In the long run stocks outperform bonds and cash. So why not put your entire portfolio into equities? For one, who wants to put all their money into something that can and did drop more than 30% in the course of a year? Remember the crash of 1987, or the internet bust in 2000 or the financial meltdown in 2008? How about the “lost decade”, the first ten years of the current millennium during which large-cap stocks provided no return?
Consider the other end of the spectrum. There are investments in which no one ever lost money, such as FDIC insured bank accounts and U.S. treasury bonds held until maturity. Very safe, but there have been spells during which they failed to keep up with inflation. We save and invest to grow wealth. Who wants to park money in a vehicle practically assured of losing spending power?
To limit potential damage from any single pitfall, you are best served by a mix of stocks and bonds versus an all-or-nothing approach. How much to put into each asset class is the essence and end result of an assessment of your risk tolerance.
You may already know your risk profile. Perhaps you completed a questionnaire online or with a broker. Maybe after decades of investing you know the proportions of stocks and bonds you like to hold. If so, feel free to move on to Chapter 47.
A brief quiz
If you are unclear about your tolerance for investment related risk, consider the following three questions:
Question One: Which of the following statements best describes your view?
1) I do not want to have losses. I do not mind accepting rates of return below the rate of inflation as long as the value of my accounts never decline.
2) I do not like volatility and I certainly do not want to see my account fall over the course of a year, though I would like a chance to earn more than bank CD rates.
3) I want to beat inflation and build up the real value of my account. I hope interest and dividends earned make up for any annual downside risk.
4) I would like a good balance of income and growth. I seek decent appreciation and can accept a slight loss of value in any given quarter or year.
5) I know stocks are the best vehicle for growing wealth. I want to take advantage, but I want to keep some powder dry and have a bond component to reduce potential downward fluctuations.
6) I want my assets to have a chance to earn the highest returns possible. I will probably experience great volatility and spells of huge loss. But in the long run, I trust a 100% stock allocation will serve me best.
Question Two: What is the largest single year loss you would be willing to absorb in an investment without losing faith in that vehicle’s viability and appropriateness for your portfolio?
1) None – I do not want anything that can go down, ever.
2) I could stand a loss of 5% over the course of a year, but not much more.
3) I could take a temporary 10% hit, but I would watch carefully after that.
4) A drop of 15% would sting, but I am in it for the long run.
5) I could lose 20% and not blink. Above that, I may pay more attention.
6) Any temporary loss is fine. Often the greater the risk, the greater the ultimate return.
Question Three: Figure 45-1 displays the average, best and worst annualized returns over the past 50 years of six investment choices. Review how they performed over time. If you had to commit all of your retirement assets to one of these six choices for a full decade, which investment would you select?
Quizzes like this help you determine and quantify your tolerance for risk. For instance, answering ‘1’ to any of the questions above indicates great aversion to risk; answering ‘6’ shows extreme tolerance. Such quantification can lead directly to a logical asset allocation.