Since we live in a very litigious society, let us get some of the legal stuff out of the way. Every person has a different risk and volatility tolerance. What I write about here may or may not be suitable to you. Please read my disclaimer below.
I believe in a portfolio with 100% stock allocation and I had nearly 100% of my portfolio in stocks for most years since April 2009. I will explain why this is the allocation that most investors should have (but not necessarily you, because I do not know your situation).
Almost every retail investor uses asset allocation, which means that a percentage of the portfolio is allocated to fixed income. As explained in Using Investment Advisors, Investment Advisors (IAs) and the Wealth Management industry tend to put clients into fixed income for the following reasons:
- Clients are deathly scared of volatility. Clients are too myopic, which causes them to panic and sell their stocks when there is a correction or a bear market. They do not understand the risk-reward equation and want to minimize risk even if it means drastically reducing or eliminating reward.
- IAs are deathly afraid of clients, as clients have a pattern of suing IAs when they lose money, even if the money is lost in short-term volatility or bear markets that eventually recover. To minimize the risk of getting sued, IAs allocate a percentage of the portfolio into fixed income to reduce the volatility and the chance of getting sued. If it is federal government bonds, the IAs can always state that these are “risk free” as the government can always print money to repay loans. Yes, there is risk if the interest rate rises as this will cause the price of bonds to drop, but the volatility of fixed income is still generally lower than with stocks. Therefore, part of the reason behind the push into fixed income is for the IAs to cover their rear ends.
The industry tends to use the age as percentage rule. If your age is 40, then 40% of your portfolio should be in fixed income. If your age is 60, then 60% of your portfolio should be fixed income. I will argue (for my wife and I) that 0% of the portfolio should be in fixed income and 100% should be in stocks, even when we are 65 and retired. The following are my beliefs and opinions and not necessarily suitable for your portfolio.
As explained in Top 4 Reasons to Invest in Stocks, stocks outperform almost every asset class, especially fixed income. There is a good reason that stocks outperform. Stocks represent ownership in businesses. Businesses have been producing profits for thousands of years and will likely produce profits for thousands of more years. Stocks are fueled by profit. If a business continues to produce profit, the stock cannot go to zero. If a business continues to accumulate profit, it will continue to rise in value. Here is a simple example: If the world has 10 businesses that sell fruit and they produce $10 of profit every year, then the value of these 10 businesses will go up by $10 per year. If the world keeps consuming fruits, the value of these businesses will continue to rise. Theoretically, the value of the fruit business can rise forever. In my opinion, buying other asset classes such as commodities, which do not produce profits, is not investing. It is speculation because it is difficult to value the asset. You have to predict how the supply and demand curves will change. Whether your prediction will be right or wrong depends more on chance than on skill. Warren Buffett stated:
“In a commodity business, it’s very hard to be smarter than your dumbest competitor.“
Therefore, one can argue that stocks, not necessarily any one particular stock, is one of the safest investments in the world because you can value it.
Stocks can be volatile, much more so than the underlying business. This is because the bi-polar and manic-depressive market causes the volatility. This volatility tends to undervalue and overvalue businesses in the short-term. In the long-term, it always tracks the value of the business. Warren Buffett stated:
“If a business does well, the stock eventually follows.”
“Fear is the foe of the faddist, but the friend of the fundamentalist.”
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.“
Most people are afraid of volatility. However, astute investors take advantage of volatility. That is how they buy stocks at bargain prices. When the market undervalues a business, that is when you should consider buying its stock. When it overvalues, that is when you should consider selling.
As shown in Top 4 Reasons to Invest in Stocks, stocks outperform fixed income despite the 30 year bull market in fixed income and despite the two major bear markets in stocks since 2000.
The worst investment in the world, in my opinion, is fixed income. To me, an investment is not an investment unless it has these two attributes:
Some people like fixed income because the risk is lower. However, the yield on some fixed income investments are so low that it is below inflation. This means that they have a negative real return. There is no risk, but there is no reward either. This is not an investment.
Besides, every chart in the world shows that stocks outperform fixed income in the long run. If one was not myopic and had some logic to know that the market has a high probability to eventually recover after every bear market, because it always had historically, then one would never prefer fixed income over stocks.
One rationale that the industry uses for fixed income is that the investor may not have enough time to recover from a loss. In the U.S. it took less than 6 years for stocks to recover from 2007 to 2013 and 7 years to recover from 2000 to 2007. These are two of the worst bear markets in 74 years. Most people, including retirees, have more than 6 to 7 years to live.
Yes, there will be another bear market. Yes, it might take several years to recover. But if we just had two of the worst bear markets in 74 years, what is the probability that we will have another one as severe? If we do, what is the probability that it will take more than 6 to 7 years to recover?
Once a bear market starts, due to a recession, many investors cannot envision that people will spend or shop again in a few years. They cannot envision stocks recovering in a few years. This is what keeps them in fixed income and prevents their portfolio from performing.
If my wife and I believe that we have another 7 years to live, we’re going to put 100% of our portfolio into stocks. Since life expectancy is at 85 or more years, we will have 100% stock allocation even when we are retired. Why make next to nothing on fixed income when you can make more on stocks, in the long run? The caveat is that you must be able to stay strapped in and know when your stocks are undervalued and that they will eventually be fairly valued by the bi-polar and manic-depressive market. Unless you go to cash at the beginning of a bear market, waiting for the market to recover or to fairly value your stocks can take years.
Warren Buffett has said:
“Risk comes from not knowing what you’re doing.”
“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”
“You shouldn’t own common stocks if a 50 per cent decrease in their value in a short period of time would cause you acute distress.“
As explained in How to beat Hedge Funds and Warren Buffett, I went to mainly cash in March 2008. It is possible, maybe likely, that I will not go to cash before the next bear market. If I do not, then I will ride the market down with my mid to big caps. When I feel that the market is near the bottom, I will switch over to small caps, as small caps rise much faster when coming off the bottom. I’ve had personal experience with this when I bought small caps in April, 2009. So, even if I get caught in the down-draft of a bear market, I will see this as an opportunity, not the end of the world.
See My Portfolio, to see the stocks that I have allocated 100% of my portfolio to.
For many people, picking stocks is too much work. In which case, the next best thing is an ETF that tracks the index.