Chances are, your stock to bond ratio wouldn’t be suitable for me and mine wouldn’t be for you. One person’s ideal investment portfolio may be completely different to somebody else’s.
It is a very personal decision. In fact, what you put in your investment portfolio is entirely up to you and there are plenty of people out there making money from all kinds of crazy things.
For some people, a stock and bond ratio won’t apply to their ideal investment portfolio because they won’t want to own any bonds at all.
However, the problem with stocks is that they are volatile. If you choose wisely they tend to go up over the long term, but unfortunately in the short term double digit drops could be a regular occurrence.
Bonds add balance
To balance stock’s volatility most experts agree that you should add bonds to your portfolio. Bonds don’t tend to go up as much as stocks, but they don’t tend to go down as much as stocks either.
In fact, when stocks go down it is often the case that certain types of bonds go up.
Consequently, you can still make money from bonds, add balance, reduce volatility and in doing so reduce risk, so the question of whether or not to add bonds is an easy one to answer. You should! On the other hand the ideal stock to bond ratio seems a lot harder to agree on.
How age influences your stock to bond ratio
There is an old rule of thumb that the bond part in your ideal stock and bond ratio should be equivalent to your age. If you are 40, you should have 40% of your portfolio allocated to bonds, leaving the remaining 60% for stocks.
I say an old rule of thumb for good reason because people live longer now, and an updated version of this rule is becoming ever more widely accepted. This says 120 minus your age for stocks and the rest for bonds, which means 80% stocks and 20% bonds for a 40 year old.
That’s quite a bit different to the original rule, but if you think that’s a little low, it is worth having a look at how some of the biggest names in the investment business allocate between the two for somebody aged about 40.
Vanguard’s Target Retirement 2045 and Fidelity’s Freedom 2045 funds and both have about 90% of their portfolios in stocks, leaving only about 10% for bonds.
What do the experts think about a good stock to bond ratio?
If that’s not enough to convince you, how about Warren Buffet whose advice to his trustees is 10% in short-term government bonds and 90% in the S&P 500 stocks i.e. a 90/10 stock to bond ratio!
He says: “I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers.”
However, not everybody agrees. Harry Browne, a famous US politician, writer, and investment advisor created the Permanent Portfolio which allocates just 25% to stocks and Ray Dalio, the founder of the biggest hedge fund in the world came up with the All Weather Portfolio which allocates 30%.
When interviewed in Money Master the Game Ray argues that most balanced portfolio’s aren’t balanced at all, and in fact “by having a fifty-fifty stock to bond ratio, you really have more like ninety-five percent of your risk in stocks.”
How risk influences things
What conclusions can we come to other than a lot of well informed people have very different ideas about an ideal stock bond ratio.
The generally agreed strategy is to increase or decrease the amount of stocks in your portfolio based on your risk tolerance and age.
If you are very young and super tolerant to risk you could have a 100% allocation to stocks, but if you’re old and not risk tolerant at all then you’d better stick to all bonds and for everybody else a stock to bond ratio somewhere in between should be appropriate.
The thing is, how can we really know what our risk tolerance is? I think I could handle my stocks plummeting for a year or so, knowing that they will come back and make more money in the future.
However, until you watch your own money disappearing in front of your eyes how can you know how you’ll react and how about the possibility that it doesn’t come back!
What does history tell us?
If we want to have a look at how stocks have performed historically a great place to start is The Dow Jones Industrial Average (the Dow), a stock market index that represents 30 large publicly owned companies in the US.
During the crash of 1929 and subsequent Great Depression it lost almost 90% of its value and took 25 years to recover. Some think it recovered faster, but in any case, I think we can agree that historically western stock markets have tended to recover from big crashes. That doesn’t guarantee that they will do in the future, though.
Crashes!
We only have to look at some other stock markets around the world to see what might happen.
At the time of writing (May 2018) the Shanghai and Shenzhen stock markets are down about 40% from what they were prior to crashing about 10 years ago and the Japanese stock market is about 40% down from what it was before it crashed about 30 years ago.
Crashes do happen and they can take a long time to recover. Historically, the Dow Jones has crashed by over 40% eight times.
However unlikely, if the stock market did crash and then did not come back for 30 years like in Japan what would that mean for an investor’s portfolio?
To answer this question, I’ve undertaken some simple analysis.
The chart below assumes you started with £100,000 and the stock portion of your portfolio was still down 40% after 30 years like Japan, but bonds increased in value by 2% annually over the 30 year period.
This 2% is the historical real growth for global bonds from Credit Suisse Global Investment Returns Yearbook 2018.
Looking at the graph, you can see that if you’d invested 100% in stocks you’d have £60,000 after 30 years and if you’d invested 90% like Buffet, Vanguard and Fidelity you’d have £72,114.
The bottom line is that you’d have lost a lot of money. However, if you were just 30% in stocks along the lines of Dalio and Browne you’d have £144,795 and with 100% invested in bonds you’d have £181,136.
I don’t need to spend too long looking at that graph to decide there is something in Ray Dalio and Harry Browne’s ideas.
If you told me my investment would definitely turn out like the graph, then I’d simply chose a 0/100 split i.e. all in bonds, but you can’t tell me how things are going to turn out. Nobody can. Not even the experts!
Recovery
The thing is, stocks might fully recover just like they have in lots of countries in the past.
So we also need to have an idea of how much money we’d have if the stock market fully recovered. That way we can get an idea what the possible gain is for a certain level of risk.
In essence, how much do the potential winnings compare to the potential losses.
The graph below assumes stocks completely rebound and that over the long run the crash didn’t impact them at all. Instead they grew on average at 5.2% annually (the historic real annual returns for global stocks from the Credit Suisse Global Investment Returns Yearbook 2018).
If your ideal investment portfolio contained 100% stocks you’d now have £457,585 and with 90% stocks you’d have £429,941, which both look a lot better than the £181,136 you’d have with 100% bonds.
In fact, it goes without saying that if stocks recover it would be a whole lot better to be all in stocks, but again we don’t know how things are going to play out so we have to decide what risk we are willing to take for our expected reward.
There those who think there’s more than half a chance that stocks may crash and not recover, but would still be willing to lose £40,000 for the chance to end up with £457,585.
Similarly, there are those who wouldn’t risk a penny and would play it safe with 100% bonds. For me an ideal stock to bond ratio of 60% stocks to 40% bonds looks like a good bet.
That way I should make a pretty big gain if the market follows the historical pattern, but still make money even if the stock market crashes and doesn’t recover.
Finally
It is worth pointing out that I used historic numbers to do this stock to bond ratio analysis. Just because something happened in the past, doesn’t mean it will in the future.
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