Every book on index investing stresses the importance of asset allocation: the percentage of equities and fixed-income investments in a portfolio. Of course, more stocks means more risk but higher expected returns, while boring old bonds provide safety and promise less growth. But just what is the long-term difference in risk and returns between stocks and bonds? How does a 50-50 portfolio compare with one that holds just 20% bonds, or 20% equities?
Paul Merriman, who runs the Seattle-based investment firm that bears his name, recently wrote an article that included a table of historical stock and bond returns going back to 1970. It compares the performance and risk of portfolios with various stock-bond mixes. The returns are hypothetical, but they represent a reasonable estimate of what you might expect from a portfolio of low-cost index funds that track the broad markets.
Merriman assumes that the equity portion of each portfolio is split equally between the S&P 500 and international stocks, and the fixed income side is half intermediate-term, 30% short-term and 20% inflation-protected Treasuries. They also deduct a 1% management fee and assume the portfolio is rebalanced monthly. Here’s a summary of the results:
|Annualized return||Standard deviation||Worst 12 months||Worst 60 months|
|100% fixed income||6.9%||4.6%||-4.8%||14.1%|
There are a couple of lessons in these numbers. First, if you’re saving for the short term—say, five years or so—think carefully about how much you invest in stocks. Even a 50-50 portfolio can lose money over a five-year period, and in 2008–09 that allocation would have lost 28.5% in just 12 months. Meanwhile, the worst five-year return for an all-bond portfolio was 14.1% (or 2.7% annualized), and you’d never have lost 5% in any year. That’s something to keep in mind if you’re saving for a child’s education, or a down payment on a house.
You’ll also notice that a portfolio of 20% equities—which most investors would consider extremely conservative—produced an annualized return of 8.2%. Many people would find that sufficient to fund their retirement. Admittedly, you would have had to weather some five-year periods of dreary returns, but even the worst of these saw 10.1% growth (1.9% annualized). The 20-80 portfolio never experienced a one-year loss of more than 11.6%. By contrast, even a plain vanilla 60-40 portfolio is vulnerable to losing a third of its value in 12 months.
The take-away here is this: figure out the rate of return required to meet your financial goals and take only as much risk as necessary.
Let’s say you’re putting $200 a month in an RESP for your five-year-old daughter with the goal of saving $50,000 by the time she’s 18. You’ll meet that target with an annual return of just 5%. If you’ve got $100,000 in your RRSP and contribute $5,000 annually, you need 8% returns to retire in 25 years with a million bucks. If the last 40 years are any guide, both goals may be achievable with a balanced portfolio.
Sure, you might get 10% or 12% with a very aggressive portfolio. The question is, why take the unnecessary risk? As Warren MacKenzie writes in New Rules of Retirement, “Investing is not about trying to shoot the lights out. It is not about trying to make as much money as you can without any regard for risk. Smart investing is about trying to reach your financial goals. If you can reach your financial goals with little risk, all the better.”