Stock vs. Bond Allocation

Allocating your investments in stocks and bonds is a critical investing decision. In this article, we look at several rules of thumb that can help you make the stock vs. bond allocation decision.

The allocation of your investments between stock and bond mutual funds is one of the most important asset allocation decisions you’ll make. Fortunately, there are some really easy to apply rules of thumb to help us make a reasonable decision.

Before we get to how much to invest in stocks vs bonds, however, here are several things to keep in mind:

• Your Allocation Will Change Over Time: The allocation between stocks and bonds typically changes as your investing horizon draws closer. Somebody with 40 years to go before retirement will likely want far more invested in stocks than somebody who will retire in 5 years. When I began investing in my mid-20s, I didn’t own any bond funds. I didn’t buy my first bond fund until my late thirties, and at 40, my allocation was 80/20 in favor of stock mutual funds.

• There is No One Right Answer: Although the rules of thumb discussed below are helpful, there is no one right allocation between stocks and bonds. As I discussed in the article about why asset allocation is important, understanding your tolerance for risk and desired returns will influence your allocation between stocks and bonds, and these decisions vary from one individual to another.

• Your Tolerance For Risk Changes Over Time: In your 20s when you first start investing, you may not be concerned with a 30% drop in the market. In your 40s with 3 kids and a 5 or 6 figure portfolio, a 30% drop in the market will take on a whole new meaning (trust me).

• Investing is a Learning Process: I’ve learned a lot in the 15 years I’ve invested, and my opinions about asset allocation and a lot of other financial issues have changed over that time. The point is not to approach these decisions rigidly, recognizing that your views will change.

Rules of Thumb

Enough with the philosophical happy talk, what’s the proper allocation? Well, good question. As a starting point, many view a neutral allocation between stocks and bonds to be 60% stocks and 40% bonds.

If you read a lot of the literature on asset allocation, you’ll see the 60/40 split used frequently. According to one report published on FundAdvice.com, a 60/40 allocation produced a compound annual return of 10.4% from 1970 to 2006.

Now that doesn’t mean that a 60/40 split is right for everybody, which brings us to an oft-repeated formula for determining a reasonable allocation: 120 – your age = the percentage to invest in stocks, with the remainder allocated to bonds.

At 40, according to this formula, I should invest 80% in stocks (120-40=80) and the remainder, or 20%, in bonds. As it turns out, the 80/20 split is what I use. Whether the formula is right for you, only you can decide. A more conservative approach is to allocate a percentage to bonds that equals your age. In my case, that would result in a 60/40 split (boy do I feel old right now).

Variations of the Same Formula

120 – your age is actually on the more aggressive side of the scale. But there are different variations on the formula.

A more conservative variation is 100 – your age. By using that formula, a 40-year-old would have 60% invested in stocks, and 40% in bonds.

And in between version is 110 – your age. That would see a 40-year-old with 70% in stocks (110 – 40), and 30% in bonds.

Whether you use 120, 110, 100, or some other base number, it’s just a rule of thumb, and nothing more. You should use it only as a starting point.

Everyone has different investment goals, time horizons, and risk tolerances. You can start with whatever number a basic formula produces, but then modify it based on personal circumstances and preferences. As written earlier, there’s no one right way to determine the stock/bond allocation of your portfolio. You have to go with what is a comfortable fit for you.

For example, a 25-year-old may not be comfortable with the 95% stock allocation that 120 – your age would produce (120 – 25). By contrast, a 60-year-old may decide that the 60% stock allocation that the same formula would produce is far too conservative to fund a retirement that can easily last for 30 or 40 years.

Using a Portfolio Allocation Calculator

In deciding what’s best for you, you may want to consider the following data taken from The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize

I can tolerate losing ______% of my portfolio to earn higher returns:	Recommended percentage to invest in stocks:
35%	80%
30%	70%
25%	60%
20%	50%
15%	40%
10%	30%
5%	20%
0%	10%

Of course, in answering how much you can tolerate to lose, you must be brutally honest with yourself. If your like me, you won’t really know how much you can tolerate losing until you experience it. That said, Bernstein’s chart is certainly a good place to start in determining your proper allocation between stocks and bonds.

The Bond Complication All Investors Need to Be Aware Of

As if deciding on an appropriate stock/bond allocation isn’t complicated enough, there’s an added wrinkle.

Most people think of bonds as a single type of investment. The general perception is that they are interest-bearing securities that offer safety of principal. That’s precisely why they’re favored as a counter allocation to stocks. Stocks produce growth–and add risk to a portfolio–while bonds provide capital preservation, and reduce portfolio risk.

What that actually describes however are interest-bearing cash equivalents, and short-to-intermediate term interest-bearing securities.

But generally speaking, bonds are securities that have terms greater than 10 years. More commonly, they run between 20 and 30 years.

The complication is that long-term securities–even interest-bearing ones–can be more volatile in price than short-term securities. In fact, long bonds can have volatility levels comparable to stocks.

This has to do with the inverse relationship bonds have with interest rates. When interest rates fall–as they have been for the past 35 years–bond values generally increase. But when interest rates rise, bonds can fall in value. During the 1970s and early 1980s, when interest rates rose dramatically, long bonds got hammered.

The bonds can still be redeemed at full face value when they reach maturity. But market values can rise and fall between now and then.

As well, there are different types of bonds. US Treasury bonds are considered have virtually zero default risk. But corporate bonds, international bonds, and even occasionally municipal bonds, do have default risk.

The point is, in determining your bond allocation, be sure you understand how bonds work, and what type of bonds you’ll hold. Shorter-term bonds are more likely to provide the capital preservation investors expect. Long bonds, however, can be no safer than stocks.

Topics: Investing

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