Principles of Sound Investing
One of the most important investment decisions is how to allocate your investment dollars among the different asset classes. The different classes can have very different returns in any given year, resulting in large variations in earnings among investors with different asset allocations.
As discussed in section 3, investments such as stock offer the potential for higher returns at the cost of higher risk, while investments such as bonds offer lower average returns but lower risk. How to allocate a portfolio among assets with varying degrees of risk is probably the most basic question an investor will face. To simplify the discussion, we will speak of the choice as being between stocks and bonds, but those categories will be understood to include other assets that are either high or low on the risk/reward continuum. Optimal diversification requires investing at least a portion of the portfolio in assets besides stock and bonds, a point that will be reiterated later.
Three factors to consider in allocating between stocks and bonds are your time horizon, your personal tolerance for risk, and your income security.
Time horizon
Time horizon involves the question of what you are saving for, or more precisely, when you are saving for. If you are saving for your children's college educations, it makes a big difference whether they are teenagers or toddlers. If they are very young, it is reasonable to invest heavily in stock, because you have time to ride out some of the ups and downs of the market. And you are generally rewarded for doing so, because stocks have usually outperformed bonds over long periods. But many parents have made the mistake of leaving the college savings in stock too long. If you're still in stock when the child is 16, you run the risk of losing a big chunk of your savings in a down market just when you need it.
This way of thinking about asset classes has strong logical and mathematical support. The riskier asset class is more volatile, and so one can easily lose money in it in the short run. But the riskier asset class should also carry a risk premium (as explained in section 3) that provides a better return in the long run. By investing for long periods, one takes advantage of the statistical tendency for results to even out in the long run. In the long run, below-average returns are offset by above-average returns, leaving investors with the average return for the asset class, which includes the risk premium. Jeremy Siegel is one of the many analysts who have popularized this theory, in his book Stocks for the Long Run.
Here is an example of the kind of evidence that is often cited in support of this theory: Over the years 1926-2005, the average annual return from large-company stocks was 10.4%. Investing for only one year would be quite a gamble, since the annual returns varied from a high of 54% to a low of minus 43%. But the average annual return for all possible 20-year periods (1926-1945, 1927-1946, etc.) varied in the narrower range from 18% per year to 3% per year. Investors who remained invested for many years were much less likely have disappointing returns.
The observant reader will have noticed that these figures do not include the market crash of 2008, which wiped out many years of stock market gains. Even a very long period of investing can have a disappointing return if it includes even one very bad year, assuming it occurs late in the period. For the 40-year period ending in 2008, stock investors received no benefit from investing in stocks rather than bonds (unless of course they were lucky enough to sell before the crash). Furthermore, In addition to the risk of having a bad year just when your nest egg is at its largest, there is the risk of entering an era in which stock returns will be poor relative to other eras. Going back all the way to 1803, Robert Arnott has identified several lengthy periods in which investors would have been better off in Treasury bonds (Journal of Indexes, May/June 2009). We won't know what kind of an era we're in now until we're in a position to look back on it!
These dangers have led some analysts to question the entire logic of holding stocks for the long run. However, one reason for doing so is simply mathematical, the tendency of returns to even out in the long run. We can still say with some confidence that:
- On the average over a very long time, stocks have outperformed bonds by several percentage points a year, which can compound into a very large advantage over time
- Investments that are held for many years are more likely to realize this risk premium, because of the evening out of returns in the long run
- But even holding stock for decades cannot completely guarantee receiving that risk premium
Consider stock a long-term investment, and reserve it for time horizons of at least five (and preferably at least ten) years. Let stock investing play a fairly large role in saving for distant goals, especially retirement. Not only is the pre-retirement period long enough to ride out many periods of market decline, but retirements themselves have been getting longer because of increasing longevity. Most people should leave at least some of their retirement savings in stock even after they retire, so that they can generate a high enough return to sustain a long retirement.
Long-term bonds should also be considered a long-term commitment, because of the risk of having to sell them at a discount if you sell them long before maturity. (And even then the risk premium, in the form of a higher interest rate, may not be big enough to justify the commitment.) Intermediate-term bonds are a safer way of saving for needs that are a few years off. Money for very short-term needs (within a year) is best kept in short-term bonds or cash accounts, for the sake of greater liquidity and stability of principle.
Risk tolerance
Before allocating a large portion of your portfolio to riskier asset classes, you also have to consider your personal tolerance for risk. It is one thing to grasp intellectually the benefits of riding out a bear market. It is another thing to handle it emotionally when it happens. When the downturn comes, no one knows for sure whether it is a "ten-year storm," a "twenty-year storm," or the "storm of the century" from which stocks won't recover for many years. If you are likely to lose your nerve and sell during a severe bear market, then you can't expect to gain much from stock investing, because you're likely to lose money by selling at the worst time.
