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Picking the Right Stock to Bond Mix
What determines the performance of your investment portfolio more than any other single factor? Most investors think it's picking good stocks and stock funds. Certainly that can make a big difference, and that's why we suggest using a proven strategy like Fund Upgrading to help make important buy/sell decisions.
But, as important as this is, it's not the most influential. All the great stock funds in the world won't have much impact on your portfolio if you only have 10% of it invested in stocks and the other 90% is in money market funds.
With that in mind, perhaps you can see why your most important investment decision is how much of your portfolio is allocated to stock investments and how much is to fixed income securities like bonds. Academic studies over the years have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.
A portfolio's stock-to-bond mix does more than dictate future returns it also tells you a great deal about how those results are likely to be obtained. Look at the charts linked to below:
Charts: Volatility Goes Down When Your Bond Allocation Goes Up
The vertical lines represent the returns for each calendar quarter between 1989 and 2003, ranked from worst to best. Starting with Chart A, you can see that a 100% stock portfolio is going to provide many quarters of big moves, both up and down. The other charts reduce the stock portion in increments of 20% each, putting that money into bonds instead. This has the clear effect of narrowing the range of results.
Not only are the bars on the other graphs smaller (illustrating that the gains and losses of these portfolios are less extreme), but the frequency of negative returns declines as well. The 100% stock portfolio suffered quarterly losses in 28% of the periods shown compared to 17% of the time for the portfolio invested just 20% in stocks. It's safe to say, then, that the more bonds in your portfolio, the smoother the ride. By contrast, the higher your stock allocation, the more you can expect returns to come in a "two steps forward, one step back" fashion.
If owning stocks subjects you to greater swings in performance and produces losses more frequently, why use them at all? Because that's where the biggest long-term gains are! The net effect of all those stock market ups and downs is greater overall returns, which you can see in the average annual returns of the charts.
So, on the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?
The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be very confident that stocks will provide higher returns than bonds.
Here's a good example to illustrate this point. Think about tossing a coin. You know that the probability of getting heads on any single toss is 50%. So if your goal is to get 50% heads, then what matters most to you is having a lot of tosses. If there are only going to be two tosses, you should be much less confident of getting 50% heads than if there are going to be ten tosses. With 100 or 1,000 tosses, your confidence should grow correspondingly that the long-term averages will emerge.
So it is with investing. The more years ("tosses") you have ahead of you to invest, the more confident you can be that you'll benefit from the higher average returns stocks have historically provided. The less years you have to invest, the more you need to protect against the possibility that the results over your shorter time period may not match the long-term averages.
That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing exclusively in stocks. They can afford to ignore the short-term ups and downs, while racking up the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.
Hopefully this article helps clarify the relationship between volatility and expected returns, and how the allocation of a portfolio is the primary driver of both. If you're nearing the end of your investing time frame (whether for retirement, college, etc.), this information should give you confidence that you can keep growing your money at a reasonable rate even if you do the prudent thing and increase your bond holdings to reduce the chance of short-term losses.
On the flip side, if you still have many years to invest, hopefully this will liberate you from worrying about what the market will do in the short-term as you ramp up your stock allocation to take advantage of the higher long-term returns stocks have historically provided.
In our Sound Mind Investing newsletter, we try to regularly emphasize why we are here serving you in this way: We want to help you to have more so you can give more to share the good news of Christ's love with the world.
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