When you start working with a new financial manager or investment website, one of the first things they’ll want to determine for you is your risk tolerance. This is a fancy way of saying they want to know how much money you can lose without freaking out. Once they know this, they’ll give you an asset allocation, which is usually some proportional mix of stocks and bonds. The slicker the company you’re using, the more likely this proportion will be displayed using a sweet, multi-colored 3-D pie chart.
What does this non-delicious pie have to do with your risk aversion? Well, the pie most likely has more stocks than bonds. Stocks are the rock stars of your portfolio. Like rock stars, they reach the highest highs, living lives of dizzying excess, but at a cost: every once in a while they crash down to earth where they wallow for a while (and sometimes record an acoustic album).
Stocks provide your portfolio with its growth and excitement, but most people cannot handle a portfolio full of rock stars. That’s where bonds come in. Bond mutual funds are, at their core, groups of loans: loans to municipal governments, federal governments and private companies. Because bonds come with locked in interest rates, their growth is steadier than stocks, though usually much slower. Think of bonds as the smooth jazz artists that the record company knows will sell 20,000 albums and tour medium-sized clubs without any publicity.
Most of the time, the smooth jazz albums sort of bum us out. “We should have spent that money creating the hit song of summer,” the record executive will lament. But when the big rock album tanks, sending the lead singer into rehab, we’ll be glad to have our smooth jazz income.
There are a lot of rules of thumb out there for bond allocation. The most common rule on the internet is to buy your age in bonds. This means that a thirty year old would set their allocation up as 30% bonds and 70% stocks, and increase it each year. This advice has the triple benefit of being simple, intuitive, and easily actionable.
Unfortunately, I also believe it’s wrong. It starts out too conservative, and stays too conservative over time.
The average worker does not have a lot to be excited about. Wages have been stagnant in many industries, and traditional pensions have all but gone extinct. But on the positive side, life expectancies have increased and could increase further. What does this have to do with finances? Everything. Time is the best friend of the investor. The longer money sits in the markets, the more likely it will grow into a large enough nest egg to sustain a retirement. You could argue that a longer life means more money required as well. But this is only partly right; extra time favors us more than it hurts us due to the cumulative benefit of compound interest.
I am not a certified investment planner. But if you asked me my allocation philosophy, it would be something like “buy your age minus 10 years in bonds until bonds become 50% of your portfolio, then stop”. Doesn’t have quite the same ring, does it?
For visual learners, Vanguard created a chart that shows the tradeoff between bonds and stocks better than any graphic I have seen. I’m reproducing it below – you can read the whole article here.
Your allocation goes from left to right, starting with 100% bonds and ending with 100% stocks. The middle number inside the bars shows the average yearly return for each asset mix, and the top and bottom numbers show the best and worst yearly performance in that mix (all of this uses historical data). An all-stock portfolio returned 10.2% yearly, but on its worst year it lost 43.1% of its value, enough to crush the spirits of all but the riskiest investors.
A good way to read this chart for yourself is to ask, “which of those negative numbers would cause me to sell my investments and put the cash in a mattress?” It’s not as easy as picking the highest return, because most could not handle a 40% loss. By contrast, a 70% stock / 30% bond mix returned 9.2% annually (not bad!) but only lost 30% in its worst year.
This is the benefit of bonds that I rarely hear explained well. A little bit of bonds helps your worst case scenario more than it hurts your total returns. It helps you sleep at night at a reasonable cost. A little, I guess, like a nice smooth jazz album.