When the stock market was booming, having anything less than 100% of your assets invested in equities felt like you were simply leaving free money on the table. But now that stocks have seen the bottom fall out of the market, many people have started asking the question they should have considered all along: Will a more conservative asset allocation still let you meet your long-term financial goals?
A recent article in the Wall Street Journal suggests that the answer is a resounding yes. Independent research based on past performance figures shows that a 50/50 allocation between stocks and long-term Treasury bonds has historically yielded returns that aren't much lower than those from a more aggressive 80/20 mix of stocks and bonds. The more conservative allocation, however, has had a lot fewer bumps along the way.
To shell-shocked investors who've seen their portfolios lose a lot of value this year, the idea of an asset allocation that would have helped them avoid a big part of those losses couldn't be more appealing. Could it really be as simple as buying more bonds?
Before you cut back on stocks, take a closer look at the study's methods. To its credit, the study attempts to measure a full cycle, starting at the bottom of the 1987 crash. Nevertheless, the events of the last two months prove to make a big difference in its results.
To show you just how big a difference it makes, take a closer look at the return figures. According to the study, a 50/50 mix had a 10% average return, versus 10.3% for the 80/20 mix. That amounts to a total return over those 21 years of roughly 640% for the 50/50 portfolio and 684% for the 80/20 portfolio.
Consider, though: just two months earlier, the Dow was nearly 25% higher than it was by the end of October, the study's end date. Bond prices, on the other hand, moved down by about 1% from August to October. So if you had measured total return just two months earlier, you would have gotten a much wider disparity -- 830% of total return for the 80/20 portfolio, versus just 723% for the 50/50 mix. That equates to 11.3% annually versus 10.6% -- a margin that's over twice as big.
Doing what it takes
Admittedly, even that larger difference doesn't sound like a whole lot to gain, compared to the added risk that you take on. As the study points out, the 50/50 mix would only have lost about 15% in the past year, versus a 25% drop for the 80/20 portfolio.
After the fact, it's easy to argue about whether you would've been better off with a more aggressive or a more conservative allocation. The tougher question, though, is how you're supposed to set yourself up going forward. As we've seen recently, history is an imperfect guide to what you should expect from the stock market.
Picking an allocation is only part of the puzzle. In addition, you have to consider the following:
- How much you contribute. If you can save a huge percentage of your income, then you won't have to be as aggressive to reach a certain savings goal as you would if you can only save a more modest amount.
- Types of stocks. Historically, small-cap stocks like Gentiva Health Services (Nasdaq: GTIV ) and Eagle Test Systems (Nasdaq: EGLT ) have had higher long-term returns as a group than more established large-cap stocks such as Pfizer (NYSE: PFE ) and Intel (Nasdaq: INTC ) . Investing in those higher-return, higher-volatility stocks also increases your risk, though, potentially making a higher bond allocation more attractive to help even out the bumps.
- How much time you have. As you get close to retirement, you don't have the time to ride out long-term declines in the stock market. That makes a more conservative allocation more attractive as you get older.
- Income needs. In today's upside-down market, many stocks, including General Electric (NYSE: GE ) , Merck (NYSE: MRK ) , and Dow Chemical (NYSE: DOW ) , have income yields far in excess of what you'll get from Treasury bonds. If you need current income, a big stock allocation may actually get you more money than a higher allocation to bonds.
Once you have a plan, the most important thing is sticking with it. If you go with an 80/20 allocation when the markets are trading near highs and switch to a 50/50 allocation after you've lost a bundle, you'll get the worst of both worlds.
Being aware of risk is an essential part of successful investing. If your risk tolerance makes a more conservative allocation easier to handle, then it's definitely worth considering -- once stocks recover from bargain-basement levels.
Here's more on making the right moves in your portfolio: