The Most Important Investment Decision You’ll Ever Make
When most people think about investing, they think about everything that doesn’t matter. They’re caught up in the minutiae: What fund should I own? What were sales of the new iPhone like? What sector is going to take off this fall? But that’s not really what determines your portfolio’s fate. What really matters is your ratio between stocks and bonds.
We’ve all heard the phrase “Risk and return are related.” By now, it mostly falls on deaf ears, just like “Past performance is not indicative of future returns.” Both phrases are pretty much white noise nowadays, but the reason we hear them so much is that they’re both absolutely true.
Historical returns aren’t a reliable indicator of future returns, and (more germane to the subject at hand) the amount of risk you take determines the expected returns of your portfolio. And your stock/bond split is your big risk lever – everything else just contributes to fine tuning that level.
The level of risk impacts your portfolio in two ways:
1. What You Own Determines How You’ll Do
That seems pretty straightforward, but sometimes it helps to get back to basics. Stocks and bonds act very differently from each other. The more stocks you have in your portfolio, the more risk you take, and the higher return you can expect over the long term.
Think back to the market during the global financial crisis. In 2008, stocks took one of their worst beatings ever, but bonds actually had a surprisingly decent year. Even in a slightly less eventful year than 2008, the returns on a portfolio that is 80% stocks will be very different from a portfolio that is 20% stocks.
Let’s look at the effects of different stock/bond splits over the last thirty years.
|Annualized Return||Standard Deviation||Growth of $100,000|
|100% Stock||10.37%||15.22%||$ 1,928,737.00|
|100% Bond||6.28%||4.47%||$ 621,777.00|
Data from 1/1986 to 12/2015. Stocks represented by the S&P 500 Index. Bonds represented by Five-Year US Treasury Notes. Data courtesy of Dimensional Fund Advisors. Past performance is not indicative of future returns. Indices are not available for direct investment.
Those are some pretty stark differences. As you can see, the more stocks you have in your portfolio, the more money you’re likely to have when you retire.
But you need to be able to stick it out through some pretty rough patches to get those long-term returns. That 100% stock portfolio lost over 43% of its value from March 2008 to February 2009. Even the 60% stock portfolio lost over a quarter of its value over that same twelve month period.
It’s not just the nasty short-term stuff, either (and yes, one year is short term) – consider the aftermath of the Tech Bubble.
In 2000, the S&P 500 Index was down more than 9%. In 2001, it was down almost 12%. In 2002, it was down over 22%.
Over those three years, the index lost almost 38% of its value. Not as much as in 2008, but it was more spread out –the pain lasted three times as long, and it was difficult for many investors to stay disciplined.
To get higher returns from stocks, you need to be able to stay put, even during the ugly times.
2. Your Risk Tolerance Determines How Disciplined You’ll Be
You may have heard of risk tolerance before – it’s the amount of risk you’re comfortable with. If investing is about the long term – which it definitely is – investing based on your risk tolerance is the major factor in your success.
Investing is about meeting your financial goals 30 years in the future, not getting the high score for this year, so making your portfolio match your risk tolerance is key to staying disciplined.
We all know someone who sold right before the bottom in 2009. They stuck it out as long as they could, and then they just couldn’t take it anymore.
Their portfolio didn’t reflect their true risk tolerance. If it did, they would have been able to hold on until the market turned around. They were in a portfolio that was too risky for them, and likely too heavily tilted toward stocks.
When you get your risk tolerance right, you can stay disciplined and harvest the market returns you deserve for putting your money to work in the market.
Stocks and bonds have different roles in your portfolio. Stocks drive the growth of your portfolio and put up the big numbers – but they’re also more risky.
Bonds are the keel of your portfolio. They slow down your growth, but they’re more dependable. Most people need a combination of stocks and bonds to keep them disciplined and on track to meet their financial goals.
The vast majority of people in the financial services industry want you to focus on the extraneous stuff, which means you’ll want to trade more often and they’ll get more commission checks. But that benefits them, not you.
By ignoring the noise and getting your stock/bond ratio right, you’ll be able to stay disciplined, get the market returns you’re entitled to, and keep moving toward your goals.