Asset Allocation – If you are young why wouldn’t you be 100% stocks?

I know I have had a few people comment on some of my posts that I’m too heavily weighted towards stocks (100%) and it’s sort of common knowledge that when laying out your asset allocation in your portfolio that it is a mixture of stocks and bonds. Even most lifestyle funds for the most risky aggressive young punk classification have some money in bonds. For some reason I can’t get it through my thick skull why someone would put any money in a historically lower performing investment tool for money that won’t be touched for 30 or more years.

If stocks are the best performing investment long-term hands down and you can wait out the ups and downs in the market, then why wouldn’t you be entirely invested in stocks to get the most bang for your buck long term. Certainly once you get closer to retirement age you should start moving a portion of your investments to more stable fixed income stocks/bonds, but when you got as much time as I do I just don’t understand why you would put any money in bonds/treasuries/etc.

So here is where someone comes along and educates me. I know stocks are riskier and you have to take into account the risk adjusted rate of return, but if bonds risk adjusted return were higher than stocks (which I’m pretty certain they aren’t) then you should be 100% bonds long-term. I know diversification is good and bonds will help hold up your portfolio in the short-term if the stock market tanks, but it’s the short term….WHO CARES ABOUT THE SHORT TERM. If long-term those stocks are going to bounce back and handidly trounce bonds, then I can handle the fact that for some 5 year span in there I am going to lose my ass (hypothetical paper I spend too much time worrying about my portfolio’s performance in the short term loss).

Now just as a caveat I’m somewhat sure my 100% stock theory here is wrong in some respects I just don’t know why, so I’m asking for someone to school me, because I’m certain that I’ve run across articles that talk about efficient allocation and some mixture is better than 100% stocks, I just am too dense to know why. I figured I can’t be the only one so hopefully once someone smarter than myself shows up with the answer this will be a valuable article for some of readers.

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24 thoughts on “Asset Allocation – If you are young why wouldn’t you be 100% stocks?”

  1. You started to touch on the answer withe the Sharpe ratio. Read about efficient frontiers. By including bonds, real estate, and other financial securities that have negative correlation with “stocks”, you can actually increase your risk-adjusted return (risk/(return – risk free return)). When you calculate the efficient frontier, you can then draw a line from the y axis (0,risk free return) that is tangential to the efficient frontier.

    Then, if you want to decrease your risk, then have some in “risk free securities”. If you want to increase your risk, borrow at the risk free rate and invest on margin.

  2. To expand on mathdude’s explanation – if your happy with the risk associated with a 100% stock portfolio, you could get higher expected returns for the same risk by using gearing and a more diversified asset mix. You draw a line from the rate charged for your investment loan (margin loan, HELOC, whatever) to “touch” the efficient frontier. [BTW mathdude - if you can tell me where I can borrow any money at the "risk free rate" please tell me ;) ] You then keep going along that line until you hit the same risk level that your ungeared 100% stocks portfolio had.

    However, this is all a bit hypothetical, as efficient frontier plots are either based on historic risk-return data, or (gu)estimates of future risk-return ratios, also, your gearing interest rate will vary over time. This makes working out an “optimum” asset mix and gearing ratio very fuzzy.

    Personally, I avoid being 100% in stocks as you can get almost the same return using a mix of property, stock, bonds, hedge funds, bullion, etc. for a much lower risk (volatility). The main benefit of this is that you won’t be tempted to change your asset mix if the stock market takes a 50% “correction” when you are 100% invested in stocks… It also means that you could THEN shift to 100% stocks (if you really want to) if the market does drop 35% or more below previous highs – this is obviously a “bargain” price if you assume that stocks will eventually recover and achieve the expected long term return…

    Unless you were invested 100% in stocks during the ’87 “crash”, or had, say, half your portfolio in tech stocks in 2000, I’d be a bit cautious about assuming that you really have the sanguine disposition to stay 100% invested in stocks all the way down a severe bear market.

    Having said that, I had my six year old son’s retirement account invested 80% in a geared stock fund and 20% in an international share fund for the past four years since I opened the account for him. However, despite having returned around 25%pa for each of the past four years, I’ve just shifted his asset mix to a more diversified mix of asset classes (see this post for details). If you have a look at the graph of Australian Stock Index (XAO) since 1980 that is in that post, you’ll see why I’m a bit nervous staying 100% in stocks (and mainly Australian stocks) in the current market, even though my son’s investment will be for another 60 years until he retires….

  3. I think you would feel differently if you were starting 5 years ago when stocks were earning negative percentages. It’s easy to say stock are the best option now, but if stocks are down 30% a year, then bonds are a way better choice. Maybe what you’re really saying is to move ALL your investments to the highest yielding investment possible at this particular point in time. Unfortunetly, that is not only very hard to do, but many fund managers are better at it than you, making it even harder.

