Asset Allocation: Stocks and Bonds in Portfolio

Are you afraid of stocks?

It’s not the stocks you hold and trade in your brokerage account  that I am talking about here, but rather the asset allocation of stocks and bonds in your investment portfolio. The question is really that are you investing enough in stocks such that the mix of stocks, bonds, and cash in your portfolio gives you the long-term growth you need to reach your investment goal? Or are you staying away from stocks because of the volatility of the market?

I have shared the allocation of our taxable investment accounts many times in the past, the latest was early this year when I reviewed our finance in 2010.  At the end of 2010, I had only about 4% assets allocated in bonds in mutual funds investments held in taxable accounts. Even for that 4% bonds, they are from funds that mostly invest in stocks, not bonds. When I started to buy mutual funds outside retirement accounts, I intentionally avoided bond funds (I had a bond fund, Harbor Bond Fund, early, but sold it and shifted to an all-stock portfolio) because I wanted to maximize the growth potential of the stock investments. Asset allocation theory shows that among all asset classes, stocks offer the highest possible returns over long-term, but they are also the riskiest. But I don’t totally abandon bonds, choosing to invest in bond funds in retirement accounts such as 401(k) and IRAs. Looking at all the investment we have in taxable and retirement accounts as a whole, we still just have about 5% in bonds at the end of April, including a couple of Vanguard bond funds in IRA accounts plus some I-Bonds, that’s less than the 9% we have in cash, which we use to meet our current obligations. As for our investments, whether they are in retirement accounts, taxable accounts or 529 accounts, they are all for a much longer time horizon, 10 year at least. That time frame allows me to be more aggressive in investing.

Of course, by investing more than 85% of our total assets in stocks, we have seen some wild swings in the past few years. As you can see from the plot in the 2010 review post, we lost more than a third of our investments on paper between October 2007 and March 2009 as the stock market has gone through some turbulent times since the recession began. On the other hand, all the losses were recovered in less than half a year when the stock started to rebound in April 2009. It hurt to see the value of our investment accounts shrunk everyday even though we kept buying every month, but without those new investments when the market kept dropping, I don’t think it’s possible to have that kind of steep gain we had when the market finally started to move up.

Are Generation Xers Afraid of Stocks?

SmartMoney had an article last week titled What’s Gen X So Scared Of? The article cited some survey results that show that Gen Xers, those are in their 30s and 40s now, have much less their assets invested in stocks than most investment experts would recommend. For example, that article says that a study by Fidelity Investment, the largest 401(k) administrator, shows that “Gen Xers in its 401(k) plans now have about 43% of their assets in stocks and equity mutual funds on average.” The reason for Generation X being much more risk-averse than they should be is what they have witnessed since late 1990s: “tech bubble burst, home prices dropped, oil prices spiked, and the markets crashed again.” While investing heavily in bonds during market downturns, such as from late 2007 to early 2009, could reduce risk and give investors peace of mind, being too conservative have proven to be costly in the long term because when looking at 10, 20 or 30 years down the road, it’s stocks, not bonds or cash, that will give investors the highest return and the best chance to reach their long term investment objective.

Asset Allocation Based on Time Horizon

While an all-stock portfolio has the highest possible return, the risk is also the greatest (as in my own example above). Therefore, when building a portfolio and choosing what and how much to invest, there’s a balance between the risk and reward that needs to be achieved. For example, the Efficient Frontier Theory has the following relationship between the risk and return, which can be translated into asset allocation of stocks and bonds in an investment portfolio.

Asset Allocation Stocks and Bonds in Efficient Frontier Theory

Clearly according to the theory, you are not going to eliminate all the risk by investing entirely in bonds or cash. On the contrary, by adding equities to the portfolio, you can expect much greater return by taking on the same amount of risk as an all-bond portfolio. Even though there are no fixed formula when it comes asset allocation, there are general rules that you can follow to find the right mix of stocks and bonds, most of them based on the investment goal and time horizon to reach the goal. For example, if you are saving

  • For a new car: Time horizon – 3 years or less; Asset allocation – 100% in short-term investments;
  • For a house down payment: Time horizon – 4 to 6 years; Asset allocation – 20% in stocks, 30% in short-term, 50% in bonds;
  • For college: Time horizon – 7 to 12 years; Asset allocation – 10% in short-term, 30% in bonds, 60% in stocks;
  • For Retirement: Time horizon – 13 to 16 years; Asset allocation – 20% in bonds, 80% in stocks; Time horizon – 17 years or longer; Asset allocation – 100% stocks.

As for retirement account, if you don’t think you can handle the task of rebalancing your portfolio as time goes by, a good choice other than investing in a stock or bond fund and forgetting about it is use target-date, or lifecycle, funds instead. These funds are managed by professional fund managers and they will make sure that the asset allocation of the fund evolves as the target date approaches.

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One Response to “Asset Allocation: Stocks and Bonds in Portfolio”

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