Risk tolerance is largely a psychological matter, and you probably can't change it very easily. But you may benefit from becoming more conscious of it. At least consider the possibility that you are too far toward one extreme or the other on the risk tolerance scale. The two extremes have been described, somewhat pejoratively, as fear and greed. You are dominated by fear if you are so afraid of losses that you avoid even reasonable risks. Then you may be saving a lot of money, but sacrificing high returns by keeping too much of it in cash. You are dominated by greed if you are so eager for big gains that you accept even unreasonable risks. Then you may be gambling too much of your money on the hope that stocks will go up in the short run. The wise course for most investors probably lies somewhere in between.
Many financial publications and investment companies have questionnaires that you can use to assess your own risk tolerance.
Income security
A third factor to consider is the security of your non-investment income. A person with solid job qualifications, steady employment, or a good pension can afford to allocate more capital to riskier, but potentially more rewarding, investments. If some of that capital is lost, it can more easily be replaced with current income. A person whose future income is uncertain and who may have to rely on savings just to pay basic expenses needs to be more cautious.
Asset allocation in brief
When you are trying to decide where to put a portion of your investment capital, think about how soon you will need your money, how vital it is that you get your money back, and how you are going to feel if the value of your investment fluctuates wildly in the short run. Think about your different financial goals, and allocate your savings among different asset classes accordingly. Invest more conservatively for short-term goals, and a little more aggressively for long-term goals. Take greater risks only if you are prepared to live with the possible consequences.
A note on computerized asset allocation
Financial planners use sophisticated computer models to help clients allocate their portfolios. These models project the probable results of various allocations, based on historical experience. Remember, however, that any such model is only as accurate as the assumptions on which it is based, assumptions that can be invalidated by unforeseen events. The model may assume that annual market returns will vary within a certain familiar range, but future returns could fall outside that range. An asset allocation that appears "optimal" from the standpoint of the model could turn out to be the wrong allocation under future market conditions.
Then why bother with such tools? Because without them, the typical investor could easily make even more simplistic assumptions than the computer models make. An investor might assume that a particular stock, or the market as a whole, will continue to go up at a constant rate, while the financial planners at least know how to build some volatility into their models. A model can also implement a disciplined approach to investing, one less prone to emotional overreactions to recent market swings. The optimal allocation will always be an elusive goal in an uncertain world, and you should take any claims to have achieved it with a grain of salt. But rational analysis can at least protect you from making the most obvious financial blunders, such as putting money you need in the near future into highly volatile investments.
Beyond stocks and bonds
In its ideal form, diversification would provide some reduction in risk with no reduction in return. An example would be allocating between two investments with the same high average return but with uncorrelated returns, that is, returns that fluctuate independently of each other. That reduces risk by making it less likely that both will fall at the same time. Holding a general bond fund along with your stock investments does reduce risk, since bond returns are less volatile than stock returns and fluctuate at least somewhat independently of them. But bonds don't give you ideal diversification because of their relatively low return. If stocks go down, you won't usually get a high bond return to compensate. That has led financial planners to recommend a wider variety of investments with potentially higher returns than bonds, such as real estate, precious metals, commodities or commodity futures, and direct investments in business startups. Including such assets improves the odds of maintaining a high return in fluctuating markets. Some of these, such as commodity futures, can be especially volatile, so ordinary investors should limit their exposure to a small portion of their portfolios.
Limitations of diversification
The ideally diversified portfolio would contain a variety of investments with such high but uncorrelated returns that losing investments would be offset by winners every year. Unfortunately, experience has shown that even the most diversified portfolios are limited in their ability to maintain high returns and manage risk. On the average, diversifying beyond stocks and bonds only adds a point or two to investment returns. And the correlations among different asset classes remain high enough to allow many different investments to lose money at the same time.
The 2008 financial crisis was so severe that even investors with reasonable diversification within and among asset classes were not protected against serious losses. Stock prices fell so much that even portfolios with modest allocations to stock were hit hard. Losses were not confined to US stocks, but also occurred in foreign stocks, high-yield bonds, real estate and commodities. The number of different asset classes that all fell at the same time was very upsetting, especially to those who had regarded diversification as a magic bullet that could kill off risk. (Even then some assets performed well, especially long-term Treasury bonds.) The financial crisis has dramatized the limitations of asset allocation models, warning us against assuming that an allocation that would have worked under most historical conditions will necessarily work today. Diversification is important, but it isn't always enough.
Perhaps the most serious problem with diversification is that it may overlook the issue of valuation. Including real estate in your portfolio isn't a great idea when housing is overvalued and the bubble is about to burst. Some analysts recommend a different approach to allocation, one that bases the allocation to a particular asset class more on current market conditions. Although no such method has been perfected, some planners do believe in allocating less to assets that appear currently over-valued and more to assets that appear currently under-valued. This opportunistic, tactical approach is discussed in section 7.