By: Laura Walton AFC®
If that’s your annual return, it’s a scary number. But some investors might not think so – why not? They might not be shocked because they chose a very aggressive allocation.
Your allocation needs to reflect your financial goals, risk tolerance and ability to save. In addition to soul searching, here’s some facts that should be considered in your decision.
Your allocation is responsible for 91.1% of your returns* – this choice is an important one! This, from the well-known Brinson study of 1986, was confirmed in a 2016 study by Scott, et al – see below.
The broad definition of allocation is the percentage of stocks vs bonds vs cash you hold. Stocks carry the highest risk. As a stockholder, you participate real-time in the fortunes of the companies in which you invest. Bondholders, on the other hand, are promised a certain return which offers a little more certainly and therefore less risk. Cash is least risky of all but does carry a hidden risk – we’ll get to that.
The highest risk allocation (100% stocks/0% bonds) over 90 years starting in 1926 experienced a -43.1% loss at some point. The good news, however, is that it also experienced a 54.2% gain along the way. Some investors might be willing to take that risk to earn its average annual return of 10.2%.
History also tells us that the longer we hold an investment, the less likely we are to have a negative cumulative annual return. For example, if you invested in the S&P 500 Index for any 15-year or longer period starting in 1926, you’d have earned a positive annual return.
So, if you have a long investing horizon – 30-40 years until you plan to use the funds – you might be willing to take the risk of a 100% stock allocation because:
- You have adequate emergency savings and have accounted for short-term goals (<10 years)
- You’re really okay with a steep decline (bungee jumping sounds fun until you’re on the platform)
- You realize things can change – that history doesn’t necessarily reflect the future – markets are cyclical
- You realize you could choose, instead, to save more to make up for lower returns of a less aggressive choice
- You know that a basic goal is to beat inflation and that a cash portfolio carries inflation risk; 100% cash would lose over half its purchasing power over a 30-year time period if inflation averaged 3%!
Beyond the stock vs bonds vs cash decision, there’s diversification within the asset classes. Stocks come in lots of flavors – large cap, small cap, growth, international, etc. – but that’s for another blog.
*More correctly stated, allocation is responsible for 91.1% of a portfolio’s movements, in other words, the variability in returns.