Asset Mix – Why risk and time horizon matter

How you mix your investment assets is one of the most important concepts in investing, so you’d think it would be complicated. However, for a lot of DIY investors it just means choosing how much of your portfolio is in stocks and how much is in bonds.

That is because more and more investors just go with a broad market index fund of stocks, and supplement that with some bonds to add stability and security.

The only decision left to make is how much of your portfolio should be stocks and how much should be bonds. How difficult could it be?

And in truth, for most, not difficult at all. There are a large number of investors who go with the traditional 60/40 portfolio. 60% of your money invested in stocks and 40% invested in bonds. If you just stopped reading now and went with that you probably wouldn’t go far wrong.

However, there are plenty of alternatives to the traditional 60/40 mix. Just about anybody who is anybody in the investing world has some kind of model portfolio you could follow and they are all different.

The experts

Warren Buffet advocates 90% stocks and 10% bonds with no mention of age. David Swenson, Chief Investment Officer at Yale opts for a 70/30 split between stocks and bonds in his book Unconventional Success. Though he doesn’t mention age either, he does suggest this mix is for the long term, which he says is over 10 years.

Charles Ellis, author of Winning the Loser’s Game does consider age in stock allocation, but not until an investor reaches 40 years old. He recommends 100% stocks until you get above 40 years old.

Of course, Ellis isn’t the only one who talks about age. In fact, there is even a rule of thumb out there that bonds should equal your age. A 40 year old would have 40% of their assets in bonds and 60% in stocks. On the other hand, a 20 year old would have 20% of their assets in bonds and 80% in stocks.

Jack Bogle, the founder of Vanguard is often associated with this idea. However, in his book Common Sense on Mutual funds he offers a slightly different approach.

He differentiates between older and younger investors and between the accumulation phase and the distribution phase of an investor’s timeline. Are you old or young? Are you saving or spending?

He doesn’t specifically state how old “old” actually is. However, according to the Office of National Statistics life expectancy in the UK is 79 for a man and 83 for a woman.

So I guess we could assume 40 is the cut off point between old and young. If you were in the accumulation phase 80% in stocks is probably fine until you pass 40 according to this.

Larry Swedroe

Bogle’s solution is good, but perhaps Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan has some even better advice about the concept of asset mix.

Rather than talk about age Swedroe talks about time horizon like Swenson. How long are you going to be saving for? A 20 year old who saves until they are 40 is no different to a 40 year old who saves until they are 60.

According to Swedroe, first you should consider your time horizon and how stable your income is. If you’ve got 25 years and a job for life then you can take on more risk. If you’ve only got a few years until you retire and you don’t know where your next paycheck is coming from you can’t.

Rather than asset mix by age, Swedroe provides two charts to be used together. First he provides the following so that you can assess your stock allocation in terms of investment horizon.

But then, perhaps more importantly you need to assess your willingness to take on risk. How likely you are to panic when all hell breaks loose and the markets crash.

Not only do you need to consider how long you are going to be saving for, but the amount of stocks you have should be based on how much loss you think you could tolerate.

This chart probably works best if you use real numbers. I think I’m going to be investing for 20+ years so I could have 100% stocks according to my time horizon.

However, looking at the table above I’m pretty sure I couldn’t handle a 50% drop in my wealth no matter how temporary it was. In fact, I don’t think I could handle anymore than a 30% drop, so I think 70% in stocks is going to be my limit.

Swedroe isn’t done yet. He also points out that you should consider your need to take on risk in the first place. If you don’t need to take on risk why bother! You are just being greedy if you invest in stocks when you don’t have to.

There is simply no point risking your money if you don’t need to. If you are saving enough so that you’ll have enough in retirement without investing in stocks it maybe good idea not to bother.

On the other side of the coin, if you need a certain amount in retirement and a savings account isn’t going to get you there, perhaps you need to take on more risk.

How to mix investment assets based on age

I think Swedroe’s approach is a really good one, perhaps the best advice out there. However, there is another approach that pretty much achieves the same goal in a single table. It is based on some updates of the age in bonds rule.

These updates account for the fact that we are living longer, and consequently increase an investors stock allocation by 10 or 20% depending on how aggressive or risk tolerant that investor is.

Using the most aggressive approach a 40 year old would have 80% in stocks, rather than 60% as with the age in bonds rule.

Basically, if you are willing to take on a bit more risk add an extra 10% to your stock allocation. Moreover, if you are willing to be really aggressive add an extra 20% to your stock allocation.

Of course, that is all very well for investors looking for more aggressive allocations, but what about investors looking for more conservative allocations? Nobody seems to mention that, but I think common sense would suggest a similar approach in the opposite direction.

Simply decreasing your stock allocation by 10 or 20% depending on how conservative you want to be. Using the most conservative approach a 40 year old would have 40% in stocks, rather than 60% as with the age in bonds rule.

The figures shown below are based on this concept.

The bottom line

Though, personally I prefer Swenson’s approach, I think a mix of investment assets based on the above would be a good starting point for choosing how much of your portfolio you want in stocks.

But don’t forget non of the approaches covered here are without risk. Though highly unlikely, the stock market could crash tomorrow by 90% and never recover!