  4. No my response would be I don’t care if stocks go down 30% this year and 20% next year. Short-term performance doesn’t matter to me. I’m not trying to time the market or predict recessions. I just know that over a long enough period of time stocks yield the best returns so I am comfortable having my portfolio drop 50% in one year because I know that historically stocks have always rebounded enough to more than make up for the dips…just need a long term view on things.

    Also so many people concentrate on the fact that stocks go down a lot in a short period of time, but they also go up a lot during short periods of times too. So yeah I might lose an extra 20% this year because of my heavy stock allocation, but next year I might make an extra 30% over bonds because the stock market took off.

    Anyway great commentary and while I still don’t “get it” there are some great comments on this post.

  5. I think you should be in 100% if you’ve got time. The best thing for me is to buy an index fund and then forget I have it. If stocks go down 50% next year, that’s fine, I’ll just keep holding. I’m holding on XLK (technology index) now for some 7 years and I’m not sure if it’s that much above break even. I will continue to hold it as part of my portfolio for another 30 years at least.

    The only exceptions I’d have to the 100% stock thing is alternative investments. I’m putting 2% of play money in Prosper.com and loving the returns that I’m getting there. I’m gradually ramping that up and can see a day when it’s at least 10% of my assets. There’s also real estate. I’m not saying it’s for everyone. It takes some study like anything else, but it allows an opportunity to get good leverage and if you live in the home, you can bank much of the appreciation tax-free.

    There are some options available that seem to me to return as well as stocks.

  6. “Young” is a relative word. When you have a 30-year span, you can afford to go with 100% stock, but as that time span gets shorter and shorter, you will realize that you can no longer afford that allocation. Besides, Besides, 100% stock doesn’t necessarily generate better returns than 95% stock and 5% bonds.

  7. Rick Ferri’s book, All About Asset Allocation, has a graph that shows that an 80/20 portfolio has almost the same return (it’s slightly less, but by a very small amount) as a 100 stock portfolio, but has a significantly lower standard deviation (or risk)…

  8. Even if you have the fortitude to not sell a single stock holding during a depression, there’s still some point at which you have to start converting your portfolio to partly bonds. This is because, suppose you plan to actually start taking money out when you’re 70. If you’re 100% stocks at 69, and a depression hits then, you’ll be in trouble – or at least you’ll never really get to see all that money you’ve saved up so carefully, only your kids (and the government) will.

    So the ideal plan is something like, 30 years before you plan to start taking out money, convert 5% of your holdings to bonds.. the next 5 years convert another 5%, etc. I think it might be even harder to do this faithfully than it would be to hold stocks during a depression – do you really have the discipline to, during a boom like the tech bubble of 2000, sell rapidly rising stocks and convert them into bonds in accordance with some plan you formulated 40 years ago?

  9. @anon –

    Well obviously as I get older I will not be 100% stocks, but that’s not the question….it’s now when I am young enough to wait out a depression should I be 100% in stocks.

    As far as having the fortitude not to sell when the stocks get hammered, to me that makes no sense….why would you sell when they went down? What incentive is there? If anything you’d have to stop me from plowing more money in.

    I like your 5% conversion plan though and maybe this is something I should start planning out…at what point do I want to start converting from 100% stocks to a mixture of bonds and how that mixture will change over time. Who knows maybe I’ve already missed that timeframe and should have a bigger chunk in bonds already.

  10. Well you can be in 100% stocks if you want, clearly history shows that over time it will do quite well. Personally, even though I’m fairly young and should be in 90-100% stocks, I’m not.

    Since 2001 I’ve held a fairly consistent mix of about 60% stocks and 40% fixed income, primarily corporate bonds. Since 2001 my portfolio has beat the S&P 500, in both the up years and down years.

    Actual returns starting with 2001:

    S&P 500: -12.0 -22.2 28.5 10.7 4.8 15.6

    My 60/40 mix: 0.7 -1.1 31.0 12.2 1.9 19.1

    The only year I underperformed was 2005, I fell short 3%. But in 2001-2002 when the broad market was losing 10-20% my portfolio was either making money or losing very little. So while it took the S&P over 3 years to recover the prior two year’s worth of losses my portfolio was steadily climbing higher rather than playing catch-up.

    For me I would rather have steady and consistent growth, not volatility. The returns in the good years are close to, if not slightly better than the broad market, and in the down years you have the hedge against large losses which means you have less catching up to do in the following years. Over time this should yield gains equal to or better than a pure stock portfolio.

    Of course everyone’s allocation will be different, and in the example above I only used the past 6 years which could be considered short-term, but even if I plug my allocation back to 20-25 years ago the returns still end up to be true.

