on portfolio combinations based on the S&P 500.

That document also contains eight other tables that give the same data for different equity combinations, including those I referenced in Tables 2 and 3 here.

Here are two lessons to take away from all these numbers:

• Regardless of the combination of equities, adding more bonds reduces both risk and long-term returns;
• Equally important, risks are usually short-term, and over and over again, these portfolios have recovered from their losses.

There are lots more lessons worth learning from 52 years of year-by-year results, and I discuss some of the most important ones in my latest podcast.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways To Supercharge Your Retirement.

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