At the most basic level, your investment portfolio consists of stocks and bonds. Yes, you can have real estate properties and alternative investments to help diversify you portfolio. You also need a storage of cash as an emergency fund. However, a traditional investment portfolio consists primarily of stocks and bonds.
Understanding Risk vs. Return
The percentage of stocks (vs. bonds) in your portfolio is probably the most important factor determining the long term return (and risk) of your investment portfolio. As you increase the percentage of stocks in your portfolio, you increase the expected return, as well as the expected risk.
You can see in the curve above that a portfolio comprised entirely of bonds would have very little risk, but also a very low return. Conversely, a portfolio comprised entirely of stocks would have the highest expected return but also the highest degree of risk (loss of principal).
You need Some Stocks In Your Portfolio
It turns out that the curve may be slightly more complicated than the one I drew above. According to the “Efficient Frontier” theory, if you add some stocks to a 100% bond portfolio, you can actually increase your expected return and decrease your expected risk, as shown below. The inflection point occurs around 25% stocks and 75% bonds. Therefore, it may not be wise have less than 25% stocks in your portfolio.
Historical Risk and Return of Various Percentages of Stocks vs. Bonds
It is important to understand the historical performance of various stock percentages. Past performance is no guarantee of future performance, and there is considerable controversy about the expected returns going forward, but it is still useful to look at the overall trends.
Vanguard prepared an excellent graphic of the historical returns and risk of various stock vs. bond percentages. This is shown below. Notice that as the percentage of stocks increases, the average annual return increases, but the size of a hit you would take during a bear market also increases.
So What is the Optimal Percentage of Stocks in a Portfolio?
There is no perfect or optimal percentage of stocks to have in your portfolio. However, there are several “rules of thumb“. One common rule of thumb is (100-age). For example, if you are 30 years old, you should have 70% stocks. If you are 60 years old, you should have 40% stocks.
This rule of thumb is a reasonable starting point, but I recommend that you modify this according to your individual situation. We’ll help you do this below.
Determining YOUR Optimal Percentage of Stocks
Your optimal Percentage of Stocks depends on several factors:
- When you plan to retire
- The expected length of your retirement
- The stability of your income source(s)
- Your expectations for future stock and bond returns
- Your willingness to take risk
Factor 1: When You Plan to Retire
If you aren’t planning to retire for 30 or 40 years, there is little reason to have any less than 100% stocks in your portfolio. You want maximum growth and maximum return. It doesn’t really matter if the stock market drops 50% in a given year. You will just keep working and keep adding to your portfolio.
On the other hand, if you are planning to retire in just a few years, you do not have much time to recover from an extended bear market. In that case, it would make sense to take less risk to avoid a catastrophic decline in your portfolio that could either significantly delay your retirement or reduce you enjoyment of retirement.
Factor 2: The Length of Your Retirement
If you are planning to retire at a typical age of 65 or 70, you probably only need your money to last 2 decades. In such a case, you won’t need much growth for the portfolio to sustain itself over that time period. If you’ve saved 33x your yearly expenses, you could essentially just park the money in a savings account or bond fund and be fine as long as inflation doesn’t go crazy.
On the other hand, if you are retiring at age 35, and need your money to last 60 years, you will need significant growth over that time period to outpace inflation. Therefore, you will need a higher percentage of stocks in your portfolio. Big ERN over at Early Retirement Now recently showed that you need a sizeable stock percentage (at least 50%) if you expect your portfolio to last 60 years.
Factor 3: The Stability of Your Income Sources
If you have a very unstable income (starting a new business, for example) then you may wish to take less risk because you may need the money in your portfolio in the event of an extended period of unemployment or low income.
On the other hand, if you have several sources of income and/or very stable income, then you can afford to take significant risk. 100% stocks might be just fine for you. Even if the market drops 50%, you’ve got a stable income that can fill in the hole.
Factor 4: Your expectations for stock and bond returns
Many smart people, such as Vanguards Jack Bogle, predict that we will not enjoy the stock and bond returns illustrated in Vanguard’s graphic. A conservative estimate is that bonds will barely outpace inflation (0% real return) and stocks will outpace inflation by a few percentage points (4% perhaps).
If you agree with these conservative estimates, then you will need a higher percentage of stocks in your portfolio to outpace inflation and reach your investment goals. If you are more optimistic about future returns, then perhaps you could afford to reduce your stock percentage.
Factor 5: Your willingness to take risk
This is the all-important behavioral aspect. How would you feel if your portfolio dropped 50% in value. Would you panic and sell everything in order to preserve capital? Or would you smile and just keep pouring money into the market.
Look again at the graphic above from Vanguard. Focus on the worst portfolio declines. How much are you willing to lose in your portfolio? If you’re just fine with losing 43% of your portfolio value (100% stocks), then more power to you. However, if the most decline you can tolerate is a 25% drop, then you might not want to have any more than 60% stocks.
Keep in mind, however, that you need to be able to take some risk. If you don’t want any chance of losing money and decide that 100% bonds or a high yield savings account is the best option, remember that the value of your portfolio will gradually erode due to the effects of inflation. You need some stocks in your portfolio, at least to outpace inflation.
Putting it all together
You can see that there is no one perfect percentage of stocks to have in your portfolio. However, if you are planning on an early retirement scenario (age 45-55), have a reasonably stable source of income during your working years, and are willing to take on reasonable risk, here is what I would recommend:
Notice that this is based upon years until retirement, NOT age, as different people may have different retirement ages. Also notice that the percentage of stocks declines significantly as retirement approaches but does not go below 50%. Any less than 50% and your portfolio is unlikely last over a long retirement horizon.
Keep it Simple
If this is all too overwhelming, then just pick a target retirement fund and let it ride. Here is the asset allocation for Vanguard’s target date fund. It assumes you’ll be retiring around age 65 and it drops stock percentages below where I would want them in an early retirement scenario, but it will probably work just fine.
The percentage of stocks in your portfolio is one of the most important investment decisions you will make, as it determines your expected rate of return, as well as the expected risk to get that return. In general, I recommend taking on significant risk if you have decades before retirement, and then gradually reducing that risk as retirement approaches. You will always need to take on some risk to outpace inflation, so I recommend at least 50% stocks, even after retirement.