Stock Allocation

The term stock allocation sounds rather imposing. In reality, it represents a simple question that we all need to answer: What portion of our portfolio should be in stocks versus other investments?

Why Stocks?

The first question you may be asking is: Why should I have any stocks at all? The Great Depression made a whole generation of investors wary of stocks and the recent housing market bubble has made many of us equally reserved. The short answer is: Stocks have the best historical returns in the long run. Stocks have historically returned an average of about 11% per year, which beats any other investment type.

Stocks represent economic activity and are an asset. So as prices go up with inflation, so should stock values. Also, as companies become more efficient and the economy grows, the stock market as a whole should actually out-pace inflation.

Why Not Stocks?

So if stocks are so great, why not make your portfolio stock-heavy? The simplest answer is that even if stocks are the best investment over time, they can be very volatile. While over a 20-year period you might expect stocks to give you the best returns, they can easily give dismal results over a 2-year period.

In addition, stock numbers are based on a relatively small period of time. Stocks have been reliable since the Great Depression, but that's only been around 70 years. While that may seem like a long time, it's certainly not long enough to declare that stocks are the ultimate no-fail investment.

So What Do I Do?

The basic rule for how much of your savings should be in stocks is that the closer you are to retirement, the smaller your stock portfolio should be. We'll look at some specific methods you can use to allocate your funds, but in general you want to be aware that stocks become a worse option the closer you are to needing your money back.

If you have 30 years until retirement, that gives the market plenty of time to work out its volatility and give you the expected returns. If you only have 5 years to retirement, a bad bear market could wipe out a good portion of your retirement account. The older you are, the more wary you should be of the stock market.

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Anonymous's picture

Rob Bennett wrote:

Mon, 01/10/2011 - 17:14 Comment #: 1

This is the most important question in investing today. The big problem we are having answering it successfully is that many are trying to find a single answer to a question re which there can never be a single answer.

Would anyone say that we should buy cars or vacations or sweaters or comic books without looking at the price? No one says such a thing. But many people say just that when it comes to stocks. Stock valuations rise and fall over time. It is how high valuations are that determines what your long-term return is and how much risk you are taking on. There never can be one stock allocation that would make sense at all price levels.

Stocks were priced in the early 1980s to provide HUGE long-term returns. Most middle-class investors should have been going with a stock allocation of something in the neighborhood of 80 percent. That was the best chance to get truly rich that most of us have ever experienced. Stocks have been selling at insanely dangerous prices from 1996 forward. Most of us should have been limiting our stock allocation to 20 percent or so during that time. It will take us many years or perhaps decades to recover the losses we will end up suffering for having gone with high stock allocations at those price levels.

Investors should be aiming not to keep their stock allocations constant but to keep their risk profiles constant. To keep your risk profile constant, you must be willing to change your stock allocation in response to big price swings. It's true that the average long-term return on stocks is 6.5 percent real (more when you add in inflation). But that is not the number that applied from 1996 forward. In 2000, the most likely going-forward return for stocks was a negative 1 percent real. We all would have been far better off in Treasury Inflation-Protected Securities (TIPS), which were paying 4 percent real at the time. Getting 5 extra point of return every year for 10 years running makes a difference in the long run!

Rob

Anonymous's picture

The Silver Purse wrote:

Mon, 01/10/2011 - 17:19 Comment #: 2

Good reminder that stocks are one of the best places to get growth over the long term. Some people like to use the formula of 110 minus your age for the portion you should have in stocks. Example: 110 - age 35 = 75% of your long term investments should be in stocks.
Here's how to balance risks and rewards http://thesilverpurse.com/Risk-and-Reward

Anonymous's picture

Squirrelers wrote:

Mon, 01/10/2011 - 18:32 Comment #: 3

Age is a big part of asset allocation, no doubt. With recent volatility, many people are just scared of stocks. Frankly, I think it's ok to question the previous conventional wisdom of just pouring money in the stock market and counting on it for retirement. It's just ONE vehicle for savings and investing, not the only source of growth. If preservation of principal is the name of the game, then it might not be the best place for short time horizons.

Personally, I'm ok with being invested in equities as a pretty decent percentage of assets, but this percentage will drop over time. Additionally, investments will get more diversified in my portfolio over time to mitigate risk.

Anonymous's picture

Everything You Need to Know about Stocks | MomVesting wrote:

Thu, 01/19/2012 - 21:47 Comment #: 4

[...] of the most important investment considerations is your stock allocation. Find out what it is and why you should [...]

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