A reader asks:
When I opened a Roth IRA in my early 20s, I went 60/40 because even though I had 40 years ahead of me, a 100% stock portfolio felt reckless. The Scottrade rep who was helping me at the time actually chuckled and tried to steer me into more stocks. I knew the math backed them up, but bonds felt safer. What is the argument that moves the needle for a young investor who understands this intellectually and is even outspoken, but emotionally still can’t pull the trigger on a stock-heavy portfolio?
Another reader asks:
I have been managing my own portfolio for over 30 years. It mostly includes ETFs and a small portion of the stock portfolio for the love of gaming. Throughout my life, I have avoided holding bonds in my portfolio. The cash I occasionally raise is held in money market funds. I’m not as comfortable with bonds as I am with stocks, but the other part is psychological because I’m always thinking about opportunity costs. I’m now approaching retirement and it’s time to partially abandon the stock run and take some of my earnings and put them into bonds. I’m having a really hard time switching to even a 10 percent bond portfolio, and I don’t know where to start or how to stop thinking about the stock market gains I’ll be sacrificing.
We have a young investor in his 20s who is more conservative in nature and invests in a 60/40 portfolio.
We have an older investor fast approaching retirement who is more aggressive in nature and wants to invest 100% in stocks.
On paper, these investors are completely left behind.
As a young investor, your greatest assets are time and human capital. You can’t invest aggressively enough when you have decades to accumulate, invest, and distribute your capital.
As a retiree, your greatest assets are financial assets. You have more to lose. That’s why many investors begin the path of shifting a portion of their portfolio toward more conservative investments as they approach retirement.
On paper, someone with 100 percent in stocks should be young, while someone with a 60/40 portfolio should be retired. This seems suboptimal and even counterintuitive in some ways.
Here’s the thing; Every investor is irrational in some respects. And that’s okay…as long as you understand the trade-offs being made.
You can have a balanced portfolio in your 20s if it helps you sleep at night, but the opportunity cost is the great long-term returns in the stock market.
You can have a 100% stock portfolio in retirement if it helps you sleep at night, but you’re also opening yourself up to the possibility of big losses at inopportune times.
Since 1950, the S&P 500 has experienced:
- -39 declines of 10% or worse.
- -11 declines of 20% or worse.
- -3 declines of 40% or worse.
That’s why some investors need emotional protection. Witnessing your hard-earned life savings lose 40% of their value can be a painful experience.
This is why it is so difficult to have only a stock portfolio in retirement. You don’t have time or future savings to wait out a bear market. If you have a bear market in your early retirement years, selling stocks while they’re down could be a recipe for disaster.
But some people are aware of these risks and still keep all their money in stock.
The truth is that your asset allocation depends on many factors.
There are factors you can measure, such as your goals, expected returns, and volatility characteristics. Some people are more inclined to manage their financial statements through spreadsheets.
But there are also qualitative aspects of investment planning that are harder to define, such as your personality, innate biases, and emotional disposition.
Investing is a form of minimizing regrets. Some people will regret participating in the massive losses and bone-crunching volatility. Others will regret missing out on big gains and will be content to endure the pain and wait.
There is no optimal portfolio unless you understand the trade-offs. In fact, the suboptimal portfolio you can keep is much better than the optimal portfolio you give up. Giving up on your investment strategy is no different than a failed plan.
The final episode of Risk and Reward is titled “The Perfect Portfolio.”
Here is a passage from the book that summarizes my thoughts on these two questions:
You must understand yourself when making financial decisions.
Numbers are important, but emotions are also important.
It doesn’t matter what your portfolio looks like if you can’t control your emotions.
We’ve covered both of these questions in a brand new Compound Ask:
We’ve also covered questions about energy stocks, selling your soul for a job you hate, disagreements with your spouse over portfolio management, and when to raise some money from your stock portfolio.
Further Reading:
Can You Live on Your Dividends?
