Previously, I wrote about investing in index funds when in it for the long run. What I didn’t cover in that article was which index funds to invest in. There are many different categories of Index Funds: Large Caps, Small Caps, Medium Caps, Foreign, Domestics, Safe Bonds, Junk Bonds, and even Municipal bonds. Which ones should you invest in and what should be your asset allocation?
Asset Allocation and Risk Tolerance
Well, the first important thing to consider in setting your asset allocation is your risk tolerance. Your risk tolerance is defined as your ability to handle and hold the course in the face of a collapse of the market. For example, if you sold all your stocks at the bottom of the 2008 stock crash, the associated 50% stock crash and your stock holdings at that time were beyond your tolerance.
Simply put you need to hold enough value in stable holdings to sleep at night while the market goes down. To this end pundits usually suggest a starting point of your age in low risk holdings like bonds. Not just any bonds, but the less risky safe bonds like treasuries and municipals general obligation bonds. Why? The assumption is that the closer you get to retirement the more you will have to lose. Extrapulated further this also means the sooner you will need your money. While this holds for some, to be honest your risk tolerance is really dependent on you. Only you will know how much risk you are comfortable with, and then only once you experience one of these 50% drops in the market.
Safe holdings which help with your risk tolerance are generally considered to be bonds. Bonds are affected significantly less than stocks in a recession. During the 2008 recession, Vanguard Total US Bond Market Index Fund actually had positive returns. However, junk bonds tanked. First point, junk bonds are not a part of a safe portion of your portfolio. They hold more in common with stock movements than safe bonds. As such, when considering your risk tolerance, look at safe high rated bonds only.
As noted previously, pundits often suggest for the above reasons carrying the safe portion of your portfolio in proportion to your age. So, if you’re 25, then 25% should be in a safe holding. That being said, this doesn’t really apply if you’re looking at early retirement. William Bernstein once said “If you have won the game, stop playing”. Translated for the layman: if you’re sitting on a million dollars, don’t take unnecessary risks by investing in a huge portion of stocks. It also doesn’t make sense to apply your age in bonds if you have a considerably low risk tolerance. The reality is that even holding all of your cash in bonds is superior to losing your nerve and selling all your stocks at the bottom of the market. Sadly, this was a common practice during the last recession.
There has been a lot of talk in recent years of bonds being inflated and thus at risk of a crash. While this is somewhat true, consider the impact on a holding like total bond market. The total bond market holds bonds at an average duration of 5.8 years for their bonds. This means the effective impact of a change in inflation of 1 percent will result in a 5.8% decline in the price of bonds.
So, even in a catastrophic situation like that of the 1970s inflation of around 10%, you’d lose 58% of your holdings. If inflation jumped to 10% overnight you’d have bigger concerns than your bond holdings. Your pay check would also now be worth 10% less! In any case you would be much more likely to see a gradual shift of 1-2 % over time. In other words, you’re looking at a risk of 10% compared to a typical crash in stocks of 25%. The gradual shift over time even further alleviates the pain as the bond fund constantly overturns their holdings. So, if the shift up occurs over a matter of a few years, the funds will adjust with little to no financial impact. This is why bonds are considered a safe investment.
Still Need Stocks
That being said it also doesn’t make sense to hold no stocks at all in your portfolio. Stocks tend to have a higher correlation with inflation. Inflation is a measure of the cash value of assets. Cash is simply a measure of exchange for those assets and stocks are just another type of asset. Thus, when assets inflate or cash devalues in the overall economy, stock values tend to run in tandem.
Bonds typically (with some exceptions) are not correlated with inflation. They tend to have fixed payout rates. In order to preserve your capital over the long run you need to have some variable portion of your investment that can respond with interest changes. Furthermore, the market and investments compensate you for the added risk of a stock by returning a higher return. Why else would people invest in something risky when they can invest with the same return risk free? Thus, you need to keep allocations in both.
Past Performance does not Guarentee Future Returns
One final thing to consider in your asset allocations is how long it will take for the economy to recover from a crash. Studies have shown that the stock market in the US has recovered within 4 years of every major crash. However, there have been examples of other countries taking much longer. Japan, for example, peaked in 1989, and still has yet to recover. Will it ultimately recover? Barring a black swan that literally dissolves the government I expect so, but it may be long after you or I are retired. Contrasting the US and Japan tells you something, you don’t want all your money tied to one class of stock or even one country’s stock. You want to diversify.
Index funds are diversifying within a single type of investment. This diversity allows you to observe the movement of the entire fund without the exposure to the whims of a single stock or instrument. Diversifying across multiple funds does the same but protects you against the risks of a specific type of stock or country. Large stocks may move differently than small. World stocks may move differently than US stocks. Bonds usually move differently than stocks. Investing in a variety of categories in a balanced way will lower your risks of failure because you will have holdings of items with non correlated returns. Always remember the stock market is never without risk, past performance does not guarantee future performance.
Asset Allocation the Personal in Personal Finance
Ultimately your asset allocation is a personal decision considering your risk tolerance, overall financial situation, and when you need the money. Hopefully this post will give you some things to consider on your way to choosing what fits you best.
Our current allocation sits at 40% domestic (25% large, 10% mid, 5% small), 10% world, 25% real estate, 25% bonds). I’ve weathered two recessions without touching my investments so I know my risk tolerance. Sadly I’m also still working on winning the game.