    This isn’t to say any way is right or wrong one way or the other, but asset allocation can go a long way in reducing volatility while maximizing returns.

  11. I was actually saying, do you have the discipline to convert 10% of your stocks into bonds during a boom.

    As for the 60/40 portfolio poster, how did you “plug in your allocation back to 20-25 years ago”? Just curious as to the methodlogy/data you used.

    I don’t see how ANY mix of stocks or bonds can produce a higher _expected_ return than pure stocks. If you add a lower expected return security to a portfolio, your expected return must decrease – this is a mathematical law.

  12. Jeremy, those numbers support your 60/40 proposition pretty good — IF you consider the S&P500 as being the entire stock market. And if that’s all you invested in, well I guess that’s an accurate benchmark. However, every stock asset category except Large Growth has outperformed the S&P500 during these past 6 years. Try rerunning your analysis after breaking out “stocks” into Large Growth, Large Value, Small Growth, Small Value, International Developed, International Emerging and REIT. Then read up on some of the research of Value/Small Value classes and re-run the numbers with overweighting on Large Value and Small Value. Then add a dash of a broad-commodity index. You may find by adding all the different asset classes, you may match your 60/40 volatility with a lot higher returns.

  13. Playing around with this, I found an example where diluting a higher return security (i.e. stocks) with a lower return security (i.e. bonds) can produce a higher return. (This was inspired by reading up on the theory of the efficient frontier mentioned by mathdude)

    Assuming we have $100 to invest:

    stocks give
    +40%, -15%, +40%, -15% = $142 or roughly a 9% geometric gain
    bonds give
    -5%, +15%, -5%, +15% = $119 or roughly a 4.5% geometric gain

    half-half portfolio gives
    +35%, 0%, +35%, 0% = $182 or roughly a 16% geometric gain

    It’s very interesting, I think, to see exactly what makes this possible. Look at the numbers for a while and see if you can see the “trick” going on here.

  14. To those who have commented in regards to my post…

    anon, my portfolio consists of just a few funds, all which have been around for over 50 years. So it was quite easy to just take my allocation in each, pick a year into the future and by looking up past returns track the returns in excel. I’ve actually been working on an in-depth post on my site about this topic, so when that is done it will clearly show the results.

    And MossySF, you are right about the different categories of stocks performing better. The reason the S&P is the best overall benchmark is because over time the average annual return is almost an exact representation of a diversified portfolio equally invested in all asset classes equally.

    For example, see this link: http://napfa.org/file.asp?F=39FB6E84481D40B4ADF7AA13A7947BAC.pdf&N=Asset_Class_Performance.pdf&C=tips_tools

    If you calculate the average return of the diversified portfolio over those years and calculate the average return of the S&P returns, if I recall they are less than 1% off, with the diversified portfolio nudging it out. I haven’t done the math on this in a while though so I could be off.

    Clearly if in recent times you had a 100% value stock portfolio, yes you would do far better than say the S&P or other stock classes. But in the 90’s your portfolio would have sucked while growth was king. So if your total stock portfolio is in only one stock asset class you are not diversified and will still experience extreme volatility over the long term with similar returns.

  15. Man this is what makes me glad I started blogging…the comments so far have been so educational.

    @Anon post #13 – Your math is wrong there for the half and half portfolio. You can’t simply add the returns. It should be

    17.5%,0%, 17.5%, 0% = $135 or roughly 7.78% geometric gain

    At least thats what I came up with.

  16. Yes, thank you for pointing out that severe error. To anyone who reads that post and makes some financial decision based on it, I want to offer my sincere…

    belly laughs at your expense for blindly following the calculations of a random person on the internet.

    I went back and revised the example to be something that actually does produce higher return due to the combination of two securities. But I won’t belabor the point, as there’s not much practical application.

    Back to the main issue, I’m really glad as well that you brought up this question, as it’s made me think about and look into this issue of asset allocation a lot more. I’m currently 100% invested in stocks, but the discussion has really given me food for thought.

  17. Jeremy, that link you posted doesn’t say anything at all about a diversified portfolio roughly matching the S&P500. I’d say run the numbers yourself because the indexes and allocations can change the conclusions. I myself used the numbers from some of the Vanguard index funds that have been around since 92. What better numbers to use than real mutual funds you could have invested in? So here’s the performance for the last 15 years of various combinations — listed in total return order.

