Equities provide high returns but are very volatile – their value fluctuates significantly and it can take years to recover after serious declines. To mitigate this risk, investor often combine equities with fixed income – assets that have low volatility but have low returns.
When your portfolio has a portion of fixed income, a serious market decline has a lower impact on your overall portfolio. Example:
- 100k EUR portfolio:100% in equities. When the stock market falls by 50% your portfolio is worth 50k EUR.
- 100k EUR portfolio: 60% in equities, 40% in fixed income. When the stock market falls by 50% (and fixed income does not fluctuate), your portfolio is worth 70k EUR.
A similar (inverse) effect happens when the stock market has a significant increase. Example:
- 100k EUR portfolio: 100% equities. When the stock market increases by 50%, your portfolio is worth 150k EUR.
- 100k EUR portfolio: 60% in equities, 40% in fixed income. When the stock market increases by 50% (and fixed income does not fluctuate), your portfolio is worth 130k EUR.
As these examples show, a substantial part of your returns will be dictated by your allocation of equities/fixed income. Therefore this is one of the most important investment decisions you will make. But which percentages should you allocate between equities and fixed income?
Your allocation should be primarily determined by your risk profile:
- Capacity for risk – How much risk can you take? If you need to have access to your capital in 1 year then you can’t take any risk. Likewise if you are already retired and unable to work, a serious market decline can have a significant impact on your ability to support yourself. Don’t risk money you can’t afford to loose. A young investor often has a higher capacity for risk because he has a an investment horizon long enough to deal with market declines.
- Need for risk – How much risk (and associated returns) do you require? If you already have all the money you need to fulfill your personal/financial goals, why would you risk it? On the other hand, young workers often need the high returns (and their associated risk) in order to be able to grow their savings to meet their retirement needs – a typical savings account won’t be enough.
- Tolerance for risk – How much can the stock market decline before you start loosing sleep? It is really upsetting to loose money you’ve worked hard to save. Taking more risk than you can tolerate can lead to bad decisions in bad times – like selling stocks at the bottom of the market when prices are low.
The changes in these perspectives of risk over a lifetime is what leads most investors to gradually decrease their exposure to stocks as they get older – capacity and need for risk tends to decrease with age, while tolerance for risk is highly personal. Note that if your risk circumstances are different, your allocation should change – an example would be a young investor which receives a windfall large enough to sustain all his retirement expenses, he has a low need for risk.
There are many rules of thumb to decide an allocation based on the risk profile. This is only a starting point because the rules of thumb are general and your circumstances might be different. This is not an exact science and you should be comfortable with making a subjective decision based on incomplete data.
A popular allocation strategy is “Your age in bonds”. That is if you are 30 years old you should have 30% in fixed income and the rest in equities, and increase your fixed income allocation as you get older. A similar rule of thumb is “Your age in bonds minus 10” – if you are 30 years old you should have 20% in fixed income.
I like Rick Ferri’s approach to life cycle investing which divides life into four phases:
- Early Savers – ages 20-39. Investors at the beginning of their careers and investment path. Investors with little assets. Allocation: 80% equities, 20% fixed income. Early investors tend to be inexperienced and as a result overestimate their ability to deal with the market’s volatility. For that reason I recommend having at least 20% in fixed income until you’ve been through a serious market decline and know your true risk tolerance. Additionally an 80/20 allocation historically has had slightly lower returns than 100% stocks with significantly less volatility.
- Mid-Life Accumulators – ages 40-59. Investors which are established in their careers and family and already have assets (e.g. cars, home, investments, etc). Allocation: 60% equities, 40% fixed income.
- New Retirees – ages 60-75. Investors approaching retirement age. In this stage investors stop accumulating wealth and start distributing it for their expenses. Allocation: 50% equities, 50% fixed income
- Mature Retires – ages >75. Fully retired investors. Allocation: 20-40% equities, 80-60% fixed income;
In any of the phases defined above you should increase your allocation to fixed income if you have a lower risk tolerance. The best financial plan is the one you can implement. Your risk tolerance will determine how much discipline you will have to keep executing your plan when the markets disappoint.
If you want to know more about this topic, the Bogleheads wiki has a great write up additional perspectives.