I am impatient. What's the gist?

If you are 40 or younger a recommended asset allocation is 80% stocks and 20% bonds. As you get older gradually move towards 60% stocks and 40% bonds in your 60’s and beyond.

What is asset allocation?

Before venturing into investing, its important to pay some attention to asset allocation. But what is asset allocation? Simply put asset allocation is deciding what percentage of your funds to allocate to stocks, bonds, cash, real estate etc. You would do that based on your appetite for risk vs reward, your age or the amount of time left to retirement etc

Cash, Bonds and Stock

We will primarily look at Cash, Bonds and Stocks. The chart here shows how the 3 asset classes compare with risk vs returns.

Matrix of Risk vs Return for cash, bonds and stocks

Cash and cash equivalents like Checking Account, Money market, Certificates of Deposit etc are the lowest risk class because of deposit insurance, but the interest rates are usually very low because you are only paid for assuming risk. While the risk of loss is low, cash is usually good for short term emergency fund (3-6 months worth). Inflation tends to severely diminish the value of cash over time.

Bonds are certificates issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time. While riskier than cash, these certificates are usually backed by the assets of the company and have preference over stock to pay back to debtors. As investors are taking a higher risk than just stuffing their money in a bank, they get a higher rate of return.

Shares of stocks are issued by corporations who want to raise capital for their business. The shareholders benefit from potential future profits which are shared between all the stock holders in a proportion to their holdings. Because of the highest risk among the three, investors expect the highest rate of return.

 

Risk tolerance and age

There are many rules of thumb on how much percentage bonds should be in your portfolio. One of the simplest one says you should hold stocks in the ratio (110 – AGE ). For example, asset allocations at

  • Age 20: 90% Stock, 10% Bonds
  • Age 30: 70% Stock, 30% Bonds
  • Age 40: 60% Stock, 40% Bonds
  • Age 50: 50% Stock, 50% Bonds
  • Age 60: 40% Stock, 60% Bonds

…. and so on.

The idea is that as you get older, the amount of time you have before you must start using your retirement stash gets smaller. Hence you must start taking lesser risks and reduce the volatility of your portfolio :  increase the components to fixed income investments and reducing the components of stocks.

In addition to age, your risk tolerance also plays a role. How well will you sleep at night if your portfolio declined 20% in a week. How about 30%, 40% or 50% decline?  If this prospect gives you nightmares, you can go more conservative than the above rule of thumb and increase the amount of bonds. If you are a risk loving individual and would use the drop in the market to continue investing more because you are buying stocks “in a sale”, then you can skew your portfolio more towards stock.

Some extreme asset allocations

100% stocks:

You like playing with fire! Awesome! This is certainly acceptable if you are young and just starting out in your teens, 20’s, 30’s etc. But as you grow older, it might be worth it to include more bonds. You don’t want to hit retirement and just in the year that you retire and want to withdraw funds for living expenses and find your portfolio decimated by Covid-40 or another financial crisis.

100% bonds and cash:

You are very conservative! I certainly understand if you are in your 70s or higher, and you want to make absolutely sure that you minimize any risk whatsoever. However, studies have shown that for retirements lasting 30 years or more there is a chance of retirement failure (i.e. running out of money before the end of the period) if you are less than 50% in stocks. If you are risk averse, a 60/40 portfolio sooner in your lifetime would be better for you.

What asset allocation do you recommend?

Personally, I don’t mind a little more risk considering that I can reduce my expenses in case of a market crash and have a long time before I need to withdraw from the equity portion. I personally am 90% stocks and 10% bonds, but I foresee myself moving to 80%/20% in the next 5 years and 75/25 in the 5 years after that.

For most investors, I recommend 80% stocks and 20% bonds if you are 40 or younger. Gradually increase the bonds every year after that until you reach 60/40 in your 60s.