The most important decision in portfolio construction is deceptively simple on its surface: how much should you allocate toward stocks and how much toward bonds? Sure, some include cash or commodities as well, but the basic issue comes down to risk – and (too) many people go all-in on stocks without realizing the rewards do not match the risks taken. Some will say that ‘this time is different’ but history shows that as hard as it is to time stocks, it may be even harder to time bonds.
But let us back up for the moment and start at the beginning with bonds. Some risk-adverse investors get stuck on this end of the spectrum, intentionally or through fear, focusing on Income. From the Vanguard model allocations above we learn a few things about the risks and rewards of going from 100% bonds to just 70% bonds.
First, average returns jump up quite a bit. Best years are about the same while worst years do indeed get a little worse. Years with a loss, however, remains essentially unchanged. Therein lies the free (or at least cheap!) lunch of diversification – a little more pain here and there, but far higher rewards – a jump from 5.5% to 7.3%, averaged.
Now onto the category of Balanced allocations. Notice how the benefits begin to drop off even here as we move through 60/40 to 40/60 bond/stock allocations – just under a one percent bump in average annual returns, but 25% more years with a loss and worst years that are more than 25% worse. This is not to suggest people should stick to 60% bonds, but it does raise the question: is that really such a bad idea?
In the Growth category, the jumps get ever more dangerous. Average return again moves less than one percent as one adds 30% more in stocks, eliminating bonds entirely, but worst years nearly double from the 40/60 we saw at the end of the Balanced category. While most markets historically recover from such events, those draw-downs can cause capitulation or market-timed course corrections that do lasting damage, too.
A brief review: Income: going from 100% to 70% bonds adds quite a lot of reward and relatively little risk (arguably, it reduces concentration risk) – worst years had less than a 15% loss and occur around 15% of the time (about 1 in 6 years). Balanced: 60% through 40% shows some increase in reward but many more years with a loss and somewhat worse losses during those years – 1 in 4 years have a loss, and the worst loss is about 1/4 of the portfolio. Growth: 30% to 0% (i.e. 70% to 100% stocks) and risk starts to take off, ranging up to over 40% loss in a bad year and nearly 1 in 3 years having a loss.
Conclusion: Benjamin Graham, famed value investor of the 20th Century, has a rule of thumb worth thinking of as a starting place: never have more than 75% stocks or 75% bonds, or, put another way, less than 25% of either. And you can see why – as one gets to either end of the spectrum, the characteristics of the individual components start to take over and one loses the diversifying power of holding two fundamentally different asset classes, each with positive expected returns and very different risk profiles.