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Ultimate Stock To Bond Ratio

Ultimate Stock To Bond Ratio
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When it comes to your asset allocation the first and most important decision to make is to determine your ultimate stock to bond ratio. Your asset allocation between stocks and bonds is primarily determined by your risk tolerance. What is risk tolerance – It is the ability to handle a particular size loss in value of your portfolio during a bear market.

In a previous post on Asset Allocation I touched on the topic of stock to bond ratios. Today I am going to expand on this further.

The old rule of thumb was “Take 100 and minus your age and you get the percentage of stocks vs bonds you should have in your portfolio” Example. If you are 35 years old then 100 – 35 = 65% stocks 35% bonds.

In recent times I have seen the rule change to 110 and even 120 to make up for the lower returns on the bonds/cash components of portfolios these days. Investors also believe that the historical average returns of stocks will not be as high in the future 6-7% instead of 9-10% in the past. We will have to wait and see if this ends up being true! There is also the fact that we are living longer than we used to.

The Next two charts show the following fund performances during the 08-09 bear market and 10 years to date. These funds are not a perfect comparison as the US-International and Growth-Value percentages are not exact. They however still give a good indication of the performance differences.

VTSMX Vanguard Total Stock Market Index Fund 100% Stocks
VASGX Vanguard LifeStrategy Growth Fund 80% stocks 20% bonds
VSMGX Vanguard LifeStrategy Moderate Growth Fund 60% Stocks 40% bonds
VSCGX Vanguard LifeStrategy Conservative Growth Fund 40% stocks 60% bonds
VASIX Vanguard LifeStrategy Income Fund 20% stocks 80% bonds

Charts from Morningstar

Ultimate Stock To Bond Ratio

In this chart you can se that the portfolio takes the biggest hit with 100% stocks and the smallest hit with 20% stocks.

Ultimate Stock To Bond Ratio

Over time you can see the performance of the funds reverse as the higher stock allocation funds perform better over the long term.

Human Capital

Human capital is a term used to describe your income earning potential due to your knowledge and skills value. When you are young you have many years of income producing ahead and therefor a high human capital. As you get older your human capital decreases and you therefor cant afford to take on as much equity risk.

Risk Tolerance

Were you were investing through the 2008 – 2009 downturn in the market? how did you feel about the losses in your portfolio? Did you sell or hold your ground? Could you handle similar or greater losses with the present size of your portfolio? 

Determine your risk Tolerance by asking yourself

  • How long do I plan on investing for?
  • On a scale of 1-10 what is my risk tolerance?
  • How have I handled bear markets in the past?
  • Would I survive if my portfolio dropped 40%?
  • Is my primary income secure?
  • Do I have additional income sources?
  • Do I have an advisor that will support me?
  • What is my level of experience investing?


Remember
: You only need to take as much risk as you need to achieve your your financial goals.

There are also many online Robo Advisers that will ask you a bunch of questions and run them through a computer algorithm to determine your risk tolerance.

Sticking to your plan gets harder and harder as time goes on. Think of it this way if you were to loose 40% of $10,000 you might be able to stay strong loosing $4,000 and not exit the market. What if you were close to retirement and had $1,000,000 could you swallow a $400,000 drop without reacting? Determining your risk tolerance and building your investment plan around it will ensure you see the bigger picture and stick to your plan.

The ultimate stock to bond ratio is one that will help you achieve your financial goals and allow you to stick to your guns as you ride through the inevitable market storms that approach.

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