    * 25% Large/Small/Intl/Reit = 12.75%
    * 20% Bonds/Large/Small/Intl/REIT = 11.70%
    * S&P500 = 11.33%
    * 20% Bonds/80% S&P500 = 10.66%
    * 40% Bonds+15% Large/Small/Intl/REIT = 10.58%
    * 40% Bonds/60% S&P500 = 9.87%

    Now let’s look at volatility (standard deviation):

    * 40% Bonds+15% Large/Small/Intl/REIT = 7.92%
    * 20% Bonds/Large/Small/Intl/REIT = 10.38%
    * 40% Bonds/60% S&P500 = 10.90%
    * 25% Large/Small/Intl/Reit = 13.00%
    * 20% Bonds/80% S&P500 = 14.09%
    * S&P500 = 17.41%

    It looks like doing a balanced stock asset mix reduces volatility similar to a +20% influx of bonds while increasing returns at the same time. The 40/15/15/15/15 portfolio would have only encountered 1 year of loss the past 15! (2002 -4.72%) By comparison, the 40/60 portfolio had 4 years of losses the past 15.

    So from my look at the data I have available, I’d say the S&P500 is NOT a good proxy for the entire equities market. Throw in a broad-based commodity index (trying to find data for this category) and I suspect the volatility of 100% stock+reit+commodities would be lower than that of 40% bonds/60% S&P500.

  18. What that link showed was that if you calculate the average return for a diversified portfolio (all stock categories plus one bond index) it comes in less than 2% from the average of the S&P over the same time period. So what I was saying is that if you were equally diversified across all stock categories you would find yourself with a similar annualized return with lower standard deviation.

    As far as the rest of your information, that just proves my point. You can achieve very similar or better results to a 100% stock portfolio while lowering volatility by simply diversifying across stock classes and adding a some fixed income as well.

    And nobody said my 60/40 mix was just an S&P index with a bond index, there is far more to diversification than that which can yield better results, which you highlighted with some of your examples above.

    I don’t think anybody is arguing that if you have a long-term investing horizon, 100% stocks would be a bad thing. The point here is that due to the efficient frontier you can effectively reduce your volatility a bit by proper diversification while still yielding roughly the same results as a 100% stock portfolio.

  19. The point I was making is that you’re overestimating your performance against the market if you just use the S&P500 as the benchmark for 100% equities.

    Point 2 is that 12.75% from 100% stock compared to 11.70% 80/20 is not “roughly” the same. 1%+ is a really big deal over a long time frame. For someone at the 20/30/40 year timeframes, this would be +24%/+37%/51%. This difference could mean the difference between a comfortable retirement and one you have to scrimp to get by.

  20. Well you are assuming a lump sum investment on those returns (as I was). Yes a 1% difference can add up to a lot over 30 years, but you have to remember that most people who are saving for retirement and beyond are doing with small amounts bi-weekly or so. The dollar cost averaging on this short of a time frame will almost eliminate any substantial difference you would see by doing a lump sum analysis over the course of 30 years.

    There is no doubt you would be better off to throw a large sum of money into a 100% stock index of some sort and yield superior results 30 or 40 years down the road, but that is not reality for 99.9% of people. So if you can achieve results within a percentage point of a 100% stock portfolio and with significantly less volatility, then with an average investor who invests small amounts frequently as opposed to one lump sum and letting it ride will end up in pretty good shape.

    Bottom line is, you can look at past performance and pick a 100% stock portfolio that returns 20% or more a year, or you could pick a stock portfolio that returns -20% a year over the last 30 years. You can pick any stocks you want as a benchmark and find different data to support any claim. The S&P is simply the best objective benchmark available without breaking it into the infinite number of portfolios you could create.

    We can debate historical returns until we’re all blue in the face, but they are all based on assumptions, lump sum investments, and that future market conditions will reflect what has happened in the past. You show me a stock portfolio that did better than the S&P over the past 10 years, I’ll show you one that did worse and vice versa. That is exactly why the MPT and efficient frontier are so important so that people can create portfolios that maximize returns while also minimizing the risk.

  21. For the sake of space I put my (long) comments in a post on my blog. Check it out if you are interested. Summary of my points:

    1. Having bonds gives you the capacity to buy low and sell high through rebalancing.

    2. Even over a long period, you can’t be sure stocks will return higher than bonds. It did so twice in the past, but twice is too few to bet all your money on.

  22. You should check out what the Nikkei has done over the past 20 or so years… Many believe that the American exchanges/indexes will do the same soon. The point is that despite the very longterm averages, stocks dont always go up in the time period that matters to you. There are also some other macro trends that are changing, such as population growth (more babies == more customers for your american businesses) So dont believe that the market MUST go up.

    That being said I still believe companies are better generators of cash than loans. The difficulty is choosing a very good business.

    my 2c

  23. I agree that the US stock market might stagnant or the stock market in general may not produce amazing returns in a short period of time (decade or two). This is partly why I have about 40-50% of my stock investments in companies outside of the US to hopefully further diversify myself.

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