A Methodical Way To Determine Your Ideal Stock vs Bond Split

2012 March 21
by Kyle Bumpus
from → Investing And Investments, Personal Finance

We’ve all heard the various rules of thumb for splitting your portfolio up between stocks and bonds, the two most fundamental asset classes. Age in bonds. 120 – your age in stocks. Double your maximum tolerable loss in stocks. The list goes on. These are all reasonable rules to be sure, but they all feel just a bit too arbitrary for many investors. Why 120 minus your age in stocks? What’s the logic behind that particular magic number?

Let me be frank: it really doesn’t make much of a difference in the long term if you hold 35% of your portfolio in bonds instead of 32% or 37% or even 40%. Since nobody can predict the future, nobody can know in advance which exact stock/bond mix will prove optimal. Sure, we can draw a few broad generalizations about the fact that holding 60% in bonds will be significantly less risky than holding 20% in bonds, but once you get down to the 34% versus 38% range the differences aren’t nearly so noticeable. It truly doesn’t matter what you choose at that level of granularity, at least not statistically.

Confidence Drives Behavior

So if  optimizing your stock/bond allocation down the the nearest tenth of a percent doesn’t matter, what does? That’s easy: confidence. Confidence in your plan; confidence that you’ve made the right decision; confidence in the fact that you have considered your specific situation and haven’t just invested in a cookie cutter portfolio using generic advice. Mind you, it doesn’t really matter whether the generic advice is actually appropriate or not. The very fact that it is generic will cause many investors to inherently distrust it. And that’s okay. We all like to think our situation is special in some way.

So How Does One Decide On Their Stock/Bond Split?

It’s really not complicated. We’ll start with the old conservative age in bonds rule-of-thumb and then increase or decrease our stock allocation depending on how you answer a few questions about your specific situation. Will the results of this exercise be superior to blindly following one of the aforementioned rules of thumb? Not necessarily. But the fact that you’ve thought about it in a methodical way will at least give you a better understanding of the issues involved and the confidence to implement your plan.

Start with age in bonds. For example, if you are 35 years old you will start with a 35% bond allocation and adjust your allocation according to how you answer the following questions.

Will you have a significant inflation-adjusted pension other than social security in retirement?
If so, your need to take risk has diminished. Decrease your equity allocation by 5%.

Is your portfolio already large compared to what you think you’ll need in retirement?
Again, your need to take risk has diminished. Decrease equity allocation by 5%.

Do you plan to leave a large inheritance to heirs or charity?
If so, you should invest a bit more aggressively. Increase your equity allocation by 5%

Would you describe yourself as a “risk tolerant” investor?
Increase your equity allocation by 5%.

If you owned equities in 2008, how did you react by the market crash?
If you felt comfortable owning equities even while their value depreciated significantly, add 5% to your equity allocation. If you either sold in a panic, thought strongly about selling, or otherwise experienced extreme discomfort it’s a good bet you were investing beyond your risk tolerance. Decrease your equity allocation by 10%.

Do you save more than 25% of your gross pre-tax income?
If so, you stand a very good chance of meeting your goals without taking on quite as much risk. Decrease your equity allocation by 5%.

Do you work in a stable career with little chance of being laid off or otherwise losing your income?
Increase your equity allocation by 5%.

Does longevity run in your family?
If so, there’s a chance your money will have to last a bit longer in retirement. Increase your equity allocation by 5%.

Tally Your Results

Tally your results. What do they reveal about your risk tolerance and need to take risk? Using the above process, your portfolio could range anywhere between age in bonds – 25 or age in bonds + 25. For example, an aggressive 35 year old investor might have as little as 10% of their portfolio in bonds. Likewise, an extremely conservative 35 year old investor might have as much as 60% of their portfolio in bonds. The average investor will likely fall somewhere in the 30-35% range. I would like to add one caveat: regardless of your results on this test, I recommend you never dip below 10% of your portfolio in bonds nor below 10% of your portfolio in stocks. I don’t believe any portfolio should be 100% in anything.

Where do you stand?

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